From Block Lords to Blockchain: How Securities Dealers Make Markets.

• Author: Donald, David C.

1. INTRODUCTION: MAKING MARKETS A. The Likely Return to Private Networks B. How We Measure the Quality of Securities Markets C. What Are Securities Exchanges For? II. Private Networks Informally Maintained A. The Concept of Market B. Initial Informal Networks for Trading Securities III. Concentrating Trading Within Designated Venues A. Bringing Trades Within a Private Club B. Private Ordering in the Clubs C. Public Regulation Boxes in Private Ordering 1. The United States 2. The United Kingdom IV. An IT-Enabled Return to Private Networks A. Technology Obviating Clubroom Walls B. The National Market System C. The Market in Financial Instruments Directive D. A Private Network Through Distributed Ledger Technology V. Conclusion I. INTRODUCTION: MAKING MARKETS

   1. The Likely Return to Private Networks

      As trading concentrated on major securities exchanges disintegrates, trading is returning to direct (now electronic) networks between major broker-dealers. For most of the roughly 1000 years during which there is historical evidence of debt instruments or shares of stock being exchanged, trades were executed over informal networks among merchants or other debtholders, (1) who met in market squares, designated city blocks, or their own offices. (2) With the notable exception of The Netherlands, concentrated trading on securities exchanges became the rule only from the 19th century. (3) Trading floors provided an environment that allowed exclusion of non-members and control of information, and in which real-time, multilateral communication of offers and acceptances was possible, but electronic communication permits the same, with even higher efficiency. Market structure changes made at the outset of the 21st century began a trend that currently projects a return to decentralized networks among major broker-dealers. (4) This change has been advanced by the largest broker-dealers, (5) and it is unlikely that their initiatives are contrary to their own interests, but serious thought has not been given to how a full return to disintegrated trading would affect the interests of savers, issuers, regulators, and other concerned constituencies. The history of markets offers insight on this.

      A return of trading to private networks affects "market quality," both in a narrow and in a broad sense. Although it is not customary in the literature to distinguish between narrow and broad concepts of market quality, such a distinction can be drawn by reference to the set of affected constituencies included in an analysis. A narrow (indeed the customary) examination of market quality focuses on how the market affects the interests of direct market participants, the broker-dealers licensed to trade in the market, assessing primarily trading costs and speed. using this measure, it would be unusual for market structure innovations not to have a positive effect on market quality, for as Francioni and Schwartz remind us, broker-dealer members of exchanges find "investors and the listed companies ... important primarily because they are critical for the profitability of the members. Nevertheless ... the interests of the intermediaries come first." (6)

   2. How We Measure the Quality of Securities Markets

      Securities markets are built by the broker-dealers for the broker-dealers, but are not solely of the broker-dealers. Many of the securities traded are linked to returns from activity in the real economy, and many investors based in the real economy buy interests in traded securities. Nevertheless, regulators measure the quality of a market on the basis of benefit to its owners, not in connection with the broader economy. As Lee observes, though "mounting anxiety about the presence of conflicts of interests at market infrastructure institutions, and about whether governance mechanisms should be put in place to minimize the occurrence of such conflicts" has been the subject of detailed examinations and proposals, (7) little or no attention is given to the fact that broker-dealers and the institutions they own control the design of key infrastructure for national economies. (8) when a regulator is guided by a narrow concept of market quality, it essentially asks: have the broker-dealers constructed a market for themselves from which they can extract maximum profits at minimum transaction cost? (9) While this may well include an assumption that the savings of broker-dealers will be passed on to the real economy, nothing in applicable theory or practice supports such an assumption. (10)

      In contrast, a broad concept of market quality places the assessed market within the overall economy and evaluates its structure and performance in connection with that economy. (11) Broad market quality includes the effects of market design on investors and listed companies, regulatory budgets, and those broker-dealers who might be excluded from the market under a given structural arrangement.

      How do leading regulators assess markets? on its website, the US Securities and Exchange Commission (SEC) declares a broad concept of market quality: "The mission of the US Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation." (12) However, it is very difficult to find evidence of this broad view in actual SEC assessments of market structure and behavior. (13) During the early 2010s, when the effects of market fragmentation and high-frequency trading were hotly debated, the SEC published two reviews it conducted of the relevant literature addressing those questions. It observed that in the papers on fragmentation it saw as important enough to be collected, "the metrics chosen to measure market quality ... [were] quoted, effective, and realized spreads, quoted depth, short-term volatility, variance ratios of volatility of various durations, and autocorrelation in returns." (14) Although these metrics could arguably have an indirect impact on any aspect of society, they only directly affect the cost and ease of trading. No analysis of broader impact is mentioned. (15)

      In a similar collection addressing the effects of high-frequency trading, the SEC casts its net somewhat broader, but stays close to the costs of trading. (16) It includes papers addressing "general aspects of market quality, particularly spreads, price discovery, volatility, and liquidity," as well as "papers that focus on the transaction costs of retail and institutional investors," and "papers that address ... order anticipation and momentum ignition, and ... on HFT during a severe market disruption." (17) Nevertheless, the examined "transaction costs" of retail and institutional investors were limited almost exclusively to trading costs, (18) perhaps presuming without demonstrating that savings to brokers would automatically be passed on to retail investors. In its review of papers examining potential market manipulation, the SEC again focused on the cost of trading (here in terms of facing an informed trader), (19) and when examining papers on severe disruptions, the SEC again highlighted trading and price behavior rather than broader effects. (20) There is clearly a difference between a website mission statement and the concrete factors that the SEC thinks important enough to be included within a collection of knowledge for regulatory policy-making. This difference is one between broad and narrow concepts of market quality.

      Aitken and his Capital Markets Collaborative Research Centre (CMCRC) undertake what are probably the most sophisticated attempts to measure market quality. (21) In 2014, Aitken and co-authors took the extraordinary step of writing about market structure in the Journal of Business Ethics so as to emphasize that market structure has an ethical dimension. (22) The paper, while broader than most studies, nevertheless restricts itself to the relationship between market efficiency (cost, speed and price accuracy for traders) and market integrity (absence of price manipulation). (23) The Kay study of the UK markets, cited above, is one of the very few expert analyses to weigh benefits to market participants against impact on the overall economy. It finds that neither issuers (seeking efficient capital allocation) nor investors (seeking good information and fair returns) are being served by the UK equity markets:

      In equity markets today we observe high volumes of trading between individuals --or computers--who deal anonymously with each other, and know little or nothing about the activities of the companies whose shares they trade. It is hard to see how this activity could contribute much to well judged capital allocation between corporate activities or to good governance in the corporate sector, and we found no reason to think that it has done so. Nor can such a trading environment generate the information needed either to make good long-term decisions in companies or to assess whether good long-term decisions have been made. (24) Although advancing technology has made market structure change one of the major concerns of regulators since 2000, regulatory actions have largely been limited to responding to the requests of broker-dealers and the problems presented by meeting those requests. Thus, when new communication technology enabled trade matching to be taken out of exchanges and placed in proprietary platforms and broker-dealers backed such a move, (25) regulators shortly thereafter issued the Regulation National Market System (26) in the United States and the Market in Financial Instruments Directive (27) in Europe. When the growing fragmentation, which was celebrated for lowering trading costs, (28) threatened the integrity of market price discovery, regulators pushed for a Consolidated Audit Trail (U.S.) (29) and a Consolidated Tape (E.U.) (30) to tie together the pricing data that had been dispersed over a wide assortment of trade matching entities by their earlier initiatives. Thus...