01.29.2015
By Terry Flanagan

Focus on Market Structure

A continuing debate over modern market structure has been underway for at least two decades, since electronic trading began to supplant floor-based traders. Recent recommendations advanced by exchanges such as IntercontinentalExchange and Bats Global Markets are geared to undoing some or all of Regulation National Market Structure, which is now ten years old.

“There have been lots of ideas thrown out, and I think these are ideas that, at least to my ear, have been debated in one manner or the other since at least 1997,” said Matt Andresen, co-CEO of Headlands Technologies and founder of Island, one of the original ECNs (Electronic Communications Networks). “The best possible policy goal is to have a nimble, non-rigid regulatory environment where innovation from markets can be brought without crippling anybody else’s market.”

Andresen has been appointed to a new committee on equity market structure set up by the U.S. Securities and Exchange Commission to review Reg NMS, the role of exchanges in the current market structure, and the presence and effect of conflicts in the routing and execution of equity orders.

“The right way to approach this from a policy perspective is to look at what is in Reg NMS, what the intent was, what the result has been, and then what changes are now necessary,” he said. “That process should be data-driven.”

Matt Andresen, Headlands Technologies

Matt Andresen, Headlands Technologies

Not everyone is on board with the SEC’s approach, believing that market-structure change should be generated by the industry, not by regulators.

“This concept of the holistic review has been advocated on behalf of folks that would prefer the status quo as opposed to any change,” said Adam Sussman, head of market structure and liquidity partnerships at Liquidnet. “That’s going to go by the wayside, and we are going to see some movement on behalf of the exchanges trying to take a market-based solution approach to what they see. The alternative would be a regulatory response which probably would be sub-optimal compared to any of the proposals that have been floated.”

One of the hallmarks of Reg NMS was preventing exchanges from ignoring, or “trading through,” orders from another exchange that were electronically accessible and had a better price. “Reg NMS said you can’t have a protected quote if you’re not accessible. That’s something that as a concept and a principle is essential,” said Andresen. “It is a leap, however, to go from that to making it incumbent upon every marketplace, before they can do anything, to check every other marketplace’s price, and then make their matching engine dependent upon another market’s matching engine. That is something that deserves closer examination.”

The SEC panel will tackle some of the thornier issues of market structure. “There’s been a lot of advancements in equity market structure over the last 20 years,” said Andresen. “The original regulatory changes that fostered these changes really can be traced back to 1997, and those, in turn, can be traced back to some of the regulatory problems that existed in the marketplace up to that point.”

As CEO of Island, Andresen helped to kick start the ‘electronification’ of the markets. “Island was most successful of the original electronic stock markets,” he said. “But at the time Island launched in 1997, Nasdaq was a dealer-driven market and the NYSE was a specialist-driven market, and you had a lot of problems with people getting access to the marketplace. You had no ability to display limit orders in the marketplace.”

This resulted in order handling rules, followed by Reg ATS, and then Reg NMS. The net effect has been an extreme tightening of the spread, so that the difference between the bid and the offer prices for the most liquid names has collapsed. Another result is that speed of execution has plummeted from seconds to even minutes, down to basically being instantaneous for investors.

“The broad theme here is that the markets have gone from dealer and specialist-driven markets to now being order-driven markets. They’re immediately and electronically accessible,” said Andresen. “Those are good things. There has, however, been some knock-on effects to this which deserve some thought.”

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