U.S. stock markets are "not fundamentally broken, let alone rigged," Securities and Exchange Commission Chair Mary Jo White said in a speech earlier this month. It was a swipe at Michael Lewis's best-selling book "Flash Boys," which caused a stir by claiming otherwise.
The markets may not be "rigged," but White understates the seriousness of the problem. The system isn't working as well as it should.
Regulators have admitted as much by recently announcing a series of initiatives: new regulations, disclosure requirements, study panels and enforcement actions affecting high-frequency traders and the private exchanges known as dark pools. (Bloomberg LP, parent of Bloomberg News, owns a stake in a company that operates a dark pool and provides its customers with access to some proprietary exchange feeds.) These ideas are mostly good, but they're tinkering at the margins.
Senators will hear a range of complaints at a hearing on high-frequency trading tomorrow. Here are some examples: Brokers are sending investor orders to the exchange that pays them the most for the business (in the form of fees usually not shared with customers) rather than to the one that offers the best execution. High-frequency traders are spending billions of dollars to shave a few thousandths of a second off trading times in an arms race that serves no wider economic purpose. Proliferating buy-sell-cancel messages ricochet around dozens of trading venues, leaving the market vulnerable to outages like the flash crash of 2010.
Many of these problems stem from 2005, when the SEC last tried to fix the plumbing. Back then, the commission welcomed the rise of electronic marketplaces as healthy competition to the slow, expensive and sometimes ethically challenged New York Stock Exchange and Nasdaq. Yet it also worried that the new computerized markets might operate in silos and ignore better prices elsewhere. So it adopted Regulation NMS, which says orders must go to the market that posts the best price -- and does so first.
This seemed to make sense, but the unintended consequence was greater fragmentation of the market. Investors now have more than 50 different trading options to choose from. Up to 40 percent of transactions never meet centrally, and instead take place within dark pools, which don't display buy and sell quotes. This threatens a vital function of the market -- price discovery -- and may deny some investors a better price.
High-frequency trading compounds the problem. In her speech, White said the spreads between bids and offers are as low as they've ever been. Once, this was the sign of a healthy market. Today, the underlying shares aren't often available. When large investors such as mutual funds try to trade at quoted prices, the shares disappear from their screens. High-speed traders place and cancel millions of orders a day to sniff out demand. When they detect interest in a stock, they jump ahead and buy the shares on all the markets, then sell them to fund managers at a slightly higher price.
White also says that trading costs are lower than before. This ignores the complex system of discounts and rebates that the exchanges use to attract business. Investors don't get the benefit of those payments, which one study estimated to be as high as $5 billion a year.
The SEC proposes that high-speed traders should have to register with it. It wants exchanges to improve their defenses against outages. It wants brokers to tell customers how their orders were routed through the various venues, and dark pools to say how their software works. Exchanges would have to disclose more about the data they sell to high-speed traders, and work with the SEC to speed up the slower feed of public data. All of this is helpful, but pretty timid and unlikely to silence the complaints.
Some caution is in order; Regulation NMS, despite its good intentions, created as many problems as it solved. But the U.S. equity market needs bigger repairs than the SEC has in mind. Here's one: Instead of trading in continuous time, move to a system of matching orders in auctions held at specified intervals (of, say, less than a second). That would stop the high-frequency arms race and lessen the appeal of dark pools. A future editorial will detail how this might work.
--Editors: Paula Dwyer, Clive Crook.
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