Assessing Market Quality

Terry Flanagan
This entry is part 1 in the series Exchanges Raise the Bar


While market quality remains a hotly debated and widely discussed topic, it is difficult to determine a common definition amongst market participants. At its core, it can be defined generally as that which gives end customers a fair deal.

In recent years in U.S. equities, market quality has come under increasing scrutiny amid perceptions that the prevalence of ultra-short-term trading strategies and a more complex market structure have impaired the transactional experience of pension plans, institutional asset managers and retail investors.

Exchanges have a vested interest in optimizing market quality, as customers that get the price they want in the size they need are more likely to trade on that exchange again. Market quality is a function of a wide range of trading-venue characteristics, so there are a number of ways in which a trading venue can raise the bar on execution.

“We want to bring all types of buyers and sellers together,” said Chuck Mack, Deputy Head of U.S. Equities at Nasdaq. “To achieve this we focus on having a multitude of displayed liquidity, narrow spreads, robust opening and closing auctions, transparency around market functions, and a fair playing field. That is what a market is meant to be.”

Price discovery and price improvement for retail investors are also vital cogs in the market quality wheel, as is stability, which is increasingly important in light of a few well-publicized market disruptions in recent years. “To prevent price dislocations, we have added protections against fat-finger executions, market-spread thresholds and additional protections around the opening auction.” Mack said. “We are also working on ways to expand and increase price improvement for retail investors.”

Regulators are constantly studying the quality of the equity markets. The U.S. Securities and Exchange Commission has stated that no market structure can be ideal for all participants; rather, market structure is a series of tradeoffs where a change that helps one group may hinder another. In light of the inevitable tradeoffs, SEC Commissioner Luis Aguilar outlined an approach for policy makers in a speech this past May.

Chuck Mack, Nasdaq

Chuck Mack, Nasdaq

In summary, Aguilar asserted that the first priority in creating market structure should go to investors and issuers who utilize equity markets to meet economic goals, followed by those seeking to maximize public benefits from highly liquid markets. After that, market makers and dealers who support markets by providing the liquidity that enables economic goals and public benefits should be considered.

“Finally, the Commission’s policies should generally disfavor the interests of traders that seek to take unfair advantage of other traders,” Aguilar said, while noting that a nuanced analysis is sometimes required to assess costs and benefits.

In the view of Matt Samelson, Chief Executive Officer and Director of equities at consultancy Woodbine Associates, market quality can be defined as “the ability to get your orders done subject to your best-execution requirements.”

“You’re looking for a venue that brings a buyer and seller together in a way to transact in a fair manner,” Samelson added.

In the $20 trillion U.S. equity market, quality will not be uniform throughout. Much of the gradation corresponds with capitalization — investors generally have no trouble buying or selling Apple, Google or General Motors at the displayed price, but the risk of an inefficient execution rises as you move through the mid- and small-cap stocks.

“In most instances with larger-capitalized securities, we have an efficient market, which gives these companies confidence to go out and issue equity and raise capital,” Samelson said. “Certainly, there are more challenges with smaller-capitalized, less-liquid securities.”

Even when liquidity is ample, there are issues that infringe upon market quality, “Fragmentation is a problem, and the disjointed way in which orders have to work to meet regulatory requirements is not good,” Samelson said. “These are things that apply to securities regardless of their capitalization.”

Samelson observed that, overall “the market is not without its problems, but market quality is good overall.”

Nasdaq’s Mack said the mission is to help the end investor, which for an exchange can be challenging because investors are often not direct members of exchanges. Instead these investors are customers of broker-dealers who access the market on their behalf.

Featured image by Rawpixel.com

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