U.S. Securities and Exchange Commission Chair Mary Jo White has made something of a stir with her recent speech on equity market structure. One interesting point was her attempt to downplay regulation as a cause:
“Although some have argued otherwise, these developments are not attributable solely to regulatory choices. Competition plays a powerful role. Well before Regulation NMS, market participants were trading in dark pools and trading with highly automated strategies. Many jurisdictions around the world with different regulatory structures than ours are dealing with analogous issues related to off-exchange venues and automated trading.”
This is a slippery and somewhat disingenuous argument. It starts out with an Obama-esque straw man — I don’t know of any credible analyst of these issues who claims the problems in market structure are “attributable solely” to regulatory choices. Having knocked down that straw man, she focuses on somewhat off-topic technological issues and thus totally sidesteps saying what role regulation and, notably, RegNMS have played.
I generally agree with her emphasis on empirical evidence as the basis for policy choices. But the empirical research has to consider all potential issues — including potential regulatory culpability.
The part of White’s speech that attracted the most comment relates to exchange competition and the self-regulatory model:
Exchange Competition and Self-Regulatory Model
“Another set of assumptions about our current market structure is related to the nature of exchange competition and the nature of the self-regulatory model itself.
Equity exchanges today operate fully electronic, high-speed trading systems using a business model that mostly was developed by electronic communications networks, or ECNs, prior to Regulation NMS. Indeed, in many ways, today’s exchanges are yesterday’s ECNs.
Exchanges differ from ECNs, however, in significant respects. Exchanges, for example, continue to exercise self-regulatory functions, even as they operate as for-profit entities.
This model for exchanges has encountered challenges. As I noted earlier, for example, the ‘lit’ exchanges no longer attract even one-half of long-term investor orders.
From time to time, equity exchanges have adopted trading models that use different fee structures or attempt to focus on different priorities, such as order size or retail investor participation. These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.
As is true for all important aspects of our current market structure, the current nature of exchange competition and the self-regulatory model should be fully evaluated in light of the evolving market structure and trading practices. This evaluation should include whether the current exchange regulatory structure continues to meet the needs of investors and public companies. Does it provide sufficient flexibility for exchanges to implement transparent trading models that can effectively compete for investor orders? Does the current approach to self-regulation limit or support exchange trading models?
This evaluation should also assess how trading venues can better balance their commercial incentives and regulatory responsibilities. For example, is there an appropriate balance for exchanges in key areas, such as the maintenance of critical market infrastructure? And are off-exchange venues subject to appropriate regulatory requirements for the types of business they today conduct?”
One thing that jumps out at me is the suggestion that there is a tension between the for-profit model and self-regulatory responsibilities, with the corollary suggestion (rather obliquely made) that for-profit exchanges should be stripped of some regulatory responsibilities.
Let me break it to everyone: There is a tension between the not-for-profit model and self-regulatory responsibilities, as well. Not-for-profit exchanges were not charitable organizations. They were established and run by very profit driven intermediaries (brokers, liquidity suppliers) who adopted the nonprofit form to prevent redistribution of wealth among heterogeneous members. This form was economically rational in floor trading days, when intermediaries and exchanges had highly specific capital that needed protection against expropriation. A big technological shock — the move to electronic trading — meant that the nonprofit form was no longer needed to protect these specific investments, or to prevent exchanges from using pricing of their services to redistribute wealth among members.
As I wrote about extensively during the mid-’90s, traditional exchanges did a good job at some self-regulatory functions and a bad job at others. Manipulation was one that exchanges policed quite badly, for instance; contract enforcement was one they did quite well.
In these papers, I identified a couple of factors that affected the effectiveness of exchange self-regulatory efforts. One was whether the exchanges internalized the benefits. In the case of manipulation, for instance, the effects of corners and squeezes on the derived demand for the services of exchange members did not reflect the effects of corners and squeezes on market participants generally. The price and quantity of exchange services depends on the impact of manipulation on marginal customers, but inframarginal customers bore the brunt of manipulations. Moreover, some effects were public bads, such as the effect of manipulation on the informativeness of prices.
Another factor is the distributive effects across exchange members. Self-regulations that led to overall efficiency gains but hurt some members were often not adopted due to such conflicts: The battles over grain warehouses in Chicago in the 1860s and 1870s is an example.
Similar problems afflict for-profit exchanges, though internalization problems are probably the most acute now. The movement to the for-profit form has reduced the conflicts within exchanges.
Back around 2000, when the move to for-profit exchanges was gaining momentum, I wrote a paper on the implications of this for self-regulation. I put it aside. I should probably dust it off and revise, but the basic conclusion holds true, I think: For-profit exchanges have good incentives to regulate some things, bad incentives to regulate others. The task is to identify these various strengths and weaknesses and allocate regulatory responsibilities accordingly, always keeping in mind that the alternative — public regulation — has its weaknesses and strengths, too.
The one major issue that has brought this to the fore is the breakdowns in the SIPs that connect exchanges and are necessary for the information-and-linkages approach adopted by the SEC in RegNMS (and Congress under the original NMS mandate) to work. This is predictable, based on the analysis presented above. SIPs have some attributes of public goods, and no exchange internalizes the benefits and costs of SIP performance. Not surprising, then, that this has proved to be a weak link in the current market structure. But since SIPs have natural monopoly characteristics, it’s not an easy task to determine how they should be owned, priced, and governed. But the question hasn’t been framed this way, which means that it’s unlikely to be answered properly. (Recall that the old Intermarket Trading System was also a chronic problem in the pre-RegNMS world: It was sort of a joke, actually.) SIPs are analogous to transmission in electricity, and transmission has always proved the most difficult part of the system to regulate and price. (Yes, there are important technological differences, but the similarities are relevant.)
Some things in White’s speech appear contradictory. For instance, she questions whether a one-size-fits-all market structure is appropriate, then denigrates exchange efforts to experiment with different models: “These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.” It seems to me that exchanges have had plenty of opportunities, and that the mixed success suggests that the potential for differentiation (including moving away from one-size-fits-all) is rather limited.
There is one form of differentiation that White seems to be quite suspicious of — trading on dark venues: “A steadily increasing percentage of trading occurs in ‘dark’ venues, which now appear to execute more than half of the orders of long-term investors.”
Combine this with her desideratum for trading: Models “that preserve pricing transparency and are more attractive to investors.” Well, here we have a great example of a non-one-size-fits-all model that is obviously more attractive to some investors, but it bothers White (and regulators, generally). One of the things that makes dark venues popular to long-term investors is precisely the lack of price transparency. Ironically, the SEC has always claimed the markets should favor long-term investors, and, indeed, White starts her speech by arguing that the markets cannot serve their capital formation function without long-term investors. Thus, the “and” in that phrase is problematic.
One interpretation is that White doesn’t want one-size-fits-all, but that the varieties that have evolved — dark venues that accommodate long-term investors and lit venues that accommodate some long-term investors and most others — aren’t to her liking. This is not a convincing position. It begs the question of why the long-term investors White favors prefer a venue she disfavors. It also doesn’t come to grips with the literature which shows that off-exchange trading venues reduce trading costs for uninformed, liquidity traders — which can include long-term investors who initiate and liquidate positions for non-information driven reasons. It also is in tension with her statement that for-profit exchanges with a strong profit motive are trying to innovate: If they are losing business to dark venues as a result of, say, predatory conduct carried in lit markets, they have an incentive to devise rules and pricing structures that curb the predatory conduct and thereby attract the return of those who have fled to dark venues.
It also bears emphasis, for this point is often forgotten, that dark venues have always been with us, and that large, long-term investors have been the users of these venues. Back in the day, this was the function of block markets. Dark venues have largely replaced the block markets, serve the same function, and service the same investor base. That’s true even though much of the trading on dark venues is not in blocks (although some dark markets are essentially for block trading). As Duane Seppi demonstrated years ago, block trading and the protocols surrounding it were ways of screening out informed traders. Dark venues have other means of performing the same function, without imposing the constraint that trades occur in blocks.
Summing up, it’s good to see these market structure issues get such serious attention. It’s less encouraging to see that regulators are focusing on secondary or tertiary issues (e.g., whether self-regulation is incompatible with for-profit exchanges) and have certain preconceptions that makes them unduly suspicious of departures from one-size-fits-all trading that accommodate the needs of an important category of market users — indeed, the category that the SEC has long said it desires to protect. (As an aside, which I may expand upon later, the SEC’s preferences, and its suspicion of dark markets, is likely driven by political economy considerations. Namely, exchanges exert more political influence, and have influenced the SEC to advance their interests.)
In my opinion, the SEC’s immediate priority should be fixing the SIP (if it deems that links-and-information is sacrosanct) This fix should look at ownership, organization, and governance, based on an understanding of the public good attributes of the SIP. (Longer term, the RegNMS links-and-information approach needs a new look.) In addition, the empirical approach that White rightly advocates should look at dark venues through objective eyes, free from prejudices which are all too apparent (as the very term “dark” demonstrates). It’s especially important that the reasons for the commercial success of dark markets be understood and explained before it is lamented. A case can be made that the non-one-size-fits-all model that works best could consist of dark and light venues operating side by side, serving different investor clienteles. It’s certainly a model that has existed over time and in a wide variety of different countries. Maybe there’s something to it. Perhaps we should understand what that might be before monkeying with market structure any more.
Craig Pirrong is a professor of finance and energy markets director of the Global Energy Management Institute at the Bauer College of Business at the University of Houston. He is also author of The Street Wise Professor.
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