Mary Jo addresses the oxymoron October 4, 2013 at 11:06 pm

From SEC chair, Mary Jo White:

Equity exchanges today operate fully electronic, high-speed trading systems using a business model that mostly was developed by electronic communications networks, or ECNs… Exchanges differ from ECNs, however, in significant respects. Exchanges, for example, continue to exercise self-regulatory functions, even as they operate as for-profit entities.

This model for exchanges has encountered challenges. As I noted earlier, for example, the “lit” exchanges no longer attract even one-half of long-term investor orders.

From time to time, equity exchanges have adopted trading models that use different fee structures or attempt to focus on different priorities, such as order size or retail investor participation. These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.

As is true for all important aspects of our current market structure, the current nature of exchange competition and the self-regulatory model should be fully evaluated in light of the evolving market structure and trading practices. This evaluation should include whether the current exchange regulatory structure continues to meet the needs of investors and public companies. Does it provide sufficient flexibility for exchanges to implement transparent trading models that can effectively compete for investor orders? Does the current approach to self-regulation limit or support exchange trading models?

This evaluation should also assess how trading venues can better balance their commercial incentives and regulatory responsibilities. For example, is there an appropriate balance for exchanges in key areas, such as the maintenance of critical market infrastructure? And are off-exchange venues subject to appropriate regulatory requirements for the types of business they today conduct?

I have in the past, probably unkindly, described the self regulatory model for US exchanges as oxymoronic. What is true, hyperbole aside, is that it is hard to be both a for profit exchange and a regulator of the market you provide, especially as execution mechanisms evolve in ways that potentially advantage one class of market user above another. It is really nice to see the SEC’s chair acknowledging this issue.

One Response to “Mary Jo addresses the oxymoron”

  1. Off-exchange volume is primarily driven by tick sizes being too large for most liquid stocks. When market makers consistently quote one tick wide it acts as a price floor on the cost of liquidity (bid-ask spread essentially being the price for instant liquidity at marginal size). Lit exchanges must quote in penny increments, but dark pools do not. Many times smart order routers will preferentially hit dark pools over exchanges to get better fills.

    Similar logic applies to internalization. With Reg NMS internalizers need to match NBBO. If Microsoft trades at bid-ask $26.67-26.68, but with tenth penny tick sizes it would probably trade closer to $26.673-26.675. Consequently NBBO is wider due to wide tick sizes, meaning that consumer protection from Reg NMS is weaker. A firm like GETCO can have its internal models tell it to bid at $26.674, fill a retail order at $26.67, pay $.002 to the broker to pay for order flow and net $0.002. But in the narrow tick scenario, after paying NBBO at $26.673 it wouldn’t be profitable for GETCO to internalize.

    I’d suggest reducing tick size to $0.001 for all liquid stocks. End consumers would end up paying less due to lower spreads. More volume would move back to lit exchanges. Speed to get in front of queues would matter less for HFTs relative to better pricing models. Many of the strange exchange rebate and order types (which are mainly just economic kludges to approximate narrower tick sizes) would go away.

    To be fair, you’d probably see higher liquidity costs for large orders. The queue system encourages liquidity providers to build up huge size to hold their advantaged position. More competition on the order of price instead of time priority would mean cheaper to trade small size, but higher price impact on large size. I’d argue that this is still a good thing, large orders are usually more informed than small orders, so they should feel higher market impact. The more efficient the market the more informed orders move price relative to uninformed orders.