Below is Joe Ratterman’s commentary on yesterday’s issues in the US market. In the document he urges market centers to work together to address key issues and also suggests that the NYSE’s LRP program hurts the market, instead of helping it, as NYSE executives suggest.
Dear BATS Customers and Members of the Trading Community,
* Volatility sets the stage.
Global and domestic issues helped set the stage for yesterday’s events.
* Differences in behavior between US market centers.
The differences in order handling employed by US market centers must be addressed.
The NYSE’s slower mode may hamper the broader market.
* Cooperation among market centers is the key.
All market centers need to work collectively to find and implement consistent solutions.
VOLATILITY SETS THE STAGE
As with other exchanges and market centers, our operations team was busy late into the night cleaning up the mess left behind from yesterday’s market action. Trade breaks have been processed and the clearing process across the markets will be chaotic this morning, but market participants will make their way through it all and trading should be mostly back to normal Friday.
The search is on for clues and evidence around what might have caused the dramatic drop in the major indices and selected stocks around 2:30pm ET yesterday. Global debt worries, a volcano in Iceland, Senate investigations, looming financial regulatory reform, and an oil slick in the Gulf are weighing on the collective minds of all market participants. Volatility is on the rise again, and that provided at least some of the backdrop for Thursday afternoon. Whether human error, run-away algorithms, or more likely a combination of factors, it’s too early yet to know exactly the root cause of the events that sent market indices over a cliff Thursday afternoon. Just as interesting as what the root cause turns out to be, at least to me, is examining how the markets behaved once the momentum picked up . Why did the market fall so far and so fast? And why did it rebound so quickly?
It wasn’t an issue of capacity – today’s market centers have ample capacity to handle high volume and trading activity. The US market centers have all upgraded their systems since October 12, 2008, when the US markets handled over 20 billion shares in a single day. That was the biggest day in US history. Thursday was the 2nd biggest day in US history at just over 19 billion shares, which were handled easily. It wasn’t an issue of technology system failures either – all market centers were fully operational, accepting and processing customer orders throughout the afternoon.
DIFFERENCES IN BEHAVIOR BETWEEN US MARKET CENTERS
It might have simply been a matter of differences in behavior between different market centers in the face of a runaway market. Differences that, on their own, might each provide a framework for mitigating the emotions of the markets. But when acting alone, apart from each other, these differences might prove to be a big part of the very problem they are trying to handle.
In several respects the different US market centers, including exchanges, ECNs, and dark pools, are well connected. The linkages between the markets themselves, and the linkages between trading participants and the markets, are highly resilient. It’s a well-developed, self-healing, active network that enables trading to continue almost uninterrupted even when one or more individual components are having issues. Trading simply migrates towards the markets that are healthy and where the best prices reside.
This is one of the biggest advantages of the current US national market system. It affords continuity and competitive price formation that yield benefits for every investor. Even during the financial crisis of 2008 and 2009, the US stock markets remained open and active, providing liquidity and price information to investors when they needed it most.
While the US markets are well connected, the way in which each market behaves and the rules they operate under are different. Often the differences are good for investors. Competition among market centers has spurred innovation in order types and routing strategies, and has allowed for varying approaches to order handling and order prioritization. Investors and trading firms are able to choose where their orders will be best served, and often times the wide range of variances in market behaviors ends up solving just as wide a range of trading and investment needs. Bottom line, one size doesn’t fit all. The US national market system is complex and robust, and the benefits that stem from the current structure are realized by retail and institutional investors alike.
There are times, however, when differences in behavior are not good for the market or the investors. This Thursday may have been one of those times.
An area of significant order handling difference between the market centers has to do with what happens during run-away markets. This is probably the one area of the US national market system that needs the most work currently. The good news is, there are at least two areas where US exchanges do behave the same with regards to run-away markets.
The first has to do with broad market sell-offs, where the major indices might reach exaggerated new lows within a single trading day. Market wide circuit breakers were implemented following the crash of 1987, providing for a temporary time-out in ALL trading of ALL securities when the Dow Jones Industrial Average falls by a predetermined amount by certain times of the day. The exchanges will all halt trading at the same time in a coordinated fashion if/when these broad market triggers are hit. It’s a good mechanism to have in place, but the levels at which the triggers will be activated are so extensive as to be nearly out of reach. Even Thursday’s short lived 900+ point plunge didn’t activate a market wide trigger.
The second way in which markets cooperate in runaway markets has to do with newly implemented clearly erroneous trade handling rules. The ways in which each exchange handles one-off trade exceptions is now synchronized between the exchanges. When trading participants determine that a trade might have been executed in error, they can file a request for review with the exchange where the trade occurred. Regardless of where they file, the handling of their request will be the same. When a trade occurs across multiple market centers, the trading participant can count on consistent handling of the various components of the trade at each execution venue.
Unfortunately there are ways in which the markets are not synchronized in their response to run-away markets, and one of those differences may have in fact made matters worse on Thursday. This is an area that I have commented on in the past, and one that needs focus and synchronization across exchanges and market centers soon.
THE NYSE LRP – NOT A GOOD IDEA IN ISOLATION
For example, the NYSE floor market model has evolved over hundreds of years and provides a unique structure distinct from other markets in the US. It has evolved from a time when the NYSE floor handled a vast majority of all trading activity in NYSE listed securities. They promote, through their floor model, a combination of automation and human interaction as a way of bringing calm and order to daily trading activity. They promise a dampening of volatility based on human intervention in times of chaos.
The NYSE floor model may have worked in the past, when they were the dominant player in their own listed securities. When the vast majority of volume ran across the NYSE floor, the promises of their unique market model might have been possible.
Today, however, when the NYSE floor regularly accounts for only 20% to 25% of the volume each day in their own listings, its promise of human interaction to dampen volatility during periods of market stress doesn’t serve the broader market and possibly worsens volatility. The specific market structure at issue is the NYSE Liquidity Replenishment Points (LRP).
When an LRP is hit, on a stock by stock basis, the NYSE floor market model effectively calls for a break, or a cooling off period for that stock to let the emotions of the trading community calm down. It’s not a long break, maybe only 30 to 60 seconds. The NYSE’s liquidity is still technically available. However, because the NYSE goes into a slow, or “manual” mode, other market participants necessarily disregard the NYSE quotes, functionally rendering the NYSE irrelevant while it is in this mode. This means that all of the NYSE’s good liquidity that was previously available for that stock on the floor of the NYSE becomes generally unavailable to the broader market.
COOPERATION AMONG MARKET CENTERS IS THE KEY
It’s in our power as US registered exchanges to communicate and cooperate on this topic, and to put in place consistent order handling rules that might work to dampen run-away markets. But the functionality must work properly in a fragmented and distributed market place, and that implies consistency in behavior among different market centers. Functionality at one market center that detracts from an overall orderly market should be analyzed closely, and turning off that functionality as a matter of promoting overall market health should be considered.
While BATS believes the differences between markets serve investors well during normal times, during periods of extreme market conditions such as those experienced yesterday, BATS believes there needs to be a coordinated approach between the markets to implement consistent procedures so that our differences in behavior work to keep markets orderly as opposed to potentially exacerbating volatile periods.
There may be other ways to maintain order in the markets, during both normal and volatile times. For example, BATS implemented the concept of a Market Order Collar on our exchange several years ago. This functionality works to keep un-priced market orders from bleeding excessively through the market. Market orders received by the BATS Exchange are immediately converted into priced limit orders at the greater of $0.50 or 5% of the inside market.
This functionality keeps market orders that might otherwise execute at prices significantly inferior to the national best bid/offer contained within a tight range. Market orders for low volume stocks at competing markets can easily trade through several price levels until the full size of the order is filled, often resulting in executed prices far away from the normal trading range in that stock. This is just one of many solutions that could be implemented at all markets to help bring calm and order to an otherwise chaotic trading environment.
In any event, it’s not enough to say “my solution works on my market and I don’t care what anybody else does”. The responsible approach is to work cooperatively to develop and implement industry-wide solutions. BATS plans to raise this as a critical issue with our peers and with the SEC immediately. As always, your comments and feedback are welcome.
Sincerely,
Joe Ratterman
Chairman, President and CEO
BATS … Making Markets Better
