By Bradley J. Bondi — Partner at Cadwalader, Wickersham & Taft LLP, senior fellow at the Center for Financial Stability, and former counsel to SEC Commissioners Paul Atkins and Troy Paredes.
Michael Lewis is a wonderful storyteller and a powerful influence on lawmakers and regulators. Some credit his best-selling book on the financial crisis, The Big Short, as contributing to the passage of the Dodd-Frank Act. The putative narrative that emerges from his latest book, Flash Boys, is that the equity markets are “rigged” by sophisticated traders who quickly and unfairly jump ahead of other traders. There is a more salient lesson hiding in plain sight – one that does not demonize one segment of market participants –that the Securities and Exchange Commission, the primary regulator of securities markets, is at its worst when it tries to regulate the detailed mechanics of trading.
The phenomenon that Mr. Lewis chronicles may be news to much of the country, but regulators and market participants have been well aware for years. In fact, the current market structure is in no small part the structure that the SEC has imposed on us since its most brazen diversion from defining general duties of market participants and into dictating how the market should execute trades, beginning in 2005.
The perceived unfairness in the markets associated with informational, physical, and temporal advantages have existed since the earliest days of the exchanges. For example, an institutional investor in New York could have its designated specialist on the floor of the New York Stock Exchange to execute its purchase orders quicker than a retail investor in Iowa using his local stock broker. To address what the market deemed to be unfair, the various exchanges adopted many years ago (and the SEC approved) rules requiring specialists on the floor of the NYSE and market makers on NASDAQ to handle customer orders in specific ways defined by exchange rules. In other words, recognizing that some market participants provided valuable services, i.e., liquidity to the capital markets precisely because they had advantages, the SEC did not seek to outlaw the advantages, but rather imposed through the exchanges responsibilities and obligations upon those market participants. The SEC and the exchanges did not hesitate to enforce those obligations when those duties were violated. The system focused on duties and, with a few exceptions, it worked fairly well for decades.
This approach was disrupted in 2005 when the SEC adopted Regulation NMS (short for “National Market System”), an extremely complicated and sometimes baffling micromanagement of the order routing process. The SEC adopted a system that put the premium on speed in execution at a specific price, without considering the effect it would have upon the balance between market professionals’ duties and responsibilities to customers and the effects on the market in general. Regulation NMS essentially shifted the duties from the specialists and market makers to the traders themselves by imposing rules that required brokers to execute orders in the fastest manner possible, prompting brokerage firms and exchanges to interconnect and develop sophisticated computer systems to route trades in a maze-like fashion. Rather than to continue to trust the exchanges and market participants to police themselves through their duties and obligations, the SEC embarked upon an awful example of regulatory micromanagement.
Not surprisingly, early adopters of technology saw an opportunity. In a system that emphasizes speed, it pays to be the fastest. In a world where information is paramount, getting it first and monetizing it is imperative. So the informational advantage has shifted from the market professionals, who have duties and responsibilities to customers, and to the traders, who do not. In other words, the SEC’s frolic into the nuances of market microstructure created the unintended consequence of high-frequency trading – not an effort to skirt the rules but instead is the direct result of following the SEC rules.
Due to the heightened scrutiny, the SEC now has a choice – it can stray further into the regulation of trading mechanics and its micromanagement of the ever-evolving markets, or the SEC can return to a more traditional approach that tempers any perceived unfair advantages with duties and responsibilities that are clearly defined and enforceable. We should hope that the SEC will agree the solution is not another needless layer of regulation and its accompanying unintended consequences. Instead the SEC should return to its strengths and define for each market participant its duties under the system.
In another great work of fiction, A Moon for the Misbegotten by Eugene O’Neill, Jim Tyrone bemoans the fact that we are doomed to repeat our mistakes. “There is no present or future” he says, “only the past happening again and again, now.” The sentiment is particularly appropriate to a debate currently underway behind closed doors in Washington, DC. At stake is nothing less than the ability of America’s capital markets to continue to lead innovation and be competitive internationally.
