Views on improving the integrity of global capital markets
10 December 2015

Forty Years of National Market System in the US — Things Have Never Been Better

Posted In: Market Structure
Technology background from siver metal gears and cogwheels on black. Highly detailed render.

The equities market in the US is not only the best in the world, but also the best it has ever been. That was my main takeaway from the 40th anniversary of the National Market System (NMS) conference at the Zicklin School of Business at Baruch College, a senior college in the City University of New York system.

The conference, which covered the winners and losers, and lessons, of US market structure regulation, was organised by Robert A. Schwartz, Marvin M. Speiser Professor of Finance and University Distinguished Professor, and Larry Tabb, founder and CEO of TABB Group, a financial markets’ research and strategic advisory firm focused on capital markets.

In opening remarks, Schwartz touched on the well-publicised concerns about high-frequency trading (HFT) and fragmentation in the past few years. However, a seemingly broad cross-section of conference participants had few existential fears about the market in this regard. Schwartz joked that the biggest winners from the complexity of modern markets as well as regulatory change were academics who had more research to conduct than ever. He noted that by all conceivable metrics, modern markets were working well. Yet there is still a pervasive sense that ‘something is wrong’ and that market quality needs to be assessed in stressful times, he said.

Another panelist, Thomas Gira, vice president of market regulation at the Financial Industry Regulatory Authority (FINRA), noted that before NMS in 1975 there was no consolidated tape, no competition, fixed commissions, and high trading costs with low retail-investor participation. The big winners from market regulation have been investors, he argued, with some qualifications about the effects of dark pools and order-driven markets without market makers.

Regulators and Technology — the Challenges

Tabb moderated the first panel session on the challenge posed to regulators by technology. Anthony Fortunato of Instinet noted that despite Reg NMS making it more complicated to set up trading systems resulting in unintended consequences, the market is currently very resilient — putting forward the example of a four-hour NYSE shutdown during a recent trading day that went largely unnoticed. John Zecca of NASDAQ agreed that NMS was a success at a macro level, while Gregg Berman of Ernst & Young (EY) argued that we had to compare the current market to what was before, not a hypothesised ideal. Markets do a lot more things than they used to do, which creates new challenges for regulators. Specifically, they need to regulate not only old practices using new technology but new practices using new technology.

The discussion then moved to data and empirical analysis with Berman highlighting the crucial role this should play in regulatory decisions. Zecca noted that regulators may appear to have an easier job with the large amounts of data available, but the extreme fragmentation of US markets added complexity back into the analysis. An example of this was the difficulty in proving spoofing cases. John Adam of Portware went further and argued that the consolidated audit trail (CAT) would not be a silver bullet and that there needed to be a strategy to trawl through the data not merely to collect it. Fortunato expressed a similar point when he noted that it was hard to show best execution when there is so much trading per millisecond.

Has NMS-Induced Competition Spawned Good Market Outcomes?

Stephen Cavoli of Virtu Financial opened the session on this topic by saying the US market was pretty good, and it was important not to go over-the-top in self-criticism. In this vein, Dave Weisberger recounted an anecdote about markets in 1987 noting that market makers would sometimes pretend to be the office cleaner when answering the phone to avoid executing client trades. In relation to recent controversy over IEX’s application to become a stock exchange, he noted that the speed bump made sense to him, but that it shouldn’t confer an advantage to IEX itself. However, based on its application to the SEC to become an exchange, it appears that the IEX-affiliated broker dealer and certain IEX-pegged order types would be able to circumvent the speed bump, which made Weisberger think the SEC would have no option but to refuse the application or have it suitably amended (see related article). Interestingly, Weisberger noted that the granular tick-size regime in the EU is something that Europe does better than the US and that one penny is too wide for big US stocks, which leads to cross-subsidisation. This is consistent with the themes in a recent CFA Institute report on market liquidity.

Fair-and-Level Playing Fields — Worthy Pursuit?

The afternoon sessions focused on the idea of fair-and-level playing fields and whether this is a worthy goal to pursue. Alan Hill from Jones Trading noted that retail and institutions are so different it makes no sense to treat each equally. Currently regulations are the equivalent of forcing a jeans supplier to treat Walmart buying 10 million pairs of jeans exactly the same as an individual trying to buy one pair.

In response to Hill, Bill Harts of Modern Markets Initiative argued that institution-specific venues already exist, yet the institutions mostly trade on continuous markets anyway. Gary Stone of Bloomberg pointed out that institutions are mostly pooled retail blocks in any case, and moved on to talking about price-time priority suggesting that experiments with batch auctions have been tried and have failed in the markets, implying that markets want price-time priority and cautioning against prescriptive regulation in this area.

(CFA Institute is for equal treatment of investors and avoiding order-flow segregation so as to minimise the negative impacts of market fragmentation, liquidity homogenisation, and the resultant problem of adverse selection. For example, see our comment letter on the New York Stock Exchange’s Retail Liquidity Program proposal.)

The panel ended with a discussion of colocation. Stone argued that colocation confers so many benefits that it should result in market-making obligations. Adam Sussman of Liquidnet, and Harts pushed back saying that one cannot treat market participants differently and that colocation and its advantages are available to anyone willing to pay the subscription fee. Stone rebutted that this may not really be accurate in practice and that more study is needed.

Andy Brooks of T. Rowe Price kicked off the final session, “The Buyside Responds,” by noting that for active managers in the small and medium-sized enterprise (SME) space the current market is not particularly good and the bigger the trade the bigger the challenges. Curt Engler from JPMorgan Asset Management agreed that Reg NMS had complicated the life of buy-side managers, but noted that complication also meant opportunities and that on balance, the buyside are also winners. Frank Loughlin from Alliance Bernstein agreed that everyone wins as a result of Reg NMS to a lesser or greater extent and that even for large institutions it’s never been cheaper to trade. To that end, regulatory priority should be: do no harm.

Moderator Pete Jenkins, from PDQ, asked whether institutional investor interest in IEX suggested that institutions were unhappy with the status quo? Brooks replied that the buyside is always looking for better ways to do block trade, and he was not happy about the incentives for order-flow routing. Loughlin agreed that interest in IEX was likely the result of managers looking for competitive advantages. Enrico Cacciatore from Voya Investment Management said that the HFT acronym is not helpful and should be retired since everyone and everything is today operating at a high frequency.

My impression of the conference, held in early November, is that most market participants are mostly happy with modern market structure and quality. The concerns about high-frequency trading are not as acute as implied in some media outlets. The instructions for regulators seems to be: improve things at the margin but, most importantly, to do no harm.

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About the Author(s)
Sviatoslav Rosov, PhD, CFA

Sviatoslav Rosov, PhD, CFA, is Director, Capital Markets Policy EMEA at CFA Institute. He is responsible for developing research projects, policy papers, articles, and regulatory consultations that advance CFA Institute policy positions, focusing on market structure and wider financial market integrity issues.

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