Healthy Markets: Bringing Transparency and Trust Back to Markets
The Financial Services Industry is in thrall of a Market Structure debate that rages from SEC to the Hill, from Twitter to the Wall St Journal. Everybody in the industry has an opinion on the state of the market and how to fix it. Unfortunately, few can agree on how to do this.
KOR Group's Chris Nagy and Dave Lauer have been at the center of this debate for years. Both are dedicated to creating fairer, healthier markets that operate with total transparency and free from conflicts of interest. KOR Group believes that, despite many differences of opinion, we can all agree on some fundamental reforms. While our views are not universally held, we believe that many leading firms will share in both our vision for securing healthier markets and our mission to lobby for these critical reforms. The changes that we’re calling for would have an enormously beneficial impact on US equity markets.
Current metrics for measuring brokers and execution quality on venues are woefully out-of-date. Before we can fix anything, we need to measure it.
Wall St could learn a lot from open source. Let's promote open data and open access across the board.
In everything that Healthy Markets advocates for, our primary goal is to increase transparency in the US stock market. Today, 40% of all trading occurs in internalization systems and dark poolsor Alternative Trading Systems that never interact with a public stock exchange. There are over 50 dark pools and regulatory filings for these Alternative Trading Systems are not publicly disclosed. It's time to change that. Alternative Trading Systems need to be held to the same transparency standards as any other lit venue. Brokers route your orders but provide little transparency into where your order goes, how well it’s executed, how much they got paid for your order and information to let you know if you got the best price or not. We seek to change that.
In addition, the SEC needs to ramp-up their data analysis capabilities and improve surveillance. This means solving their data problem (MIDAS doesn't have this functionality; CAT is several years and billions of dollars away), and their software problem (simply stated, they lack the software skills). In his 2012 US Senate testimony, Dave Lauer laid out a plan to collect the data and crowd-source surveillance algorithms. This plan should be adopted right away, and could be in place by the end of 2014.
Transparency means that data is clearly, unambiguously received in a fair way. That means we need to reform our system of data feeds in the market, starting with the public, consolidated feed. There are several proposals on how to do this, including having multiple feeds that compete with one another, or removing control from the collection of exchanges that it now rests with. No matter what, the end result must be that the consolidated feed is built using the same level of technology as any other data feed, and that data on the consolidated feed is always received by participants before any other data can possibly be received.
Finally, all market centers (Exchanges, ECNs, ATS's) must syncronize timestamps across all of their servers, at microsecond-level precision. This technology is readily available, is not burdensome and would dramatically simplify research and surveillance of markets.
Brokers have a duty of Best Execution in accepting orders and routing them to a market center for execution. Brokers generally act as agents for their customers and owe them a duty of Best Execution. Unfortunately, the rules and metrics that the SEC designed to measure and track performance of these duties are woefully outdated.
These rules were put in place in May of 2001, and functioned well to ensure Best Execution and measure outcomes. Brokers increasingly sought Best Execution and regularly published various statistics regarding execution quality.
Over time and in particular with the adoption of Regulation NMS, the rules became increasingly outdated and their usefulness, while still relevant, has diminished. In part, the rules have eroded due to the increasing complexity of order-types, speed and routing practices in today’s marketplace. Rules 605 and 606 have not kept pace with these changes. The Commission even went so far to say “improved visibility could shift order-flow to those market centers that consistently generate the better prices for investors and the Commission will assess the impact of the rules to determine whether additional action is necessary to further the Exchange Act’s objectives for a National Markets System.” It's time to re-assess these metrics and bring them into the electronic trading era.
In addition, before further changes in market structure are evaluated, these rules must be updated so that efficacy of changes can be objectively compared and evaluated. You can read more information about our specific ideas in our recent post: Special Study: The Need to Reform SEC Rules 605 and 606
Wall St firms use open source software in nearly every part of their business. Most high performance servers run Linux. The open source movement has succeeded in incredible fashion and it's time to adapt some of its principles. One of these principles is that "data yearns to be free." Healthy Markets will push to have the SEC provide open access to their MIDAS system for analyzing market data. This will spur the academic and open source communities to build incredible studies and learn far more about US markets than any team at the SEC possibly could. It will leverage the network and community effects of the open source / open data movement.
One effect of having the SEC provide access for academic research will be the burgeoning flood of independent research in an environment in which independent research has become increasingly difficult. Today, it is very difficult to gain access to the vast amounts of data needed to competently analyze market dynamics. Moreover, once academic researchers do gain access, it can be extremely difficult and costly to process it. This generally means that academics are beholden to the providers of that data, and all of the biases this implies. If researchers publish findings that their sponsor disagrees with, as most recently happened with a study conducted at Notre Dame, they risk losing access to this data. This places researchers between a rock and a hard place as they work to produce objective studies of the US stock market. We are all suffering as a result. Having the SEC serve as the intermediary will produce immense dividends for the study of our markets.
Healthy Markets will advocate in every way possible for free and open access to data. This will also include FINRA's upcoming release of dark pool reporting data. This data should be made freely available and in a form that can be easily processed and analyzed. It is inexplicable that a regulatory organization should look to profit from the sale of this data.
It is often lost in the debate that the stock market is supposed to serve two purposes: capital formation (i.e. raising money via IPO) and price discovery (determining what a company is worth). Price discovery is a complicated process, but one primary component is quotes that are displayed on an exchange or ECN. Since the implementation of Regulation NMS in 2007, the volume of internalized and dark pool trading has grown every year and now stands at over 37.5%. In addition, many stocks trade over 50% of their volume off of the standard set of exchanges. Trades can only take place off of an exchange because there are quotes being displayed, and therefore dark trading can be seen as "free riding" the public quotation.
As off-exchange volume increases, it acts as a disincentive for market makers to post liquidity. Originally dark pools were built to facilitate block trades by institutional investors, but currently the average trade size in dark pools is nearly the same as on lit exchanges. In addition, all marketable retail orders are being sent to internalizers based on backroom deals, instead of being sent to public markets where market makers can compete for those orders.
Many markets around the world have adopted some form of a trade-at rule, including Canada and Australia, and a form even exists in the US Options Market. The philosophy behind this rule is simple: publicly displayed quotes should have precedence over those in hidden systems. Moreover, if you are going to execute a small trade off of an exchange you must provide a significant amount of price improvement to offset the damage to the price discovery process. Healthy Markets will soon post a detailed proposal of what the trade-at rule should look like.
Of the critical changes advocated by Healthy Markets, this is perhaps the most vital. As such we are advocating for a pilot test to see what the impact of a trade-at rule would be. We believe that reducing the access fee cap should be part of this test as well, to help reduce investor costs across the market and help eliminate the skewed incentives that the maker-taker exchange model has created.
Healthy Markets is run by KOR Group LLC
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