The US Securities and Exchange Commission has spent more than 32 years trying to follow Congress’s order to use modern technology to ‘facilitate’ the development of a ‘national market system’. I have been a student of their efforts since the law was passed in 1975. This is my latest opinion of where the national market system is now.
The Commission’s most recent attempt has been the final implementation of ‘Regulation NMS’. It has been almost fully implemented, but unfortunately it is still far apart from the system envisioned by the lawmakers, almost all of them long gone from Washington as a result of retirement or death.
What has happened is that the Commission has misused technology throughout the three-plus decades they have been trying to implement a national market system. Instead of building a central market, they have used their regulatory power to build a market that is unfortunately even more fragmented than it was in 1975.
Initially the SEC had the right plan. They advocated a system in which all bids and offers in each security would be able to interact, with the best bid and best offer, first entered, being executed ahead of other bids and offer at the same prices or inferior prices. This was termed a ‘CLOB’, for ‘Composite Limit Order Book’.
For three years after the legislation was passed – from 1976 through 1978 – the direction was clear and simple. In its Exchange Act Release No. 14,416 of January 1978 the SEC stated:
The Commission urges the self-regulatory organisations to prepare and submit to the Commission, preferably jointly, a plan or plans no later than September 30, 1978, contemplating the design, construction and operation of a Central File [another name for a CLOB]. However, should voluntary cooperation among such organisations to that end prove difficult, or involve undue delay, the Commission intends to commence rulemaking to consider the manner and timing of compulsory development of a Central File (including the question of whether that task should be assigned principally to a single self-regulatory organisation. [Emphasis added.]
But in 1979, thanks to intensive lobbying efforts by the New York Stock Exchange (NYSE) and other market professionals to preserve the status quo, the SEC suddenly reversed course and mandated a trio of unconnected systems to be, as the Commission put it, the ‘cornerstones’ of the national market system. That reversal sealed the unconscionable delay in introducing a true national market system, at least for the rest of the 20th century. In April 1979 the SEC stated:
Most other self-regulatory organisations opposed creation of a Central File as described in the January Statement. These commentators argued that the kind of priority proposed to be afforded public limit orders entered into the Central File would have significant and deleterious effects on the exchange trading process. In essence, these commentators asserted that such a preference for public limit orders would provide a major trading advantage to those orders, thereby creating a disincentive to the commitment of market making capital by dealers, and would eventually lead to the elimination of exchange trading floors by inexorably forcing all trading into a fully automated trading system. In addition, several self-regulatory organisations suggested that, in lieu of the immediate implementation of a Central File, the Commission should permit the participants in the Intermarket Trading System sufficient time to attempt to provide limit order protection on an inter-market basis using the ITS. Specifically, the New York Stock Exchange, Inc. and the MSE submitted proposals which envisioned the electronic dissemination and display of limit order information from each market center and use of the ITS to assure inter-market price protection of displayed limit orders in any market.
Not everyone was pleased with ITS. The President of Merrill Lynch, William Schreyer, testified under oath before two House Subcommittees in 1979 that “it [ITS] is as far from the concept of an automated, efficient marketplace as a Tom-Tom is from a communications satellite.” Although ITS still remains, it is almost moribund.
Instead, the Commission has spent the last three decades issuing Exchange Act Release after Release, trying to implement their version of the establishment of a national market system. Every year there has been at least one change, often amending the previous version.
Until very recently, it has been consistent in only one feature: Competition must also have unfettered competition on the place to trade, rather than solely on the price at which a trade occurs.
The Commission finally realises that price – not place – is paramount. However, it still holds to the notion that the place where a trade occurs is equally important. As a result, the notion that best bid, first entered, always meets best offer, first entered, has still not been implemented. Only the highest bid and lowest offer at a moment in time – whenever and wherever entered – is supposedly assured.
Now the latest iteration of Regulation NMS is being implemented. The result is that there are now estimated to be as many as 40 different venues – exchanges, ECNs, ATSs, ‘dark pools of liquidity’ (created mostly by hedge funds), and internal crossing systems – trading the same securities at the same time. There are no guarantees that investors’ bids and offers will always be sent first to the venue that has the best price first entered, with the lowest transaction charge. If a large order that needs to be executed at more than a single price is entered, there is no guarantee that executions at inferior prices will always be at the best prices that exist at the time the additional executions occur. And many professionals who enter orders may not have access to all of the 40 or more venues. Traders must ‘surf’ as many of the 40 venues as they can seriatim, starting with the professional’s preferred starting venue (whether or not that venue has the best price), rather than automatically accessing the venue with the best price at that moment.
Many investors are not happy with this version of the SEC’s system. Neither are a number of the trading venues.
Here is a view from the buy-side investors:
Michael Plunkett, president of North America for Instinet, which has partnered in a dark pool with Credit Suisse, Fidelity, NYFIX Millennium, Liquidnet H20, and the International Securities Exchange, sees reciprocal access increasing.
“If you speak to the institutional clients and buy-side clients, one of their primary concerns, which will increase over time, is this new version of fragmentation,” he says. From the buy-side perspective, a time will come when the efficiency of dark pools will no longer pay for itself because there are too many to check. “No one wants to have five front ends – they want to be able to enter the order once,” he says.
“From the buy-side perspective, a time will come when the efficiency of dark pools will no longer pay for itself because there are too many to check. No one wants to have five front ends – they want to be able to enter the order once,” he says.
Investment Dealers Digest: Dark Pools Evolve, Elizabeth Trotta, 9 April 2007.
Even the Commission has concerns about the success of their new system.
In a letter written the last business day before Reg NMS’s implementation on 5 March 2007, Erik Sirri, the SEC’s Director of Market Regulation, written cautioned that unexpected volumes of data or other problems may cause the ‘best price execution’ rule of Reg NMS to become suspended:
As a supplement to individual use of the self-help exception during the Trading Phase, if market-wide problems arise, the Commission staff intends to consult with the self-regulatory organisations to assess whether these systems problems are so serious that an industry-wide exception should be triggered under Rule 611(b)(1). Staff particularly will consult on this matter with the NASD, as the primary self-regulatory authority with responsibilities for broker-dealers participating in multiple markets. When appropriate, either the Commission or NASD will issue a public notice that the equity markets are experiencing conditions that appropriately trigger an industry-wide use of the self-help exception. This industry-wide exception would effectively suspend operation of all trade-through provisions. For example, it would allow all trading centers and order routers to execute trades and route ISOs without regard to the protected quotations displayed at any particular time. The exception would continue for the time period specified in the notice. [Emphasis added.]
Automated execution is a big part of the SEC’s proposal. Its salutary effects already have been widely reported in the national and trade press. It has already caused major changes on the NYSE.
For example, in a news release by Bloomberg on 29 March 2007, the following reductions in floor personnel were cited:
UBS AG, Europe's biggest bank by assets, is cutting 23 jobs from its 30-member staff at the New York Stock Exchange, joining a growing list of firms that are relying more on computers instead of floor traders.
UBS follows Lehman Brothers Holdings Inc., Bank of America Corp., Credit Suisse Group and Van der Moolen Holding NV in cutting the number of jobs on the stock exchange floor.
Van der Moolen, the fourth-largest market maker at the NYSE, said in January that it would eliminate about 55 jobs, reducing its staff to 135 and saving $4.5 million a year. Bank of America's specialist unit is cutting 100 jobs and Credit Suisse Group, the second-biggest Swiss bank after UBS, reduced its staff at the NYSE by almost a third to 20 people.
The NYSE in January automated trading in a final group of stocks included in its Hybrid Market, capping a three-month drive to enable faster trading in 3,627 of its listed securities. About 91 percent of trades were executed automatically in three-tenths of a second after the Hybrid market was introduced, compared with an average of 9 seconds before.
Lloyd Blankfein, Goldman's [Goldman Sachs] chairman and chief executive officer, told investors in November that the firm's equities revenue was higher than in 2000 even though the number of people employed in the unit was cut in half.
In addition, a trade publication very familiar with electronic trading systems, Global Investment Technology, predicted in their 2 April 2007 issue that continued implementation of Reg NMS would cause a ‘Data Tsunami’ because of the increased amount of quotes, cancellations of orders and transactions. In that article, forecasters predicted that by October 2007 there would be a quadrupling of data volumes. This would require either a significant slowdown or failure of the market process.
What is likely to happen? Rumours abound: the specialists will be completely replaced by electronic market makers; one or more major firms will cease buying NYSE trading licenses; only a single trading licence will be needed for any firm to have access to the NYSE, regardless of how many branches they may have; he hybrid market will disappear; the ECN and ATS venues will eat the exchanges’ lunch.
The NYSE has been brilliant in its business plan during the past three years. First its CEO, John Thain, came up with the idea of buying the Arca ECN, an electronic execution system using price-time priority for executions, and merging it with the NYSE. Although many of the members (who collectively were the ‘owners’ of the NYSE) argued loudly and passionately that the decision to divide the merged firm 70-30, with Arca shareholders receiving the 30 percent, was far too generous, hindsight now confirms that much of the value added by the merger came almost entirely from Arca, since automated executions finally arrived at 11 Wall Street after more than 200 years. Late in 2006 the NYSE allowed automatic execution on the floor in addition to permitting floor brokers and specialists to trade manually if their clients chose.
It came as no surprise when nearly all trading executions became electronic, and many floor traders and their clerks (like the fabled rodents on ships) headed for the exits.
The combination of greatly increased data requirements and the overwhelming use of automated executions has started tolling the death knell for the world’s formerly largest stock trading floor, which is being made redundant daily.
My prediction: All NYSE executions will become electronic within the next year. (For the sake of full disclosure I must confess that I made a similar prediction in 1976 when my colleagues – Morris Mendelson of the Wharton School and R. T. Williams, my fellow consultant – and I proposed a fully-electronic price-time priority auction trading system to the SEC’s National Market Advisory Board. Our proposal also included decimal pricing and anonymity for all orders entered. We were roundly vilified by the Wall Street establishment for such a preposterous idea.)
Whether the NYSE will wind up as the trading location winner is not clear at this point. Although the exchange has won many advantages from the SEC for the trading licensees that use their combined hybrid system, the number of specialists and floor brokers has been cut back severely, as noted earlier, and healthy profit margins have been turning into red figures. The recent merger of NYSE Group with the European exchange, Euronext, adds a new and untested dimension to the trading system landscape.
The ECNs – and other electronic execution system such as the Nasdaq exchange – have been eroding the share of NYSE-listed securities traded by the NYSE-Arca combination to less than two-thirds of the total volume, as compared with 85%-plus for the NYSE alone a few years ago.
A system that requires 40 or more choices of where first to enter a bid or offer, and then specifying the sequence of venues if the first one does not have the best price, does not seem to be a long term viable solution.
A real central market – a CLOB – would be far less costly, simpler and more efficient, and would create the type of national market system the Congress and the SEC wanted in the 1970s. The factors preventing implementation of that solution are the enormous sums of money that have been invested in the existing system, and the perceived economic self-interest of the market professionals – trading venues and broker-dealers. As usual, politics will trump efficiency and investors will be saddled with the extra costs.
Market structure during the next year or two will dramatically change the face of securities trading. Stay tuned!
Parts of this article were first included in a paper delivered at the Brooklyn Law School.
