Is Scream The Movie Coming To An Equity Market Near You? Hopefully Not If Senator Kaufman Is Finally Heard
Senator Ed Kaufman keeps the fight for market integrity alive with the following FT Op-Ed (highlights ours):
Preventing a horror movie ending in the US markets
By Edward Kaufman
High frequency trading, dark pools, and flash orders – unknown to most Americans a few short months ago - have now joined the American lexicon. As phrases, they are easily tossed about. But trying to understand the arcane, high-tech and labyrinthine way stocks are traded - radically transformed from just a few years ago - is far more difficult.
Many on Wall Street assure us there is nothing to worry about. In their view, the dramatic proliferation of competing markets and the extraordinary rise in high velocity trading have had only beneficial results: greater liquidity, narrowed spreads and lower transaction costs for all investors.
Lost in this reflexive defense against meaningful government review, however, is a more overarching concern: the integrity of our capital markets, which are now too fragmented, too opaque and well beyond the effective surveillance of the Securities and Exchange Commission.
That’s why I have urged the SEC to undertake a comprehensive “ground up” review of a broad range of market structure issues before more piecemeal changes occur. We have seen this horror movie before, and only timely regulatory examination can best prevent a sequel: When markets develop rapidly and are not transparent, effectively regulated or fair, the movie’s ending scene can be one of tragedy affecting millions of people.
The facts speak for themselves. We’ve gone from too few stock markets to too many; from an era dominated by a duopoly of the New York Stock Exchange and Nasdaq to a highly fragmented market of more than 60 trading centres.
In competing for market share, those trading centres encourage or permit a variety of questionable practices. Dark pools, for example, which allow confidential trading that takes place away from the public eye, have flourished: Five years ago, there were 18 dark pools comprising 1.5 per cent of the market’s volume; today, over 50 dark pools execute over 12 per cent of market trades. And the total percentage of trades taking place in dark pools or internally at broker dealers, another source of private trading outside public markets, now approaches one quarter. For strictly retail investor orders, it may be twice that amount.
Moreover, in just two years, the percentage of daily stock trading volume by high frequency traders – whose computers are constantly probing the market for miniscule price advantages -- has reportedly skyrocketed from 30 percent to nearly three out of every four trades.
Left unchecked, high frequency trading could develop into a systemic risk, becoming simply too big and too fast to regulate. If all the machines “zig” at the same moment when they should have “zagged”, market chaos could ensue.
And when the average investor loses confidence in the integrity of our markets, when he or she believes that the price at which they are able to buy 100 shares of IBM is higher than it should be, even if only marginally, because of high frequency gaming strategies, then the reputation of our capital markets for basic fairness is significantly tarnished.
The SEC’s review should be all-encompassing, reviving old ideas and examining new ones: should markets be centralised or decentralised; should we separate the markets based on investor types; what should be the role of market makers; what role might there be for real time risk management?
At a minimum, a few simple themes should guide us to a regulatory framework that permits vigorous competition while substantially reducing the possibility of a two-tiered trading network, where long-term investors are vulnerable to powerful trading companies that exist not to value or invest in the underlying companies, but to feed everywhere on small but statistically significant price differentials.
First, we should reconsider the criteria for becoming an exchange or market centre because the market’s unhealthy fragmentation – and the high-speed trading strategies that thrive on it – are growing rapidly.
Second, we should consider rule changes that ensure the best prices are publicly available, not hidden from view in private trades. The strength of a free market is based on this public display. Accordingly, we should reduce “internalisation” (by insisting on meaningful price improvement in comparison to the public quotes or by granting the public quotes the right to trade first) and trading in dark pools (by reducing the permissible threshold for dark trading and defining indications of interest, and other quote-like trading signals, as quotes).
Third, we should root out conflicts of interest by ending payments from market centres that encourage orders to flow their way. The search for best execution by broker-dealers should not be subject to temptation from the highest bidders. Competition for market share includes liquidity rebates and direct access for hedge funds, which also deserves careful review.
Fourth, until regulators can measure execution fairness in milliseconds for stock trades of all kinds, the credibility of the markets cannot be assured. The audit trails and records of order execution in fragmented venues must be synchronised to the millisecond and made readily available in statistically understandable formats to the regulators and the public. Currently, while high frequency traders bank profits in milliseconds, the first column for time on the Rule 605 form, used by regulators to measure execution quality, reads “0-9 seconds.”
Fifth, regulators must also develop more sophisticated statistical tests, such as following volume patterns to gain a granular view of gaming strategies. Only then can regulators separate high frequency strategies that add value to the marketplace from those that inexcusably take value away.
As a nation, our credit and equity markets should be a crown jewel. Only a year ago, we suffered a credit market debacle that led to devastating consequences for millions of Americans. While we must redress those problems, we must also urgently examine opaque and complex financial practices in other markets, including equities, before new problems arise. It is essential to ensure the integrity of US capital markets.
Edward E. Kaufman is a Democratic senator for the state of Delaware