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The Courage Deficit: Why Regulators Must Act More Decisively in Equity Trading Markets

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Public confidence in the integrity of equity trading markets appears to be at a once-in-a-generation low. The flash crash, the 45-minute path to near-insolvency at Knight Trading, and the large losses for investors in Facebook have not instilled confidence that the public can engage fairly in US equity markets.

The response of regulators has been underwhelming. Regulators appear to accept the notion that speed equals efficiency, and that high-frequency traders offer liquidity. In the case of Knight Trading, it is clear that speed offered something quite different than liquidity. Speed created the means for rapid failure of a tightly-wound trading system. Knight’s debacle occurred so quickly that, in less than an hour of trading, the firm was near collapse. Knight appeared unable to identify the source of the trade errors even days after the event, and may not have been aware of the scope of the problem until it was nearly too late to save the firm.

The Advocacy Committee’s view is that (1) equity market trading operates today under new technology, and old rules; and (2) there is a distinct blurring of the lines between clients and market makers. When these two dynamics interact, a comprehensive review of the rules needs to occur. In particular, we would welcome a requirement that all market participants hold their quotes for a material period of time, and that all exchanges be required to slow or cease trading in individual stocks if an imbalance is declared by a “Designated Market Maker.” Such requirements would help ensure that bids and offers demonstrate true market depth rather than phantom liquidity, and that trades occur based upon willful acts rather than by malfunctioning algorithms. While representatives of high frequency traders have objected to this possible requirement, we would expect that these beneficiaries of decimalization, technological advancement, and decentralization across multiple exchanges will find the means to adapt.

A historical context helps inform the discussion. Equity trading has undergone rapid evolution over the last decade. The replacement of fractional quotes with decimalized quotes allowed for more flexible bid/offer spreads. Increased computational power and algorithmic trading also allowed market participants to try to conceal the size of their orders, reducing the potential market impact of their trading. It also allowed, along with the deregulation of exchanges, for the evolution of private exchanges known as “dark pools” where buyers and sellers would attempt to match their buys and sells with the initial objective of not impacting prices on exchanges.

Being a stock specialist on the NYSE became a financially dangerous business. The specialists’ responsibility to maintain a fair and orderly market became less attainable as order flows increasingly routed to other trading venues.

The evolution of algorithmic trading across multiple trading venues decreased transparency with regard to market depth. Specialists were out of business by the time of the flash crash and were replaced by “Designated Market Makers” or DMMs. The DMMs are also charged also with monitoring trading, can intervene to add liquidity, but cannot be held to as high a standard as the old stock specialist because market fragmentation dilutes their ability to see sufficient market flows. The evolution of high frequency trading [HFT] appeared to bring more liquidity to the market, offsetting the decline of the specialists. However, the roles of the two are quite different. Specialists were charged with, and held responsible for, maintaining orderly markets. They provided liquidity when buyers and sellers were not balanced and, when a severe imbalance was occurring, specialists were permitted to suspend trading until a reasonable equilibrium could be established.

HFT firms are not charged with maintaining orderly markets, and there no longer are other participants truly held responsible for orderly markets. Moreover, when market prices move sharply, HFT firms are believed to reduce their trading volumes as a risk mitigation tool. Where HFT firms may represent well over 50% of market trading volumes, and specialists no longer exist, it is not hard to see how a “flash crash” could occur. Moreover, fragmentation of trading across a growing number of dark pools and other exchanges could hinder market liquidity when it is needed most.

Aside from the risk of flash crashes and failures of large equity trading firms, Advocacy Committee members were also concerned about the “illusion of liquidity” in the markets. Committee members who act as traders now witness substantial price movements against their orders, and believe the “market impact” price they pay today substantially exceeds the bid/offer spread and “market impact” they had paid prior to the departure of the specialists and the rise of the HFT businesses. Widespread use of “fill or kill” and similar orders allows HFT firms to probe across markets in ways unimaginable 10 years ago, but also arms them with radar-like tools to essentially detect investors’ wishes and front-run their trading. Indeed one of the strategies is called “order anticipation.”

Speed is not necessarily efficiency, and it may instead be part of the illusion of liquidity we have today in the absence of the role of specialists. The rising use of “fill or kill” and other rapidly dissipating orders both for exchanges and for dark pools, for instance, creates large numbers of orders that offer little liquidity for moderate to large trades. “Order anticipation algorithms,” while apparently legal, undermine fairness in the market and appear to create a legal means to front-run customers’ orders.

NYSSA’s Advocacy Committee recommends that regulators modify or ban the use of “fill or kill” and similar short-tenor orders and instead require orders to be held for a minimum period of time spanning a few minutes. “Fill or kill” orders were designed long before the advent of high speed trading, and their widespread use by technology firms may not be suitable for purposes of ensuring fairness and transparency to investors.

If DMMs and their HFT clients are intended to replace specialists and act as market makers, then regulations should be in place to ensure that they are acting that way, and to ensure that they cannot act as principal traders whose only purpose is to front-run real stock orders. These can be separated easily. Market makers “give” liquidity by placing bids below the best offer and offers above the best bid. Real orders can then “take” this liquidity from the market by lifting offers and hitting bids.


Advocacy Committee members agreed that, while the evolution of equity trading markets has many positive aspects, its current manifestation has actually become less fair, less transparent, and less competitive over the last five years. Markets are now exposed to “flash crashes,” and rapid systematic failures among large brokerage firms, damaging pubic trust of the equity markets. What is most surprising to Advocacy Committee members, however, is the ineffectiveness of the SEC and FINRA in their most fundamental tasks with regard to equity trading, particularly in maintaining fair, orderly, and efficient markets.

Any changes to rules may be seen as “risky” to implement across all markets rapidly. However, regulators could implement some changes rapidly with a small subset of listed equities as a first step, to test whether any proposed transition would function as planned. Moreover, while there is risk to any regulatory changes, there may be even greater risks to permitting the status quo to devolve.

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