S.E.C.’s Review of Stock Trading Will See Some of Its Own Work

There are now at least 58 stock exchanges in the United States, many of them dark pools where the trades can be made anonymously. With institutional investors claiming they are outgunned by high-frequency traders, and individual investors adrift in fragmented markets, it’s no wonder that Mary Jo White, the new head of the Securities and Exchange Commission, is moving to review and overhaul how stocks are traded. The issue is that the S.E.C. may have created the problem it is now hoping to solve.

The world used to be much simpler.

When a share of stock was traded, it was typically traded on either the Nasdaq stock market or the New York Stock Exchange. Before 2007, the New York Stock Exchange executed 79 percent of the trades in stocks listed on its exchange. The Nasdaq, through its own internal networks and affiliates, controlled about 81 percent of its volume.

That changed in 2007, when the S.E.C. stepped in with Regulation NMS. Regulation NMS was well intentioned. Its goal was to make things better for individual investors by requiring that brokers execute trades at the best price available. Trading thus became a mechanical exercise — the best price had to be obtained, no matter where quoted or by whom. To ensure that the best price was obtained, the S.E.C. also put in place rules requiring all exchanges to make their quotations and trade executions public.

The idea was simple and compelling, but the problem was that Regulation NMS did not require brokers to obtain the fastest execution or weigh the reliability of an exchange when obtaining the best quote available.

As a result, the rule disrupted the flow of market trading, just as high-frequency trading was arriving. The result was to put traders in control of the markets. The only thing that now mattered was getting the best quote.

This removed brokers from the equation and empowered the traders. After all, if an exchange was going to prosper, it needed liquidity and that came mostly from high-frequency trading. This would give the exchange the best quotes. By 2009, high-frequency trading was estimated to account for 50 to 60 percent of the market volume, meaning that it wasn’t just traders, but high-frequency traders, who were in control. Though people quibble about the definition of high-frequency trading, it involves traders who use algorithms and focus on being as fast as possible. By being the fastest, these traders could execute trades ahead of slower institutional and retail investors.

Markets now focus on drawing in high-frequency traders, and it seems that every entrepreneur has a stock market to peddle.

There are now 13 public stock exchanges — the so-called “lit” exchanges. And there are 45 dark pools, which now execute the trades for over 50 percent of long-term investors. What’s the difference between the two? Lit exchanges publish quotes and then report the execution of the trade. This way everyone gets to see the trades and knows who is trading what. The dark pools allow anonymous trading and the hiding of trades until they happen. Only after the trade occurs does the public know it occurred and at what price.

This fragmentation of the markets was directly a result of the new competition to show the best price. To attract traders, these new markets began to offer them special benefits.

If you are a high-frequency trader, being close to the actual exchange is important. It can give you extra milliseconds to execute a trade before someone farther away can get to the exchange. Exchanges thus began to offer co-location and microwave services, allowing traders to be on site or to send their trades in faster than others. To emphasize how important this time is, Spread Networks spent $300 million to build a high-speed fiber network between New York and Chicago to shave three milliseconds off trading times.

What’s so bad about catering to high-frequency traders? By their very name, high-frequency traders execute trades ahead of everyone else, grabbing the best prices or, in a worst case, offering false bids to lure sale offers. These trades can “take” quotes before ordinary investors can buy, and then turn around and sell for a penny more to the same buyer who lost out. Academic studies have found that the flight to dark pools probably made pricing worse and created higher trading costs.

Even though institutional investors are skilled, they still sometimes lose to high-frequency traders. But retail investors do not even play. The online brokerages often enter into contracts with these new markets to have them execute their trades, putting retail investors at the mercy of the high-frequency traders. According to S.E.C. reports, for instance, E-Trade sent 23 percent of its market orders to Citadel Securities last quarter, and another 23 percent to KCG Americas, whose parent was at one point the largest high-frequency trading firm. The two firms paid E-Trade for this flow, an average of less than $0.0015 per share. But ask yourself this: Why would someone pay E-Trade to execute an order? Probably because these orders are being fed into the high-frequency trading maw.

George Fischer, vice president for trading, margin lending and cash management at E-Trade, defended the firm’s practices. “From a retail perspective, wholesalers generally offer a better opportunity for price improvement than the exchange environment,” he said. “This is a great time to be a retail investor as we are seeing historically high levels of price improvement.”

But as we’ve seen in the flash crash in 2010, the failed trading in the BATS initial public offering in 2012 and the Nasdaq trading malfunction last August, markets are too complex and, perhaps, too interconnected. There is real systemic risk.

It’s no wonder, then, that the S.E.C. is saying it will re-examine the rules on market structure. The agency did not immediately respond to a request for comment.

The S.E.C. moves slowly, though, and in the meantime the markets are trying to reorder themselves. Some trading firms have banded together to form the Modern Markets Initiative, an organization that will be an industry representative for the high-frequency traders. The idea is to explain the good that high-frequency trading does by promoting volume and keeping prices equivalent.

The institutions are also fighting back. Last fall, a group of institutional investors and hedge funds founded the IEX Group. IEX aims to end high-frequency traders’ advantage by creating a dark pool with a speed bump. That bump is all of 350 microseconds, but, according to IEX’s executives, it levels the trading field. IEX officials say they are off to a good start, with trading on some days above the American Stock Exchange (now known as the NYSE MKT). High-frequency trading is also welcome on IEX because it now does not have an undue advantage.

But the IEX and Modern Markets Initiative are stopgap measures and do not address the fragmentation of our markets and the risk that poses.

The S.E.C. review is expected to take about a year, after which it is likely to propose radical changes.
The only problem is that the S.E.C. and its Regulation NMS are partly responsible for destroying the old trading model, while still leaving ordinary investors at a different disadvantage. The question will be whether the S.E.C.’s new proposals are a different recipe for the same meal, doing nothing to settle the war between traders and investors.