Editor's Note: On Thursday, September 20, 2012 Larry Tabb of TABB Group testified before the US Senate Subcommittee Hearing on Computerized Trading. The following is a portion of his remarks and further installments will be posted shortly.
What, if any, policy changes should be considered by regulators or Congress in order to better protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation?
My first statement is to do no wrong. As you can see, the markets are very complex and interrelated. Small changes here can cause a huge impact there. For example, the implementation of penny spreads killed market maker profitability; forced markets to automate; enabled (created) the fragmented trading environment, which filled HFT coffers; forced firms to invest millions in infrastructure; and has been blamed for the destruction of equity research, the IPO, investor confidence, and the downfall of corporate America including the inability of US companies to create jobs. Of course, that is a bit hyperbolic, but from the research, blogs, and talking with many market participants, I know that these sentiments are in the market and have heard many of these stories in discussions with industry professionals.
So first do no harm, and that means do nothing radical. A radical re-shifting of the market will actually hurt investors and not help them. Radical changes will provide incentives to traders to thoroughly read the rules and learn how to profit off of less-astute investors or traders. This opportunity will only close once investors pressure their brokers and the brokers to develop counter-measures.
What I Would Do
1. Start defragmenting the market. Stop granting new exchange and ATS licenses immediately. Also create a new license or structure, which limits the number of internalizing brokers. Maybe grant every internalizing broker a license but grant no others.
a. Determine the optimal number of exchanges, ATSs, and internalizing brokers. As these entities go bankrupt, merge, or consolidate, reduce the number of licenses.
b. Maybe grant a maximum number, and say anything over that number can't even be transferred and must be retired.
c. We need to be careful; we don't want to limit competition too much, but 13 equities exchanges, 50 or so ATS licenses, and who knows how many internalizing brokers is too many.
2. Manage broker/ATS solicitations. Currently it is very difficult to understand what happens to your order and where it goes. Larger orders are being executed in smaller pieces. A 50,000-share order can be executed in more than 200 trades. While this information is provided to many institutional money managers, it is much more difficult to tell them where their order was routed but not executed. This information may actually be more important than where it was actually executed. An order may be seen by 50 to 100 firms before it is routed to an exchange for execution. Between brokers soliciting the other side, ATSs routing to each other, and exchanges routing to ATSs -- virtually everyone that may have wanted to trade against an order will have seen it before it is executed.
3. Better manage Minimum Price Variations (MPVs or spreads). Currently, we have a minimum of 1 cent MPV for stocks over $1. We should follow the direction of the JOBS Act and try to widen the spreads for less liquid stocks (small caps). This may also extend to high-priced stocks, too, as why should Apple priced at almost $700 a share trade at the same MPV as BankAmerica trading at $10. A penny spread in BankAmerica is 10 basis points, while the same spread in Apple is only 0.143 basis points. We need to think about appropriate spreads for appropriate pricing bands, liquidity characteristics, and capitalization levels.
4. Provide greater transparency of order types and routing mechanisms. Currently, most exchanges post their order types; however, the descriptions of what they do and how they work are not tremendously intuitive. Exchanges, and for that matter ATSs, ECNs, internalizers and even brokers need to begin to provide greater transparency, descriptions, and concrete examples of how each order type works, how fees/rebates are generated, where they show up in the book queue, how and when they route out, and how these order types change under the various market conditions. If these entities are not willing to be more transparent, then maybe that is one way to limit the number of matching licenses.
5. Quickly develop a market-wide consolidated audit trail for equities, options and futures markets. Develop incentives that will facilitate the cooperation of the SEC, CFTC and various SROs to ensure harmonious oversight. Develop clear rules on what is manipulative behavior in an electronic marketplace and have it updated frequently. Provide regulators with the tools and people who can develop ways to understand the market and find people and/or machines that are driving manipulative behavior. These people and organizations should be stopped, fined, or imprisoned. If we had confidence that our regulators had the tools and capabilities to surveil our markets, it would give the public more confidence that pernicious behavior was being flagged, challenged, and resolved. It would provide investors with the assurance that our markets are safe again for trading, investing, and raising capital.