By Lou Pastina, Global Markets Advisory Group
Gary Gensler, the newly minted Chair of the Securities and Exchange Commission, testified recently that he will seek a deep dive into the market structure of the United States Equity Markets.
My question is, does anyone really care anymore?
It was early in the new millennium that the Commission – fresh from Nasdaq scandals and the introduction of competition with new alternative trading systems – enacted Regulation NMS. Buy side traders were tired of being traded ahead of and Sell side desks were tired of paying huge commissions to Specialists on the floor of the NYSE, especially when they felt that they were being sometimes “pennied” by Specialists. The Commission, fed up with the NYSE’s entrenched positions, determined that a fundamental overhaul was needed. The resulting regulations essentially sowed the seeds of today’s modern markets.
The one-two punch of moving from fractions to pennies, and the introduction of Reg NMS reordered the economics of the market making business so drastically that payment for order flow – an insidious practice prior to NMS – became the only way market centers could reliably attract liquidity. This type of competition was not what the authors of the Exchange Act and its amendments originally envisioned; they assumed market participants would direct their orders to the markets with the deepest liquidity, and therefore sought competition between orders for priority based upon price and time. They also enacted restrictions to limit the time and place advantage that accrued to Floor traders. All of that changed when Reg NMS took effect. In fairness, not only did the change in regulation have an impact but so did the rapid application of technology to trading, and the painful awareness that came from the tragedy of 9/11, that the United States was extremely vulnerable with physically convened markets.
It was not a smooth transition into the future. As the person who helped guide the NYSE into electronic trading from open outcry, I can say from first-hand experience that it was fraught with many bumps and more than a few crashes. There were technology imbalances that dramatically shifted the balance of power among players; there were those who played fast and loose with interpretations of what was allowed and what wasn’t; the Exchanges switched from mutualized, member owned facilities, to for-profit public companies with fundamentally different goals; the financial crisis knocked out several significant players from the markets; and all participants – including the regulators – made mistakes. One does not have to look any further than the “flash crash” of May 2010 to understand that the Commission did not know how to reconstruct the decentralized, fragmented market that it had brought into being. Only now, eleven years later, with the introduction of the Consolidated Audit Trail, do they have the tools to do so, and it remains to be seen whether that is enough.
The Commission continues to approve new Exchanges, adding to an already complex and expensive infrastructure. The costs of market entry are high. But the fact remains that if you can attract enough order flow, it is possible to make a go of it. What’s different is the mechanism for attracting that flow. Once upon a time, it was the guarantee of depth that came with trading on the Big Board, or the chance to profit from the more free-wheeling trading in the Curb Market. Under Reg NMS, price took primacy over quality of execution; liquidity was atomized across thousands of penny and sub-penny price points and dozens of lit and dark venues; and average trade size plummeted. Markets responded by rewarding makers and charging takers, which naturally raised the question of who should pay the fees and who should keep the rebates. Throw in the move to commission-free trading and here we are, once again questioning the fundamental tenants of what Reg NMS wrought: should payment for order flow be allowed; should odd lots be the best bid and offer; should you have to route to better bids and offers?
These are complicated questions that require much analysis but at the end of the day, the current community, having “retired” the former community long ago, is so used to this market structure that changing it raises the kind of cries that were once heard from the mighty Specialists in their day. Funny how we all become our parents.
The recent GameStop trading fiasco powered by the likes of the democratizing Robinhood and others like them have, I believe, made the question of market structure moot. No one cares. The young of today, used to free products where they and their data are the product; who order anything and everything online; who Venmo cash electronically; who invest in Bitcoin and Dogecoin enthusiastically; and who have come to expect instant gratification and settlement, want change, but on their pace and timeline, not Chairman Gensler’s. They are not going to sit in a conference room and debate what should happen.
The last Market Structure Committee of the SEC that did that resulted in zero changes, leaving the members of the Committee, some of them former bosses of mine, genuinely and completely frustrated. No, the young will simply act. They will make change happen with new technologies; by knocking down old ways of thinking; by operating on the fringe at first, if necessary, until they become the majority. That is the way real change happens.
As we look back at Reg NMS and the market structure that we have today, we must ask, is it in some ways better? I think in many ways it is and it isn’t. We are no longer vulnerable to physical attacks on our markets, but we are highly vulnerable to cyberattacks. We have several markets innovating and competing, but it’s not clear that the competition is healthy. And it doesn’t address some fundamental questions: Should orders go to markets that pay the most or does that degrade the quality of executions overall? What happens when someone figures out a dramatically faster way to trade? What is it about the structure of the market that is causing young companies to continue to wait later and later before entering the public markets, and is that a good outcome? And is one share, one vote a thing anymore, especially if founders control all the votes? These are the questions that will be debated. But will there be any tangible result.
After all, everyone agreed that May 2010 should never be repeated, but it took the exchanges and the SEC eons, as measured by the lifecycle of technology companies, to get the Consolidated Audit Trail finally up and running. In the end, does anyone care?
Lou Pastina is a managing member of Global Markets Advisory Group. He was a 31-year veteran of the New York Stock Exchange and was the manager of the Exchange’s Hybrid Market implementation plan in response to Reg NMS. He spent the next seven years as Executive Vice President managing the NYSE’s transition to electronic trading before retiring in 2015. Contributing to this article were GMAG members Jim Buckley, Dan Labovitz and Charles Dolan.