Without modern computers, the implementation of the order handling rules would not have been possible. Think about it.
The order handling rules have been single-handedly credited with leveling the playing field. Technology enables customers' limit orders to be electronically disseminated and made transparent. Back in the 1950s, or even in the 1960s, that would not have been as easy. (Conversely, allegations of unfair trading practices on Nasdaq arose because traders were said to be perpetrating abuses – on a computerized dealer market.)
But the question arises, is the regulation of fairness for investors bound by the technological advances of the late 20th Century? The conventional wisdom on Wall Street – and across Main Street – is that technology has unleashed unprecedented opportunity for the little guy? But is the little guy better off?
Steve Wunsch, the founder and president of the Arizona Stock Exchange, the struggling call market run out of New York City, says the answer is no.
The little guy, he argues, has been used as an excuse by the regulators to re-engineer the U.S. stock markets, causing these disruptive consequences: uncontrollable volatility, massive price manipulation, a dearth of liquidity and a breakdown in price discovery. In such an environment, Wunsch claims, the reputed reduction in transaction costs created by "leveling the playing field" is eliminated.
"The academics and regulators, in a sort of mutual admiration society, have spun theories that don't hold water," Wunsch, the former head of the stock index futures department at the now defunct Kidder Peabody, states in a pamphlet he recently published. "Settled doctrine or not, it makes no sense to turn the stock market into a testing laboratory for anyone's theories. But the fact is that, after all the tinkering, the academics and regulators have become the chief designers of the stock market today."
In a telephone interview, Wunsch is even more outspoken. "The order handling rules and the National Market System [enacted by Congress in 1975] are designed to ensure the retail guy has the same opportunity as Salomon Brothers," he said. "But that is exactly what Marx tried to do"
Here is what Wunsch thinks: Centralized markets, organized around membership-owned stock exchanges are good for the investor. Centralized markets encourage profitable intermediation and healthy stock exchange monopolies. Centralized markets encourage upstairs discussions among dealers about order flow and the discovery of good prices based on those flows. Too much regulation is bad.
"Because the [order handling rules] require that all electronic communications networks be allowed to free-ride on each other's and the general market's liquidity through SelectNet, the concept of proprietary liquidity on a market whose members are loyal to it is already out the window in the Nasdaq market," Wunsch states. "Once ECNs become exchanges, as several plan to do, this situation will also apply in NYSE-listed stocks."
Wunsch's provocative opinions are unpopular, especially among the buyside.
"Steve's argument is that the broker used to do this great upstairs pricing job. That's just crap," said Harold Bradley, a portfolio manager at American Century in Kansas City and the former head of the mutual fund giant's trading desk. "Upstairs trading was not done in the investor's interest because it was offboard and ineffective."
William Christie, a professor at Vanderbilt University, who co-authored the study that concluded that dealers tacitly colluded to keep spreads artificially wide, stoutly defends the introduction of the order handling rules. "You had a system where market makers found ways to take advantage of investors," he said. "The SEC came in and said, if you are not going to play fair, we are going to invite the public in to compete."
Those rules have caused Nasdaq trading costs to drop to their lowest level at American Century, Bradley notes.
Eric Sirri, chief economist at the SEC from 1996 until earlier this year, disagrees with Wunsch that the SEC is stepping out of line. "The SEC does not want to dictate market structure and it has been very clear about that," Sirri said. "The SEC is bound by the NMS rules and other changes."
But Gene Finn, who served as a chief economist at the SEC, from 1969 until 1976, strongly takes Wunsch's side. "Regulation has gone too far," he said. Finn said the exposure of customer orders on Nasdaq makes the playing field even more unlevel. "If a market maker accumulates an [aggregated] position in a stock for 100,000 shares on the bid, it will exert upward pressure on the price," Finn said. "An institution, on the other hand, does not have to expose its position like that."
Wunsch has been on the anti-regulation bandwagon for as long as most trading pros on Wall Street can recall. His star shone brightly when the Arizona Stock Exchange was introduced in 1990, because it was among the first advanced software systems to respond to the burgeoning trade volumes of the U.S. stock market. While the Arizona Stock Exchange has seen its volume decline to roughly 5,000 trades, representing 50,000 shares – down from 200,000 shares in 1996 – Wunsch and his system are still considered forces to be reckoned with.
With the stock market still strong, Wunsch's current arguments sound shrill however. "Some of the regulations have made it difficult for some organizations to compete," said Lee Korins, president of the Security Traders Association, "but the rules haven't created an impediment that has forced them out of business. We really haven't had a bad marketplace."
Brandon Becker, director of market regulation at the SEC from 1994 until 1996, says the level of price transparency today in the U.S. stock markets has created more integrity and confidence in them. But Becker does acknowledge that SEC rulemaking can sometimes be "unnecessarily mechanical and counterproductive."
Wunsch blames the regulatory changes for all the supposed problems on the dealer and listed markets, such as volatility and the dearth of shares immediately available for block trading.
Wunsch's fixes? One of them is a call market on Nasdaq and on the Big Board. Wunsch himself acknowledges that this sounds self-serving. But he makes a compelling case as Nasdaq officials wrestle with a constituency resisting the introduction of a call, according to people familiar with the situation.
"Now that we are eliminating the membership-owned stock exchanges, the ferociousness of pure unadulterated continuous trading is becoming visible," Wunsch said. "A call market is good because it is not continuous." Wunsch's latest advocacy for call markets dovetails with opinion in regulatory circles.
According to a source familiar with the situation, NASD President Richard Ketchum recently highlighted to members of Nasdaq's Quality of Markets Committee, the benefits of a call market on Nasdaq, citing the concerns over Nasdaq volatility raised by Arthur Levitt. Ketchum alluded to a speech Levitt had drafted, which made a strong case for a call market on Nasdaq. (The reference to a call market was subsequently watered down in the final version delivered by Levitt at the Securities Industry Associations's annual meeting held last month in Boca Raton, according to this source.) Market maker members who participated in the Ketchum presentation thumbed their noses at the call market proposition, this source said.
In the SIA speech, Levitt said, "A unified opening on Nasdaq is both possible and long overdue. I am happy to report to you today that the NASD has committed to address this problem recently. The Quality of Markets Committee has made this a top priority. We will hold them to this pledge."
Market makers on the Nasdaq committee were not available for comment at press time. A spokesman for the NASD declined to comment. A spokeswoman for the SEC said that all speeches by the SEC chairman go through multiple drafts and the SIA speech was no exception.
The New York Stock Exchange currently runs a lukewarm call mark, but it is far from the model envisaged by advocates of pure call markets. "There is no direct access for customers and only specialists see the book," Wunsch said.
American Century's Harold Bradley, who is an advocate of call markets, is clear why the Big Board possibly shuns them. The specialists are running hugely profitable business, he said, citing the 70 percent return on capital as stated in the prospectus for La Branche & Co., a Big Board specialist which recently went public. "Most of that money is made at the opening and at the close," Bradley fumed.
The call shouldn't replace the continuous two-sided markets, Wunsch says. It would be available as required to alleviate bottlenecks, such as at the opening and closing of the markets. That's better, he says, than relying on the current system of price discovery which has turned into a "crap shoot" fostered by an overregulated marketplace.
