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A market-structure agenda for the SEC

Michael Lewis's recently released book, "Flash Boys," has unleashed a storm of criticism about equity trading in the United States. While much criticism is well founded, the book does not provide a balanced view of U.S. electronic equity trading. It is not as bad as it seems. But where it is bad, the Securities and Exchange Commission must make important changes.

Electronic trading has greatly reduced trade costs for retail and institutional investors. Numerous careful empirical studies show that trading is now cheaper than ever before due to the cost efficiencies of electronic systems.

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Many studies directly address Lewis's concerns. For example, studies (including one of my own) show that the costs of filling huge institutional orders that are broken into thousands of trades are lower than they used to be. These orders are the ones that high frequency traders (HFTs) are most likely to front-run.

The fact that trading costs have dropped does not mean that we should continue to tolerate certain bad behaviors present in our markets. A few important changes could further lower trade costs for retail and institutional investors. Consider some specific suggestions:

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For-profit exchanges have created exclusive high-speed data feeds and special order types that allow HFTs to profit from retail and institutional investors. The exchanges then tax the HFTs by charging them high fees for access to these special data feeds.

The SEC should ensure that all traders have equal access to data. These high-speed data feeds do not make our markets function better —just the opposite, they ultimately increase transaction costs for public investors. The SEC also should eliminate order types whose only purpose is to favor HFTs over public traders.

Most exchanges give brokers transaction-fee rebates when they route certain customer orders to their exchanges. Since almost all brokers keep the rebates instead of passing them through to their customers, the order routing decisions that brokers make often reflect their own profit calculations and not their clients' best interests. Not surprisingly, these corrupted routing decisions frequently allow HFTs to profit at the expense of the brokers' clients.

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This system of rebates is known as maker-taker pricing. Trades occur when one trader (the taker) is willing to trade at a price offered by another trader (the maker). Exchanges that use the maker-trader pricing system charge high fees to the taker and rebate most of that fee to the taker.

The SEC should get rid of maker-take pricing, and its evil cousin, taker-maker pricing (makers pay high fees, with rebates to the takers). Instead, exchanges should simply price their services as they always did — by charging a small fee to the buyer and the seller.

Maker-taker and taker-maker pricing schemes also allow HFTs to front-run other traders by improving net prices by less than the one-cent minimum tick that historically has protected large traders from predation by faster traders. The SEC can limit these losses by banning the rebates.

Brokers often send orders from their retail customers to off-exchange dealers in return for payments from the dealers. Worse, many brokers fill their client orders themselves in a process called internalization. In both cases, the orders are not exposed to exchange markets where they often would obtain better executions by interacting with orders from other public traders and from competitive dealers (including HFTs). The SEC should either ban payments for order flow and internalization, or force dealers to provide significantly better prices when filling client orders off exchanges.

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Many brokers operate dark pools to which they send customer orders. While many of these pools can provide valuable services to large institutional customers, they often do not, and most customers cannot easily determine whether they are being well served. The SEC should ensure that all dark pools fully disclose their trading rules, fee structures, and the types of traders that they permit in them.

Finally, attention focused on equity market structure unfortunately distracts the SEC from addressing bigger trading problems present in the bond markets, where trading effectively remains stuck in the 19th century. Bond transaction costs are outrageously high — often in excess of 3 percent. If the SEC mandated a public order display facility for these markets, as it once did for the equity markets, bond markets would improve overnight.

Larry Harris holds the Fred V. Keenan Chair in Finance at the University of Southern California Marshall School of Business. He was chief economist of the SEC between 2002 and 2004.