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Man Vs. Machine: Commentary—How the SEC Helps Underwrite High Frequency Trading

Let's stop the political rhetoric and attend to building better markets

New listings, not complex financial packages, should be the SEC's focus

A small number of the most sophisticated electronic market making operations are said to be “remarkably profitable,” as were a small number of yesterday’s market makers and upstairs traders. A small number of high frequency traders have used unethical trading practices. A majority of the firms read the tape as traders have done for generations and exploit the orders of lumbering, too big to succeed asset managers.

The irony of all the focus on high frequency traders is that SEC rules that govern the consolidation of all exchange trading data and the associated payment streams keep many of these guys in business. Known as the Consolidated Tape Association (CTA), its purpose was essential in the days before microprocessors and fast gigabit Ethernet.

The theory went that tape revenues would help mitigate the self-regulatory costs of exchanges. A few years ago, the exchanges began to share the revenue from this government-imposed economy and rebated it to those traders who chose to report stocks on a specific exchange. Exchanges then began to aggressively compete on the portion of revenues rebated to customers.

One exchange in the Midwest is owned by a number of high frequency trading firms. Is there any wonder why the orders print on that exchange?

The SEC allows little competition in the provision of stock quotes. Every time a trade happens and is reported to the exchange, that trader earns a piece of the action in today’s markets. The reported high cancel rates of these firms reflect a readiness to trade a stock at any time just to earn a tiny sliver of tape revenues. The competition among high frequency traders for every trade possible at any time creates unprecedented liquidity for small retail investors.

Furthermore, the extra time required to consolidate trades from enormous numbers of exchanges has created “slowness” in the system that some market participants now consider unfair. Exchanges created a new source of revenue by selling the same data as a subscription to firms wanting to bypass the slow central systems, and some exchanges beefed up the product offering by including information about customer orders above and below the best prices in the market.

Once upon a time, the CTA was viewed by the SEC as an important weapon to keep the NYSE from putting all of its competitors out of business. Today, high frequency firms wouldn’t be in business and neither would several exchanges if not for the sharing of the ample earnings derived from sales of last-sale data to customers of firms like Thomson Reuters and Bloomberg.

What a system! An investor places an order in the market to buy or sell at a price. Those quotes and sales are posted on an exchange which, in turn, sells that data to vendors and firms. The vendors resell the data to the investors. The excess profits derived from this government-mandated activity are rebated back to the high frequency firms and other trading intermediaries.

I’m told that an exchange recently suggested that investors were paying too much for quotes in today’s world; that a major exchange proposed a 20 percent fee reduction for market data. Such a fee reduction would have lowered costs of market information for all investors.

It was vetoed by members of the plan (the electronic exchanges and high frequency firms who would be harmed). You see, savings for investors require a unanimous vote of the interested intermediaries. If prices for data were reduced, then trading rebates would immediately drop.

Do we really think that tape revenues retain the same critical role in preserving competition that they once did—when the NYSE held 80 percent market share rather than 30 percent? And while trading speed doubles every 18 months at the same cost to investors (Moore’s Law), investors today pay the same or more for trading information from the major exchanges that the very same investors create with each order they put into the system.

The SEC also worries that the use of so-called dark pools has a potentially negative effect on price formation. The fix for such legitimate concerns are politically bedeviled but very simple if just outcomes are the regulator’s desire. Dark pools and brokers who “internalize” orders rely on the prices set by traders in other markets—often the primary exchanges—to consummate their private trades.

Currently, anyone who places an intention to trade in the market is treated by the market’s current rules as “dumb money.” Much of large trader behavior in dark pools changes overnight if the SEC does two simple things. One, require a dark pool or internalizing broker to first satisfy all displayed orders at the price they intend to trade; and two, require 1c price improvement to take the other side of the trade. In markets driven by profit margins of less than a penny a share, the SEC can exercise enormous regulatory leverage by consistently rewarding those who establish the market’s best prices.

The SEC’s focus on high frequency traders should be instead on the proliferation of High Frequency Products (HFP) and protecting the interests of those who create the nation’s best bid and offer on the consolidated tape.

Rather than complex rule making, the SEC needs to step back now and do a few courageous things.

  • Reward traders who reveal the size and price of orders in the public markets. Do not allow dark pools and internalizing brokers to trade at the same price as those revealed in the public market unless the public orders are filled first. This is Vitamin D therapy for broken price discovery disease.
  • Require significant price improvement (1c) for orders matched internally by dark pools and internalizing brokers. These businesses rely on the setting of price by third parties, creating what economists call a “free rider” problem. End the free ride.
  • Do not repeat the mistakes of history by relying on affirmative obligations for market makers. History shows that affirmative obligations affirm only intermediaries’ profits. High frequency traders have sharply reduced trading costs for the investing public.
  • Do not allow buy stop orders and sell stop orders to go into the market without price constraints. The SEC is considering imposition of arbitrary limit up and limit down prices in markets. Instead, require stop orders in the market to have a trigger price and minimum/maximum execution price. Retail broker dealers don’t enjoy the same rebates from limit orders that they do from market orders. They won’t change without a nudge.
  • Fix the mechanism for stock quotes and trades. Reduce costs to the investing public.
  • Eliminate cross subsidies that were intended for better market regulation, not for exchange internecine warfare.
  • Create an investor’s guide to the overlap of securities held in ETFs, especially small capitalization companies. There is no place where one can easily understand which securities are held in which ETFs. Information is the path to knowledge.
  • Tell the big mutual funds and asset gatherers to quit whining and spend money on technology to compete. The over concentration of assets in the hands of a very few managers hurts returns and trading flexibility; this cannot be repealed by regulatory initiatives.

Let’s stop the political rhetoric and attend to building better markets for new public companies trying to attract necessary capital for growth. New listings and not new complex financial packages should be the focus of the SEC as watchdogs of our capital markets.

Harold Bradley is Chief Investment Officer of the Ewing Marion Kauffman Foundation.

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