Traders on the floor of the New York Stock ExchangeU.S. regulators and securities professionals should re-examine rules implemented in 2007 that transformed stock trading in the U.S., according to a NYSE Euronext executive.
The proliferation of venues where investors can buy and sell shares, advances in trading speed spurred by computers, and the use of increasingly complex orders by high-frequency firms warrant a coordinated assessment, Joseph Mecane, head of U.S. equities at NYSE Euronext, said yesterday at a conference. The analysis should focus on Regulation NMS, the set of rules meant to foster competition and speed trading in shares listed on the New York Stock Exchange, he said.
The Senate Banking Committee is scheduled to hold hearings today on electronic trading. Last week, the Big Board, owned by NYSE Euronext, agreed to pay $5 million to settle Securities and Exchange Commission charges that it sent price and other data to feeds used by brokers and high-frequency companies faster than it did to the public.
The SEC should arrange a “series of market structure roundtables to discuss a lot of these items as an industry and to have a holistic recommendation or series of legislative changes coming out of these issues,” Mecane said. “Each of these items is interrelated. I don’t think they get addressed, largely because you can’t address them in isolation.”
Scrutiny of equity infrastructure has increased this year after a series of computer malfunctions raised questions about the stability of modern market structure. Knight Capital Group Inc. lost $440 million in August after it mistakenly bombarded exchanges with erroneous orders. Bats Global Markets Inc. pulled its initial public offering after failing to get its stock trading on its own exchange and Wall Street firms lost hundreds of millions of dollars when Nasdaq OMX Group Inc. mishandled Facebook Inc.’s public debut.
Regulatory Review
Executives from exchange companies Nasdaq OMX Group Inc. and Bats Global Markets said they also support a regulatory review of features in Regulation NMS, which the SEC adopted in 2005. The SEC published a so-called concept release paper in January 2010 asking for views on market structure, seeking opinions on how high-frequency traders affect longer-term investors.
'Holistic Response'
“This has to be a holistic response and not a hair-trigger approach where they say if you just do this the issues will be solved,” Eric Noll, executive vice president for transaction services at Nasdaq OMX, said yesterday at the same Georgetown University conference in Washington.
Buy and sell orders for U.S. equities are executed on 13 stock exchanges, several alternative venues, more than 40 dark pools and through other broker-dealer systems. Firms including Credit Suisse Group AG and Goldman Sachs Group Inc. introduced most U.S. dark pools, which don’t display quotes publicly, to automate some of the block-trading services they offered clients through human traders and to help customers limit price impact after Regulation NMS was approved. Most transactions through dark pools occur at the best price available in public markets or better.
Trading away from exchanges shrinks the share of trading on public markets. It accounts for about a third of volume, according to data published by Bats. U.S. equity trading across exchanges and other venues fell to 6.8 billion shares a day in the first half of this year from 10.8 billion in the first six months of 2009, data compiled by Bloomberg show.
Chris Isaacson, chief operating officer at Bats in Lenexa, Kansas, said regulators should evaluate Regulation NMS’s broader changes instead of engaging in a “piecemeal” review of issues as they arise. Bats, which began as an alternative venue, operates two exchanges, as does Direct Edge Holdings LLC in Jersey City, New Jersey. NYSE Euronext and Nasdaq OMX each have three stock exchanges.
Altered Rules
U.S. execution venues multiplied once Regulation NMS altered trading rules and incentives, Mecane said. The rules drove a focus on speed and led to the expansion of order types for high-frequency firms, he said. It also boosted the share of trading away from exchanges and use of so-called maker-taker pricing, in which a firm on one side of a trade pays a fee to encourage others to supply orders or quotes, he said.
Data Feeds
The SEC said last week that the NYSE sent data through two proprietary feeds to paying customers before relaying the information to the so-called consolidated feed, which sells trade and quote data to the public. NYSE, which didn’t admit or deny wrongdoing, agreed to hire an independent consultant to assess its compliance systems.
Andrew Brooks, head of U.S. equity trading at T. Rowe Price Group Inc., which had $542 billion in assets under management at the end of June, told the Senate banking committee in written testimony that regulators should focus on the fairness and stability of markets and question whether speed has become so important that it jeopardizes the interests of other investors.
A practice known as co-location, in which high-frequency firms and brokers pay to keep computers near the engines used by exchanges to match buy and sell orders, gives advantages to professional traders, Brooks said.
“We believe that the widespread use of co-location creates an uneven playing field that favors those who can and will pay for it,” Brooks wrote. “We question whether this has produced a market that values speed over fair access.” While high- frequency trading produces a lot of volume, it’s not always liquidity that institutions can trade with, he said. “We feel that this volume is transitory and misleading,” he added.
Trading Incentives
Brooks said the SEC should consider pilot programs that ban maker-taker pricing and “other inducements for order flow routing.” Another pilot could test wider price increments for stocks or a minimum period of time during which quotes must remain accessible to investors on exchanges before they can be canceled, he said.
Chris Concannon, a former SEC official and Nasdaq OMX executive, urged regulators to test programs that could improve trading. The current market structure was created for the most active U.S. securities and doesn’t work for smaller stocks, said Concannon, now a partner and executive vice president at New York-based broker Virtu Financial LLC.
'Over Engineered'
He told the Senate in written testimony that the U.S. equity market “is overly fragmented and, likely, over engineered.”
By spawning faster trading, Regulation NMS cleared a path for for-profit exchanges and brokers to cater to high-frequency firms, which provide more than half of the volume in the market, Mecane said. Exchanges offer myriad order types, or automated instructions that determine the series of actions a buy or sell request can take, to high-frequency and other users with “economically sensitive” trading strategies, he said.
“A lot of the reason why the number of venues that are out there have proliferated is because of the structure of Reg NMS,” Mecane said. “Maker-taker has evolved because there’s an incentive provided to liquidity providers, some of which is to compensate them for the fact that not all orders make their way to public markets. There’s a certain amount of toxicity that exists in the public market so there’s a ’transfer payment’ in essence for people being willing to provide liquidity.”
The SEC is holding a roundtable discussion on Oct. 2 to examine possible measures to prevent technology problems that can make trading disorderly. The group will also focus on how to limit the consequences of errors that occur.
While the meeting’s purpose isn’t to analyze the broader issues about how markets are organized, the “outcome from that could be some sort of best practices or guidelines around technology or potentially controls or tactical-type technology suggestions,” Mecane said.