There is a distinct irony in regulators pushing for speed bumps in U.S. equities markets after we’ve spent the last decade to make the National Market System faster. Increasingly, when it comes to the efficiency of U.S. equities markets, it’s safe to say that we should be careful for what we wish for. You might even argue that we did the job too well.
American equities markets have been through a succession of gyrations–decimalization, Nasdaq’s SuperMontage order entry and execution platform, and the Reg NMS reforms that brought the trade-through, access and sub-penny rules. The push for uber-efficiency has continued with new rules governing the activities of "large traders," FINRA’s expansion of the order recording and reporting obligations for OATS to include orders in all NMS stocks, and an effort to limit the use of IOIs in dark pools.
The SEC’s new registration and reporting rules for large traders covers investors or others trading their own money when they transact more than 2 million shares on any given day in a month, or if they trade greater than 20 million shares per month. It also imposes recordkeeping, reporting, and limited monitoring requirements on registered broker-dealers used by large traders to execute their transactions.
Supposedly the SEC benefits because it will be able to capture a great deal of information on key transactions and use this information to craft better regulation. But the large trader and new OATS requirements will add up to more administrative work for firms just when they thought life might get easier via far more efficient markets.
In addition, we have already seen the first wave of regulation put in place to limit or control market access. I don’t think anybody would argue that proper controls and limits should not be in place for firms to adequately manage their risk. But has this regulation artificially created a problem and a market that didn’t exist?
As you can see, a strange theme is emerging–the push for more efficient markets has paved the way for the painful inefficiencies of huge data volumes and extreme market volatility. High-frequency trading strategies and the demand for low-latency delivery of market data have emerged to help firms cope and capitalize upon the incredible volumes and volatilities. To counter the volumes, volatility and their own regulations, the regulators are now planning speed bumps to stop panic selling, greatly accelerated by such extremely efficient markets.
The impetus for circuit breaker market-wide trading halts grew dramatically after the "flash crash" of May 6, 2010 when the Dow Jones Industrial Average rapidly dropped 1,000 points but swung upwards in minutes. The market volatility continues to the present, evoking unpleasant memories of the worst days of the Great Recession. The circuit breakers will have thresholds based upon point levels and new SEC rules will allow for pauses on individual securities when their prices fluctuate 10 percent or more in a five-minute period. The new rule applies to stocks in the S&P 500 and Russell 1000 indexes and exchange-traded products. The trading halt will last five minutes. A pilot project testing all of this is slated to run until Jan. 31, 2012.
But the rules that improve efficiency, the reporting demands, and circuit breakers do not make sense for market makers and other firms that traditionally put forth liquidity. In their place are New Age market makers–the high frequency trading firms–who are smart traders willing to provide liquidity when it makes sense. But if there’s a sign that conditions are not ideal, they no longer provide liquidity, which can result in massive swings in the markets.
Yet bringing trading to a halt runs counter to the grand goal of an efficient NMS and gets us back to where we were at the start.
One solution could be to let market makers act in ways similar to the specialists once working the floor of the New York Stock Exchange. Then, specialists were required to take positions even if they may not have always been favorable. By sometimes taking these positions, specialists were granted certain exceptions to market rules enabling them to minimize losses associated with those positions. I don’t think anybody wants to move backwards, but at least the past behaviors stabilized the market and allowed for investors to trade freely. I think this would be a better way than screeching halts, followed by mad dashes to recover.
Besides, regulations spur ingenuity in the opposite direction. Every time a regulator devises a rule to stop bad behavior individuals figure out creative ways to trade within the rule but not specifically the way rule was intended. We have seen this to date with the use of ISO day routing thus, continuing the cycle of madness.
Ralston Roberts is a senior vice president in SunGard’s global trading business