Algorithmic Trading and its Role in Market Structure

Terry Flanagan

The consequences of Regulation NMS (National Market Structure) continue to be seen years after its adoption, with fragmentation and sourcing of liquidity top of the agenda for all market participants.

“The exchanges have had to become nimbler, more efficient and more competitive as a result of Reg NMS,” said Andrew Brenner, head of MGE Advisors. “NYSE Euronext has three exchanges, as does Nasdaq. So you end up with greater fragmentation, but that also offers a form of creativity and differentiation.”

However, there’s also a downside to fragmentation.

“Fragmentation makes for a more efficient market place, but it can also make it more expensive for the broker-dealer community because they have to connect and route to more venues to ensure that they’re providing best execution to their customers,” said Brenner.

The business case for smart-order routing (SOR) and algorithmic trading is built on the need to source liquidity when it’s scattered across multiple markets.

But the buy side is no more confident that information leakage can be prevented when their order flow is being sliced and diced by computers than it did when it dealt with human traders on the floor.

“We’re beyond SOR when it comes to institutions,” said Brenner. “Institutions would prefer to see a marketplace with fewer venues so they could find liquidity more easily. When I started in this business, you went to a floor specialist who would call around the Street. Now everyone is so fearful of information leakage that they’re unable to find the best price.”

Dan Mathisson, head of U.S. equity trading at Credit Suisse, noted in congressional testimony in December: “Equity market quality has improved markedly over the past two decades, and the competition spurred by the adoption of Regulation ATS and Regulation NMS has benefited the average investors. However, there is still plenty of room for improvement in the market structure.”

The exchanges, Mathisson said, have transitioned to a for-profit model that places them in competition with broker-dealers.

“We believe this new model for the markets has proven itself to be costly to investors, unfair to broker-dealers, and rife with conflicts for the exchanges themselves,” said Mathisson.

Brenner at MGE Advisors added: “Exchanges are trying to look more like broker-dealers, while broker-dealers want the benefits of being an exchange.”

Exchanges now function as broker-dealers in many ways, Mathisson at Credit Suisse said. For example, Nasdaq had announced last May “that they would compete with broker-dealers by selling execution algorithms, which involve significantly more complex technology than simply crossing stock like the Facebook IPO. Complex trading technology like algorithms should be exercised when rolling out these types of programs.”

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