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2016-03-01 13:46:58
Discontent is rife at the very heart of capitalism: the trading of shares
Feb 27th 2016 | NEW YORK
THE brokers who traded shares in the Tontine coffee house in 18th-century New
York often resorted to stronger drink, leaving them a little addled ,
according to one contemporary account. The technology involved in share-trading
has changed a bit since then, and at least some of the participants have
sobered up. But more than 200 years later, investors in American equities still
wonder whether they are really receiving decent service.
On the face of things, they have little to complain about. The cost of trading
has declined sharply over the years (see chart). Explicit commissions, which
were once levied in percentage points (0.25% in 1792), have largely
disappeared. This is thanks mainly to competition. Whereas the New York Stock
Exchange (NYSE) dominated the trading of shares listed on it for most of the
20th century, there are now lots of places where they can be bought and sold.
The impetus for the fragmentation was Regulation NMS , adopted in 2005 by the
Securities and Exchange Commission (SEC), Wall Street s main regulator. This
required share-trading orders to be funnelled to the exchange offering the best
price. The intention was to boost competition to NYSE and NASDAQ, which had a
near-duopoly in share-trading at the time. It succeeded in that: both now have
less than a fifth of the market. (In response, firms running exchanges have
branched into other markets see next article.)
American shares are traded on a dozen exchanges; at least six other exchanges
cater to investors in derivatives linked to shares. Shares also change hands on
another 40 or so alternative trading systems , as well as a number of
single-dealer platforms . Finally, many trades are now internalised by big
banks and asset-managers, meaning that they pair up buyers and sellers within
their sprawling empires rather than use an outside trading venue.
Yet investors worry that, in many cases, competition has brought down the
visible price of trading by adding hidden costs. Two anxieties stand out. One
is the worry that the current set-up of the markets allows high-speed traders
to anticipate big orders and front-run them, moving prices in an unfavourable
direction before an order can be executed. The other is the question of how
robust the system is, with regulators still unable fully to explain events like
the flash crash of 2010, when the Dow Jones Industrial Average plunged by 9%
in minutes before rebounding.
Start with fears of front-running. Many institutional investors complain that
ultra-fast traders spot big orders entering the market, and race ahead of them
to adjust their prices accordingly. Attempts to hide from the speedsters can go
awry. In January Credit Suisse and Barclays, two big banks, agreed to pay $154m
in fines for misleading clients about the workings of their dark pools , where
offers to sell and bids to buy are not published. In theory, that protects
investors from front-running; in practice, several of the firms running such
venues had concealed the central role that high-frequency traders played on
them. (Credit Suisse didn t admit or deny wrongdoing in the settlement.)
There is another, less-often-told side to the story. Speed is necessary to knit
together a dispersed set of exchanges, so that investors are immediately routed
towards the best price available and so that their orders are the first to get
filled. And plenty of high-frequency traders are market-makers; it is their job
to adjust prices in response to new information. Nonetheless, the idea that
markets are rigged is widespread, not least thanks to the publication of Flash
Boys , a book by Michael Lewis on the evils of high-speed trading.
One proferred solution is to level the field by slowing things down
deliberately. IEX, whose founder is the hero of Mr Lewis s book, is a trading
platform that has applied to the SEC to become an exchange. It uses miles of
coiled cable to create a speed bump that delays trades to the advantage of
institutional investors. The SEC has received more than 400 letters in support
of its application, but there is a vigorous debate about whether IEX s system
complies with the requirements of Regulation NMS. Some think that the better
solution would be to get rid of Rule 611, which in effect requires orders to be
sent to the exchange showing the best price, even though such quotes can
sometimes be unobtainable in practice. The SEC will vote on IEX s application
by March 21st.
Front-running is not the only concern about America s market structure. The
other is the risk of sudden spasms like the flash crash. Glitches are common.
In 2012 two public offerings, for Facebook and BATS ( Better Alternative
Trading System , a firm that runs exchanges and other trading venues,
ironically enough), suffered disruption. Later that year faulty software
toppled Knight Capital Group, a big trading firm, by vomiting orders to
exchanges without tracking those that were filled. In 2013 the primary
electronic market and the back-up system both failed at NASDAQ thanks to a
software bug, and so on.
Andrew Lo, a professor of finance at the Massachusetts Institute of Technology
(MIT), argues that investigations into such events tend to focus on the venue
most affected. How they reverberate through the broader system is very little
studied or understood. Sometimes, the existence of other venues may help: in
July the NYSE briefly went offline and traders barely noticed as other
exchanges filled the gap. On other occasions, they may amplify volatility. In
August lurches in the future and equities markets caused the value of
exchange-traded funds to deviate from the value of the underlying shares they
owned.
Mr Lo proposes a simple reform: the creation of a commission that can subpoena
witnesses and evidence to look into the causes of crashes, just as the National
Transportation Safety Board investigates air disasters. The commission would
look as widely as it liked at what went wrong and then publish its findings.
The SEC acknowledges that the rules governing share-trading need amending. Mary
Jo White, the chair of the SEC, has mused, for example, about monitoring the
controls firms use to prevent their algorithms running amok. Another idea is to
provide the SEC with the power to curtail otherwise legal trading when the
market is convulsing. The risk is that in addressing market complexity, the
regulators only add to it. A single SEC proposal, on a facet of a facet of the
overall system, is now up for public comment. It runs to 581 pages.