Meeting Market Structure Challenges Where They Are.

AuthorPeirce, Hester

There was a young lady named Bright, Whose speed was far faster than light; She set out one day In a relative way, And returned home the previous night. Arthur Henry Reginald Buller (1)

  1. INTRODUCTION II. KEY PLAYERS IN TODAY'S MARKET STRUCTURE STORY: HIGH FREQUENCY TRADING AND DARK POOLS A. High Frequency Trading B. Dark Pools III. ANOTHER KEY PLAYER IN THE MARKET STRUCTURE STORY: REGULATION A. Federal Government Market Structure Reform Efforts B. New York's Attorney General's Market Structure Reform Efforts C. Non-governmental Market Structure Reform Efforts IV. IDENTIFYING EQUITY MARKET STRUCTURE PROBLEMS AND DEVISING SOLUTIONS A. Determining whether a Problem Exists 1. High Frequency Trading 2. Dark Pools B. Disentangling Market and Regulatory Failures 1. Identifying Market Failures 2. Identifying the Regulatory Roots of Failure C. Allowing Market Solutions to Work D. Devising Regulatory Solutions 1. The Regulator Matters 2. The Regulatory Approach Matters 3. The Regulatory Attitude Matters V. CONCLUSION I. INTRODUCTION

    Equity market structure discussions are full of good stories--stories of power struggles, fortunes gained and lost, and careers ruined and redeemed along the way. Michael Lewis and Scott Patterson capture some of the most fascinating of these stories in their recent books about how high-speed, algorithmic, and now artificial intelligence-driven, equity markets have replaced the human-dominated trading floors that still fill our imaginations and rulebooks. (2) Today's stories feature the unfathomable speed of high frequency traders who operate across a complex array of trading venues through a growing mix of order types. Government regulation features more heavily in modern market structure stories than the private regulation that loomed large in the slower, but equally enthralling early market structure stories. (3) Regulation--sometimes subtly and sometimes quite obviously--shapes the actions of other characters in the narrative.

    It is tempting to allow the rich stories about market structure to drive regulatory outcomes. Tales of high speed, algorithmic duels, and dark pools nudge many well-intentioned observers to reach for the government rulebook. More careful deliberation is needed. Before writing rules, regulators need to identify the problems they are trying to solve. Is it a market failure or a government failure? If it is the latter, how can existing rules be removed, reformed, or better enforced to address it? If it is a market failure, will changing technology and new competitors fix it, or is regulatory intervention necessary? If regulation is necessary, should it be state regulation, federal regulation, self-regulation, (which can mean many things) private regulation, or a combination? What should regulation look like, and how should regulators approach the task? This Article does not undertake to answer all these questions across the range of equity market structure issues, but it seeks to lay out a general framework for approaching these questions.

    The Article proceeds as follows. Part II introduces two of the key distinctive features of today's equity market structure--high frequency trading (HFT) and dark pools. Part III describes recent regulatory actions related to equity market structure. Part IV lays out an approach for confronting a number of trouble spots in today's equity market structure. Part V concludes.


    Well-functioning secondary equity markets--the infrastructure within which companies' shares trade after companies initially sell them--serve investors and the broader economy. An investor is more likely to invest her money in a company if she knows that she can sell the shares when she needs the money for another purpose. A well-functioning market offers accurate prices and liquidity. (4) An asset's liquidity turns on direct transaction costs, the price impact of a transaction, and the time it takes to sell the asset. (5) These determinants of liquidity are in turn influenced by characteristics of the stock (such as analyst and market maker coverage) and the market in which it trades. Liquidity affects share prices; a stock that is hard to sell is worth less. (6) When stock is more valuable, it is easier for companies to raise money to make investments. (7) As a result, investors, companies, and the economy benefit from a stock market that works well.

    Equity market structure has changed dramatically in its more than two hundred years of documented history in the United States. In general, the equity markets work well, but there is room to improve the way they serve investors and issuers. Much of the impassioned discussion about market structure turns on HFT and dark pools. HFT firms dominate equity trading, (8) and off-exchange trading accounts for approximately 38% of total equity volume. (9) Today's "teched-up" market structure is partly the product of the same progress that has brought us smarter phones and self-driving cars. As the Securities and Exchange Commission (SEC) has acknowledged, however, our market structure "also reflect[s] the markets' response to regulatory actions ... as well as enforcement actions." (10)

    1. High Frequency Trading

      HFT, which is now pervasive in the markets, lacks a simple definition. HFT firms and their trading strategies are not uniform. (11) The SEC, acknowledging the definitional ambiguity, (12) proposes the following definition of HFT: "professional traders acting in a proprietary capacity that engage in strategies that generate a large number of trades on a daily basis." (13) The SEC identifies the following typical characteristics of HFT firms:

      (1) The use of extraordinarily high speed and sophisticated computer programs for generating, routing, and executing orders;

      (2) use of co-location services and individual data feeds offered by exchanges and others to minimize network and other types of latencies;

      (3) very short time-frames for establishing and liquidating positions;

      (4) the submission of numerous orders that are cancelled shortly after submission; and

      (5) ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions overnight). (14)

      The SEC's HFT list highlights characteristics--technological, informational, and geographic advantages over other traders and staggering order (and cancellation) volume-- that worry many market participants and observers. (15) Others argue that these same characteristics allow HFT firms to keep markets liquid--serving as ready buyers and sellers. (16)

      HFT is a key aspect of today's markets, even though the number of active HFT firms is relatively small. (17) Recognizing that definitional haziness makes precise quantification of HFT difficult, the SEC estimated that HFT made up 50% of equity market volume in 2010. (18) According to a Tabb Group estimate, the 2017 percentage was fifty-three percent, compared to thirty-five percent ten years ago and fifty-one percent five years ago. (19)

    2. Dark Pools

      U.S. equity markets include not only traditional exchanges (20) (which no longer look very traditional) and a large number of non-exchange trading venues. The registered equity exchanges require regulatory approval to operate, serve as self-regulatory organizations (SROs), obtain SEC approval for rule changes, make extensive public disclosures, and offer fair access. Exchanges have certain privileges: they can list stocks, are protected by legal immunity for certain of their activities, are entitled to a share of the revenues from market data sales, and enjoy trade-through protection for their best bids and offers.

      Greatly outnumbering registered exchanges, alternative trading systems (ATSs) also match buyers and sellers of stock. In 2015, the approximately forty dark pools accounted for approximately fifteen percent of trading in stocks listed on NASDAQ and the New York Stock Exchange. (21) ATSs register as broker-dealers, become members of the Financial Industry Regulatory Authority (FINRA), and comply with other elements of the SEC's Regulation ATS. (22) Unlike exchanges, the SEC does not preapprove ATS rules and fees. ATSs also tend to be less publicly transparent than exchanges about their fees, their operations, and their potential conflicts of interest.

      ATSs include a variety of trading venues. A subset of ATSs--so-called electronic communication networks (ECNs)--publicly post their best bids and offers just as exchanges do. (23) The remaining ATSs offer dark liquidity. Unless trading volume reaches five percent of average daily volume for a particular stock, these "dark pools" do not have to publicly post their bids and offers before trades occur or offer fair access. (24) For most stocks, dark pools only provide post-trade information. Dark pools offer a valuable service to institutional investors--the ability to trade without drawing instantaneous unwanted, costly, price-moving attention to the trades. Traders in dark pools also typically incur lower direct transaction costs than they would on exchanges. (25)

      Most retail trades do not take place on exchanges or on ATSs. Instead, they occur in another dark part of the market; they are "internalized" by over-the-counter market makers or wholesalers, who generally do not publish their best bids and offers. Internalizers provide price improvement over the published best bid or offer and make post-trade reports. Internalizers often pay the retail customer's broker for directing customer order flow to them. (26)


    The structural complexity of U.S. equity markets is driven in part by the regulation that shapes the markets. This regulation comes through multiple avenues. The following sections describe some of the most important ones.

    1. Federal Government Market Structure Reform Efforts

      Congress gave the SEC a broad...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT