In 1992, Francis Fukuyama published his famous panegyric to the historical inevitability of market democracy: The End of History and the Last Man. In 2004, the Securities and Exchange Commission and the European Union brought Fukuyama to the markets, effectively declaring the evolution of trading systems over.
The SEC's 'Reg NMS' proposal has at its heart a market-wide extension of the 'trade-through rule', which enshrines two fundamental principles of Just Trading: expressions of interest to trade should be published and ranked by price and time, and orders executing against them should obey this ranking irrespective of the wishes of the traders placing them. The EU's Markets in Financial Instruments Directive (MiFID) enshrines only the first of these principles through the Article 27 and 44 'pre-trade transparency' rules, but there can be little doubt that the second principle will eventually be mandated in train.
The significant feature which they share in common is that both describe a single market structure and a single method of trading in which eligible limit orders must be displayed and in which market orders have no discretion. These are the essential attributes of the continuous electronic auction market - the market structure that swept the globe in the 1990s. Bids and offers are ranked by price and time and posted for all and sundry to see, and can then be hit or taken instantaneously in strict accordance with the ranking.
So where does Fukuyama come in? Consider this summary of The End of History and the Last Man from the Library Journal, posted on Amazon.com:
"Fukuyama argues that there is a positive direction to current history, demonstrated by the collapse of authoritarian regimes of right and left and their replacement (in many but not all cases) by liberal governments. 'A true global culture has emerged, centering around technologically driven economic growth and the capitalist social relations necessary to produce and sustain it.' In the absence of viable alternatives to liberalism, history, conceived of as the clash of political ideologies, is at an end. We face instead the question of how to forge a rational global order that can accommodate humanity's restless desire for recognition without a return to chaos."
Fukuyama market reg, The End of History and the Last Trading System, can be summarised identically, with only the key subjects and objects changed:
"The SEC and the European Commission argue that there is a positive direction to current history, demonstrated by the collapse of the floor auctions and dealer markets of Chicago and London and their replacement (in many but not all cases) by automated limit order books. 'A true global trading culture has emerged, centering around technologically driven trading growth and the capitalist social relations necessary to produce and sustain it.' In the absence of viable alternatives to automated limit order books, history, conceived of as the clash of market structures, is at an end. We face instead the question of how to forge a rational global order that can accommodate humanity's restless desire for trading without a return to fragmentation."
There can be no doubt that thinking about 'the right' market structure at the SEC and the European Commission has been profoundly shaped by the proliferation of continuous electronic auction market systems, operated both on and off exchanges, over the course of the last decade. The Nasdaq and London dealer market structures were buried once and for all in 1997, and floor auctions in the derivatives markets have been driven to near extinction by Eurex and others. It should not be surprising, therefore, that regulators have adapted their conception of what 'good trading' looks like accordingly.
The problem is that continuous electronic auction markets, as useful as they are, have flaws that are apparent to any institutional trader. They require institutional-sized orders to be chopped up into small bits, each often as little as 1% of actual order size, and executed over days or weeks in order to avoid huge market impact costs. That's why in every major US or European marketplace - New York, Nasdaq, London, Frankfurt, Paris - about 30% of trading volume is executed in blocks, 'upstairs', away from these systems.
More importantly, new electronic systems are expanding to make this block trading more efficient. Liquidnet is the most prominent example. By foreswearing limit-order display, or 'pre-trade transparency', in favour of a structure in which potential matches are revealed only to the relevant buyer and seller, institutions are encouraged to reveal their true order size to the system.
What does this imply for market regulation?
First, mandating pre-trade transparency undermines the usefulness of post-trade transparency. Since only small orders match in a continuous electronic auction market, a trade going off for a few hundred shares tells the market nothing about the current true market price for a stock. After all, whereas the buyer of 800 shares may only want 800, the seller of 800 shares may actually want to sell 800,000, in which case the true market price of the stock is almost certainly less than the price at which this trade takes place. Liquidnet, on the other hand, generates much larger trades, and its trade prices are therefore far more valid indications of true market prices.
Second, by assuming that continuous electronic auction markets are the end-of-history trading system, and hardwiring their limitations as well as their benefits across all marketplaces via regulation, regulators are shutting down the impulse to innovation that will generate the next generation of trading systems to fix the flaws of the current generation. In that sense, it will truly be a tragic mistake for a trade-through rule or an MiFID to regulate a Liquidnet out of existence, or force it to morph into something far less efficient, since what's at stake is far greater than the future of a clever trading system. It's the very capacity of the market to generate new ways to address old problems that are still very much with us.
The end of history is a long way away. Now is not the time for Fukuyama market reg.
