Market Structure Changes Assessed

Terry Flanagan

Changes in equity market structure created by regulations and technology have resulted in tighter bid/ask spreads and improved order execution, while ushering in the era of high frequency trading.

These themes were explored this week at a congressional hearing held in New York on Monday.

Under Regulation NMS (National Market System), which took effect in 2007, exchanges are required to handle electronic order instantaneously or else be branded a “slow market” that could legally be traded through, or ignored, by other market participants.

Since under Reg NMS, displayed quotes could no longer be ignored, new ECNs, such as BATS and Direct Edge, were formed as consortiums by the broker-dealer community, and they aggressively gathered liquidity, and the NYSE’s market share dropped precipitously.

“Reg NMS was created to address the disparity between traditional floor-based exchanges and newer electronic exchanges,” said Matt Andresen, co-CEO of Headlands Technologies, which develops and implements quantitative trading strategies in exchange-traded financial products. “In electronic markets, a displayed price is available to everyone, whereas in the floor-based model, price discovery was based on private negotiation. Reg NMS forced human-driven markets to become electronic.”

Dan Mathisson, Credit Suisse

Dan Mathisson, Credit Suisse

This has resulted in more liquid markets, while at the same time creating displacement within the securities industry by putting floor brokers and specialists out of work while creating new jobs for quantitative traders and technologists as algo trading desks, ECNs, and high-frequency trading thrived under the new rules.

The flip side is that the number of trading venues has increased, which also the number of self-regulatory organizations (SROs), each with its own set of rules.

“Unfortunately, NMS has led to increased complexity,” Andresen said. “Once you have electronically accessible pries, anyone can differentiate. So what should have made interactions between exchanges simpler has in fact made them more complex.”

The current equity market structure can be traced to 1997, when the SEC’s order-handling rules designated computerized trading platforms such as Instinet as electronic communication networks (ECNs). Under the new rules, ECNs would be electronic market makers, and would publish their quotes on the publicly displayed markets.

Within a few years of the order-handling rules, more than 10 new ECNs had entered the market, competing on price, speed, and reliability.

This was followed by decimalization, which began the trend toward order slicing, tiny print sizes, and algorithmic trading, and Reg NMS.

The new regulation produced the intended consequence of providing the public with access to quotes provided by ECNs. It also produced an unintended consequence: with ECNs forced to publish their quotes, best execution requirements made it impossible for brokers to ignore them. As a result, ECNs were able to siphon market share away from the listed markets.

“Overall, the U.S. markets are the best in world,” said Dan Mathisson, managing director and head of Advanced Execution Services (AES) at Credit Suisse Group. “A large variety of empirical data shows that the U.S. market is the most liquid, with half of the world’s market cap.”

The SEC published a concept release on equity market structure in 2010, which has been followed by a succession of widely-publicized instances of market failures.

“Arguably there’s a lot of operational risk,” Mathisson said. “The Facebook and Bats IPOs, and the Knight trading debacle have left the impression that the system is fragile. The operational problems are due to the fact that we have complex market structure and it involves a lot of technology.”

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