They have grown so complex, fragmented and opaque that they don’t serve their stated purpose. Rather than a place where individual and professional investors can put a value on shares and where companies go to raise capital, the markets today look more like a video game. The trouble is, it’s one where only a few understand all the rules.
Excessive complexity has costs. Individuals, wary of an uneven playing field, may choose not to invest. Long-term investors, frustrated by a market that doesn’t value their participation, may take their trading to overseas venues or alternative private networks. Companies, unaccustomed or unprepared for the amount of work needed to go public, may look for other forms of capital, such as debt or private equity.
Capital markets work best when all the participants — investors and companies — come together in one place. Although everyone may not have the same interests, at least there is an understanding that a common set of rules exists.
Today, you need a super computer or a doctorate to understand the rules of the stock market. So it isn’t surprising that there is a perception that you, your neighbors and others have no chance of getting a fair price in the market. For example, why go to a store if you think there are two prices — one for the regular person and one for those with inside knowledge?
Old Days
Several forces have conspired to get us where we are today. In the old days, it was pretty simple. There were a few types of trades and only a couple of places where you could executive them. There were orders at the market price, those with price limits and good-till-canceled orders; you could go long in a stock, betting on its appreciation, or short, expecting it to fall; and you knew there was an investor on the other side of the transaction, or a market maker (a buyer and seller of last resort) if there wasn’t.
Today, there are more than 100 order types — and when you add on variables such as time of day, participant designation and session type, it multiplies very quickly.
For example, the NYSE Arca Order Type page lists more than 30 classifications (before accounting for all the variables). One kind of order adds liquidity to the market, another might be filled or immediately killed, still another can have two different price components, and so on. Larry Tabb, an equity- market expert and chief executive officer of Tabb Group LLC in Westborough, Massachusetts, estimates that there are more than 100 order types for each of the 13 U.S. exchanges, not to mention the 50 or so dark pools, where trades are executed in private venues.
In 2004, when the New York Stock Exchange first looked into changing the order-handling rules, the objective was to integrate the existing trading environment with new technology. The market would be faster and more efficient, one that was fair to the individual investor and attractive to larger participants. In other words, an even playing field that moved faster and cost less.
But the Securities and Exchange Commission, in its effort to be viewed as independent from the NYSE and promote competition among the different exchanges, permitted multiple exceptions to the rules. In other words, small operators could enter the market with different order-handling procedures. As long as their volume remained at less than 10 percent of the total trading in a security, alternative marketplaces could operate with limited regulation.
Order Flow
In addition, brokerage houses used their influence to move more order flow away from the stock exchanges and to their own private trading sessions, or pools, of securities. Think of it as a place to go for a “first look” or “private sale.” It was less expensive and gave them a captive audience for their best customers. Order flow no longer went straight to one centralized marketplace. This reduced transaction fees and increased efficiency for those that had access to it. Unfortunately, it was only the beginning of fragmentation.
Technology advances continued, fueling the rise of high- frequency trading, which exploits discrepancies in prices of different exchanges that might last for less than a 1,000th of a second. Order-handling rules became so complicated that few people could understand what each change meant. By trying to be more technology-friendly and open to all participants, the exchanges and the SEC lost control. We now have hundreds of mini-markets within markets.
The pendulum has swung too far. The exchanges are fighting for their survival. They must react to the demands of their best customers — large brokerage houses and high-frequency-trading firms — and have less influence than they did a decade ago to change the markets. In 2006, more than 80 percent of market volume was controlled by less than 20 percent of the participants. Today, high-frequency traders alone control more than 50 percent of the volume.
By allowing markets to descend into a mire of complexity, the SEC has abdicated its core values and mandate, which is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation,” according to the mission statement on the agency’s website.
When only firms with the most advanced technology have an advantage, the markets aren’t fair. When market participants can no longer understand order types, the markets aren’t orderly. When there is no cost to using capacity without making actual trades, as high-frequency firms do, the markets aren’t efficient.
The SEC needs to simplify the markets. It could start by mandating a limit to the types of orders allowed, say, no more than 10. The agency also should draft a rule book that we can all read and understand.
To contain the explosion in trading volume, the SEC should require that traders pay a transaction fee for both trades and capacity. Right now, there is no limit to the number of “looks” at the order flow for high-frequency traders, who then can craft their strategies with advance knowledge of what other participants are doing. Such fees alone would help to return the markets to a place where capital formation, not just high-speed arbitrage, is the primary objective.
Here’s one more suggestion: Require that the SEC be able to explain market structure and order types to a high-school senior. It isn’t a test that the agency can afford its students to fail.
(Amy Butte is the former chief financial officer of the New York Stock Exchange. The opinions expressed are her own.)
