Defining Rules of Road for Computerized Trading
Can For-Profit Exchanges Regulate Selves? NYSE Euronext, Nasdaq OMX, Credit Suisse, ITG Weigh In
December 18, 2012
Testifying before the Senate Banking Subcommittee on Securities, Insurance and Investment today, executives from NYSE Euronext, Nasdaq OMX Group, Credit Suisse and the Investment Technology Group were asked to help establish rules of the road for computerized trading.
“There was considerable agreement on topics such as the importance of simplifying market structure and the need for an audit trail,” said Miranda Mizen, a Tabb Group principal and director of its equities research. “There were also some sharp disagreements about topics such as how to best level the playing field between exchanges and brokers.”
Those testifying were Robert C. Gasser, CEO and President of ITG; Eric Noll, executive vice president and head of Nasdaq OMX Transaction Services; Dan Mathisson, head of equity trading for Credit Suisse; and Joseph Mecane, executive vice president and head of U.S. equities for NYSE Euronet. To a large extent their answers had to do whether they were representing an exchange or broker, lit markets or dark platforms.
Underpinning the discussion, the subcommittee noted there are currently 13 equities exchanges in the United states, more the 40 “dark pools"and 200 broker- dealers who can execute order flow internally. What are the strengths and weaknesses of this market structure?
In Gasser’s view, the structure has yielded huge benefits in terms of cost savings for retail and institutional investors. “ITG’s own data indicates that total trading costs for U.S. equities have fallen more than 70% over the past decade,” he noted.”
The increase in the number of execution venues has also led to a more robust national market system, with built-in redundancies and “no single point of failure.”
A potential weakness in the structure, according to Gasser, is innate complexity. “Unlike the days when equity trading was essentially an oligopoly of the exchanges, today the proliferation of competing brokers, dark pools, and exchanges may be difficult for even many investment professionals to fully grasp. This complexity and the perceived lack of market structure transparency have grown to the point where it may be impacting investor confidence.”
NYSE Euronext’s Mecane concurred. “In light of the market events that have occurred in recent years, how technology and our market structure have created unnecessary complexity and mistrust of markets; and...what NYSE believes the industry, regulators and Congress should be doing to address it.”
The bottom line is that the diverse structure of markets increased overall complexity. “Our main message is that if we want to reduce the complexity of technology and our markets, we should simplify the overall market structure,’’ Mecane said. “Doing so would certainly prove beneficial for the future of our national market system, for investors and issuers, and to the growth and well-being of our economy.”
Exchanges have converted from mutually-owned not-for-profit organizations to publicly-owned for-profit companies, the subcommittee noted. This change resulted in two related questions: How has this influenced the operating model? Should exchanges still be self-regulatory organizations?
Nasdaq’s Noll said exchanges can regulate themselves, effectively. “Only exchanges have the authority and responsibility to oversee broker-dealers as they interact with the market. That authority is the result of a rigorous public process of qualifying to be an exchange conducted by the SEC,’’ Noll said.
“In the case of Nasdaq, it took six years. Exchanges alone adopt member and market regulation rules, develop automated surveillance systems to detect rule violations, and discipline broker-dealers that violate rules and harm investors,” he stated.
“Congress recognized that enforcing rules in U.S. securities markets is so important that two regulators rather than one are needed to enforce them. Congress codified the authority of exchanges to act as self-regulatory organizations (SROs), to set and enforce trading rules and to halt trading during extraordinary national or international events. SROs supply the SEC and other regulators vital information about the trends and performance of U.S. capital markets. The SEC is our partner in protecting investors,” Noll said.
Mathisson of Credit Suisse took an opposing view, noting that exchanges have unfair advantages over brokers. Credit Suisse is exploring ways to gain acceptance for its Light Pool as an exchange.
For instance, the Consolidated Tape Association distributes $400 million in market data revenues to exchanges after operational and administrative expenses have been paid. “The enormous revenues from market data are way out of proportion with the costs of exchanges’ self-regulatory responsibilities. Market data revenue has simply become a government-granted windfall at the expense of the investing public,” Mathisson said.
His recommendation: Remove the self-regulatory status of the for-profit exchanges. “For-profit entities should not be shielded from liability for damages that arise as a result of their own actions,” he said. “ For-profit entities should not be able to audit and regulate their competitors. Exchanges have already transferred most of their regulatory tasks to FINRA (the Financial Industry Regulatory Authority). It is time for Congress to revoke their special quasi-governmental status and government privileges.”
Gasser and Mecane also stressed the need for the Consolidated Audit Trail, proposed by the SEC. “It is a vital component to ensuring effective surveillance in a highly fragmented marketplace,” said Mecane. “Such surveillance should include better identification and reporting on high frequency trading, similar to that being discussed by the Commodity Futures Trading Commission, to increase the transparency of this practice.”
“The SEC’s Consolidated Audit Trail, if implemented properly and cost effectively, will give investors confidence that regulators can police bad actors and predatory strategies,” added Gasser.