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More on SEC's Shapiro: Strange Omissions

SEC Chief Mary Schapiro has spoken at the Economic Club of New York today (see my prior blog). She addressed several market structure issues, including high frequency trading, but curiously left several other important issues out.

Let's hope the SEC finally gets serious about this: the market structure it has created around Reg NMS needs some serious tweaking and was likely a major contributing factor in the May 6 Flash Crash.

I have spoken about this many times, and will be addressing these issues in more detail as the SEC publishes its Flash Crash report at the end of this month. Here are some issues the SEC needs to address:

1) How fast is fast enough? We have already decided that under some circumstances we want to slow trading down: we have circuit breakers in place. Do we want to go further? Do we really want an arms race to see if we can make trades in under a microsecond (a millionth of a second)? Should we adopt some limit on how fast trades can be made, a minimum quote duration of, say, 1 second?

2) Extend stock circuit breakers to cover the entire equity universe. Some have advocated "limit up, limit down" rules that would prevent trades outside of specific parameters.

3) Don't allow "clearly erroneous trades" to print. Once a trade prints, it becomes a nightmare making everyone whole. FINRA and the exchanges are considering clearer rules for breaking trades, which would require that trades only be broken once the stock has been halted and if it trades at a certain percent away from the price at which it was halted.

4) More data on who is trading, what, and when. Beefing up market surveillance and creating a better audit trail will increase the trust of all investors. The SEC has proposed a Consolidated Audit Trail System to track information on trading orders and is reviewing comments recently submitted by the public. This should be quickly adopted.

5) Eliminate stub quotes and raise the requirements for what it means to be a market maker. Market makers should not be able to fulfill their obligations by putting in a phony bid of $0.01. If you are a market maker and are required to provide liquidity, you should be required to provide some! The SEC has discussed requiring market makers to post bids or offers that are not more than 10 percent away from the last price, but without any size requirements this won't mean too much.

6) Promote deep order books. Exchanges for years have opposed the idea of a Consolidated Limit Order Book (CLOB), which would essentially dump all bids and offers into a single "pool." It is time to rexamine this idea. There is usually plenty of liquidity, but crazy order handling rules sometimes allows absurd trades to print, far away from the best bid and offer.

7) Raise the barriers to entry for exchanges. In theory, there is no reason you could not have 100 different exchanges, but in reality when you have 100 different pricing mechanisms, it would be tough for the market participants to figure out the most efficient way to route orders...let alone the difficulties regulating all these exchanges.

Who's trading stocks these days? I get asked this question constantly; last Friday Larry Tabb, who runs Tabb Group, and I had a fascinating discussion about high frequency trading and the Flash Crash. Here's Larry's estimates on who is trading as a percentage of total volume on all the equity exchanges.

Who's trading?
(% of daily volume)

- High frequency trading 56%

(includes proprietary trading shops, market makers, and high-frequency trading hedge funds)

- Institutional 17%

(mutual funds, pensions, asset managers)

- Hedge funds 15%

- Retail 11%

- Other 1%

(non-proprietary banking)

Where does the trading occur? Here's Larry's estimates.

Exchanges 73%

Internalized 15%

Dark pools 11%

Electronic Communication

Networks (ECNs) 1%

Source: Tabb Group

You can see that dark pools and "internalized" trading (where market makers match orders against their own internal supply) now constitute about 26 percent of the volume. This is important, because these two venues do not display bids and offers to the outside world, they are "unlit" in the parlance of Wall Street.

It's not clear if removing that much liquidity from the rest of the market disadvantages everyone else. This is another issue the SEC needs to at least examine.

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