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Defending the NYSE 'dinosaurs'

In the wake of the debate ignited by Michael Lewis's "Flash Boys," I have found some very real support for speaking out against high-frequency trading. On the other hand, I have also found that many think I am wrong and that being a broker on the NYSE is akin to being a "dinosaur."

It just makes me wonder: Is this really what the Securities and Exchange Commission envisioned when it modernized the U.S. capital markets? Is the U.S. equity market better, stronger, more vibrant and accessible? Does the race to zero really accomplish anything?

Traders work on the floor of the New York Stock Exchange.
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Traders work on the floor of the New York Stock Exchange.

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On June 13, 2000, then-SEC chairman Arthur Levitt testified before the Senate finance subcommittee on decimal pricing in the equity and options markets. He stood on his soapbox and told the subcommittee essentially that investors would be better served by decimal pricing, noting that "investors may benefit from lower transaction costs due to narrower spreads. Moreover, the markets will be easier to understand for the average investor."

For the tiny fraction of "individual investors" who exist in the market, he was right. But for the much more important institutional investors who represent the individual investors, he was completely wrong. Institutional liquidity has all but gone away, causing the cost of trading for the institution to dramatically increase which only hurts the individual investor that Levitt sought to help. And this is the very root of the problem.

It is important to understand that Reg NMS (Regulation National Market Structure) was a concept born of Levitt's testimony (2001 – 2007) and was designed to bring the U.S. capital markets into the 21st century. It became clear that we needed to look at the very dramatic changes in technology, communication, new investment products, connectivity, decimalization, sub-decimalization, etc.

While trading has changed and changed dramatically, traders and brokers still face the same challenges — to minimize trading costs, reduce impact, remain anonymous, control information leakage while embracing new technologies to trade more effectively and efficiently.

Reg NMS has fostered "competition" and today there are 12 exchanges that are regulated like exchanges. But it also created the 80+ alternative venues (not exchanges nor regulated like exchanges — leaving room for a whole other conversation) that create a web for what we now call U.S. capital market structure.

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It has raised huge "conflict of interest" issues, while reducing and fragmenting liquidity. Who exactly is conflicted? The list is long and that, my friend, is exactly where this conversation should go.

'We have allowed technology to control us'

Opportunities for gaming the system have never been greater — and that is different than being "rigged"as Michael Lewis has chosen to call it. We have allowed technology to control us vs. us controlling the technology and this is key to the conversation about what we as a country want our markets to be.

The SEC is charged with overseeing more than 12,000 publicly-traded companies, more than 10,000 investment advisors, 6,000+ broker dealers with branches around the country...

That leaves you to wonder: Do they have adequate resources and can they really monitor trading in a world gone mad?

Today, the 12 exchanges are known as "lit markets" because they are transparent; meaning, you can see supply and demand — bids and offers. The 80+ alternative venues or "dark markets" (dark pools, internalization engines, crossing networks) are described this way because they are not transparent — nor are they regulated like an exchange. For them to be successful, they must use the information from the lit markets in order to the price stocks correctly.

This competition has given birth to complex algorithms and order types that claim to tame the very complexity that they create. In the end, the complex web of networks fracture, fragment and weaken the U.S. capital markets allowing for the chaos that benefits no one but the predatory HFT crowd.

Defending the 'dinosaurs'

For those who call NYSE brokers "dinosaurs," it is clear that you do not understand the role of the broker and designated market makers — nor the transition and role of the NYSE.

An NYSE broker today is not the same person he/she was 15, 20, or 30 years ago. The role of the broker can be compared to the role of the sales trader — his clients include asset managers, defined as mutual funds, hedge funds, endowments, pension plans and family offices. Those brokers will be registered with a minimum of a series 7 & 63 — more registrations than many of the people who today have access to the U.S. capital markets. Brokers who continue to do a member firm/non-member firm business only are not held to the same guidelines as per SEC regulation.

We use our location to interact with our "competition" via the very same technology that everyone else uses. We access all of the "alternative venues" but more importantly, we have firsthand access to the very marketplace that so many listed companies find so important and significant to them.

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The DMM is what was formerly known as the specialist, is the ONLY participant that has a true obligation for maintaining a fair and orderly market in their assigned securities and remain buyer/seller of last resort. They are held to depth guidelines and Capital Commitment Schedules that assist them in their function as they employ both manual and electronic participation during openings, closings and times of instability. The other "liquidity providers" do not have that obligation and can, at a moment's notice, cancel and flee the marketplace — which we see happen all too often.

The NYSE today operates electronically, meaning that the open outcry "dinosaur" auction market from yesteryear is, in fact, gone and has been replaced by cutting edge technology that allows for human intervention, judgment and most of all, accountability. It is exactly the human element, advanced technology and steadfast commitment by its members that draw companies from around the world to choose the NYSE as their exchange of choice.

A lone hero? Not so much

The excitement created last week with the release of Michael Lewis's book and the supposed realization that a young man named Brad Katsuyama was the only person in the industry — or the country — to realize that something was amiss is a bit exaggerated. But, it has served to ignite a conversation that needed to happen.

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So, if nothing else, that is a good thing. In the end,though, another "dark" trading venue (not an exchange yet) only further fragments and fractures the marketplace — creating another opportunity for the games to play on.

Kenny Polcari is director of NYSE floor operations at O'Neil Securities and a CNBC contributor, often appearing on "Power Lunch." Follow Kenny on Twitter @kennypolcari and visit him at kennypolcari.com.

Disclosure: The market commentary is the opinion of the author and is based on decades of industry and market experience; however no guarantee is made or implied with respect to these opinions. This commentary is not nor is it intended to be relied upon as authoritative or taken in substitution for the exercise of judgment. The comments noted herein should not be construed as an offer to sell or the solicitation of an offer to buy or sell any financial product, or an official statement or endorsement of O'Neil Securities or its affiliates.