In the past 20 years US equity markets have evolved dramatically. The two major US markets the NYSE and NASDAQ have moved forward at different paces but pretty much have converged at this point with how they interact with traders. Trades can be executed on either exchange within a blink of an eye by computers and humans alike. For an excellent book that summarizes this evolution check out Dark Pools by Scott Patterson that was released a few months ago. In it Patterson somewhat prophetically quotes a consultant that claims a financial institution will lose “billions” from a loop in HFT code at some point. The loss turned out to be $440 million.
The move to automated execution can be traced back to the crash in 1987 when NASDAQ market makers stopped answering phone calls from those wishing to get out of rapidly falling positions. The SEC endorsed an automated trading system for the NASDAQ which would allow investors to enter small orders of up to 1,000 shares which would be required to be executed automatically at market makers posted quotes. This change allowed several upstart firms to crash the Old Guard of Wall Street by building trading platforms to take advantage of this new “direct access” being granted to the NASDAQ market.
The next phase of evolution in electronic trading was facilitated by the SEC’s regulations in 1997 that allowed electronic communications networks to post competing price quotes for NYSE and NASDAQ stocks. This began to narrow spreads in the most liquid stocks. Typically the most liquid stocks traded with 1/4 spreads at the time (the “spread” is the difference in price between the bid and offer in a stock and is one of the ways in which a “market maker” earns profits). Their spreads began to narrow to 1/8ths and sometimes 1/16ths. As a trader risking my own capital in the market I liked the idea of narrower spreads which reduced the risk on every trade I made each day. The SEC’s reasoning behind encouraging price competition with the major exchanges was transaction costs would come down for investors. And more traders would be attracted to participate in the markets increasing liquidity. The studies that I have read examining market liquidity indicate that it has increased significantly since the introduction of these structural changes (there is a common refrain from critics that this “liquidity” disappears during volatile market periods. I address this point with a suggested market change below).
Part of the SEC’s willingness to introduce ECNs was related to the price fixing behavior of NASDAQ market makers posted quotes. Some academics had noticed in NASDAQ stocks despite market makers being allowed to post quotes in 1/8ths that they rarely did so. This was the opposite of the behavior expected in a competitive dealer-based market where each dealer should be competing for order flow by adjusting their posted quotes. It turned out that the big players GS, MS, MER SBSH, and LEH had a tacit agreement to collude and not quote prices in 1/8ths thus maintaining a minimum profit level for making markets. The colluding firms settled for around $1 billion which was distributed to traders who filed claims against the market makers. The $1 billion settlement was a small fraction of the profits that the old guard had reaped over the years from their collusive behavior. This episode received very little attention compared to the Wall Street scandals of the past few years as it occurred prior to the 24 news cycle and the explosion of the Web.
The next change to occur that has caused a huge shift in US markets was the introduction of “decimalization”. Stocks began to be quoted in cents instead of fractions reducing the theoretical spread for stocks from 6 cents (1/16th) to 1 cent. I remember when this switch occurred having great difficulty figuring out what prices to place my orders to buy and sell. I was use to trading in 1/4 (25 cent) increments and all of the price quotes in between was disruptive to my flow as a trader. In the meantime computer trading programs became more prevalent. ECNs and decimalization allowed them to trade in thousands of stocks with minimal risk. This was pretty much the end of the gravy train at sales and trading desks at large Wall Street firms. The narrower spreads removed most of the justification that banks had for the large “markups” banks charged institutional clients to execute their trades.
The current structure of US equity markets is here to stay. There may be some tweaks from time to time to attempt to address unfair beahavior that is occurring but there is no going back to the structure of the 90s with wider spreads and a lack of competing quotes from ECNs. This new structure will eventually be adopted by all electronic markets globally as they seek to attract more capital. Here are some changes I would like to see to make our equity markets fairer for all participants.
- All participants should have the ability to “hide” orders until they are executed. As it stands now when I attempt to keep my orders hidden from predatory algorithms I am unsuccessful. It seems to be the case that exchanges like NASDAQ are selling information on “hidden” orders to HFT firms that are willing to pay for it. Why this is legal I have no idea. For those who believe all orders should be available to other participants to see I would agree with you if their was also a requirement for orders that are entered to remain “live” for at least one second. Otherwise who cares if you can see quotes that will just be canceled before you can execute against them.
- Private firms should not be allowed to have servers hosted in the same data center as the exchanges. This provides an unfair execution advantage to the wealthiest market participants. The SEC should mandate that quotes be disseminated at a minimum pre-determined interval to all those who pay for quote data from the Exchange. For example, the NYSE and NASDAQ must deliver all price updates .1 of a second after they are received giving everyone the same opportunity to execute against these orders. I understand that those with HFTs will execute many orders before I even react to the quote updates but that change would level the playing field. From my perspective this change would be the equivalent of a Reg FD for market structure.
- Establish a pilot program on a series of stocks experimenting with minimum spreads of .05 cents. Many have argued that less capital is being committed to markets during volatile periods and this directly relates to penny spreads taking away the incentive of market makers from risking significant capital. I see no harm in adjusting trading rules for 100 stocks and analyzing the data with respect to increases/decreases in liquidity levels. A recent article in The Wall Street Journal discusses the concept of a pilot program to move some stocks back to fractional quotes from decimals.
In the past 16 years I have seen all sorts of market conditions and massive structural changes. Hopefully our markets will continue to evolve in a way that encourages the greatest amount of capital participation, which is their core function and what encourages capital formation and economic growth.
Steven Spencer is the co-founder of SMB Capital and SMB University and has traded professionally for 16 years. His email address is [email protected]. To listen to his live morning all each week day click here.
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