Market Structure Debate Principles: White Paper…

Under the leadership of senior fellow Bradley J. Bondi, the Center for Financial Stability (CFS) organized a nonpartisan working group with a wide range of market participants, academics, lawyers, and public officials to focus on the structure and operations of the U.S. equities markets.

CFS hosted discussions in New York and Washington, D.C., synthesized the comments from those events, and circulated a draft to the working group and other market participants for additional feedback.

After additional review and consideration, key principles include:

  • Avoid Rhetoric and Generalizations,
  • Craft Clear, Transparent, and Predictable Regulations,
  • Structure Markets to Serve a Diverse Clientele,
  • Use a Careful Regulatory Process,
  • Develop Cost-Effective – Yet Impactful – Regulation, and
  • Deepen Diversity in the Decision-Making Process

The CFS Working Paper offers guidance, rather than specific policy recommendations, to the SEC and other policymakers considering changes to the equity market structure.

To view the full paper:
http://centerforfinancialstability.org/research/CFS_Market_Structure_081616.pdf

Academic Paper Investigates Advantage for High-Frequency Traders in SEC Dissemination Process

Academic researchers from the University of Colorado and University of Chicago published a paper titled “Run EDGAR Run: SEC Dissemination in a High-Frequency World,” which finds that the delay between an SEC filing’s acceptance by the Electronic Data Gathering, Analysis, and Retrieval System (“EDGAR”) and its initial public availability on the SEC website, may provide an advantage to certain traders that pay a subscription fee for direct access.

According to the paper, while the delay is “relatively short,” with a median posting time of 36 seconds, prices, volumes, and spreads respond to the filing news beginning around 30 seconds before public posting. Therefore, the paper finds, some computer-driven market participants may be taking advantage of this posting delay.

The paper states that the findings “show that the SEC’s process for the dissemination of insider filings (and likely other types of filings as well) is not a level playing field.” The paper’s research is related to the recent literature on high-frequency trading, providing evidence that there are opportunities for certain traders to profit by trading on delays in the public dissemination of information.

In response to the findings, an SEC spokeswoman stated that the SEC is “conducting a thorough assessment of the dissemination process, including timing increments, and will make any system modifications that may be necessary to optimize the dissemination of information to investors and the markets.”

Lofchie Comment: Although the paper demonstrates a supposed “flaw” in the means by which the SEC disseminates information, this ought not be embarrassing to the SEC. Rather, the paper should be taken as evidence of just how difficult it is to perfectly control and transmit public information to all investors, given the increasing complexity of technology and the continuing rapidity of technological progress. Query: how would the SEC have dealt with a similar “flaw” had it occurred with a private market participant: by bringing an enforcement action or, as we have advocated, by using it as an industry-teaching experience?

If the SEC, or other U.S. regulators, treat each technological problem that occurs with a market participant as cause for an enforcement action, the result is that market participants have no incentive to share information as to problems that they discover. On the other hand, a regulatory culture that incentivizes the sharing of information as a response to technological problems may result in shared incentives to solve those problems.

See: Run Edgar Run: SEC Dissemination in a High-Frequency World” by Jonathan Rogers, Douglas Skinner, and Sarah Zechman.
See also: Wall Street Journal Article; New York Times Dealbook Article.

 

New Research Discusses Impact and Future of HFT

The Financial Engineering Division at Stevens Institute of Technology published new research on the state of high-frequency trading (“HFT”) and a proposed solution to mitigate key problems, the authors believe may be created by HFT, while “maintaining its benefits.” 

The institute’s white paper, titled “On the Impact and Future of HFT,” addresses three major areas:

  • HFT, as seen from various market agents’ perspectives;
  • the imminent problems and risks of HFT, including potential HFT systemic risk, as seen by various stakeholders; and
  • possible solutions to existing issues of HFT, along with recent claims of unfair practices facing HFT. 

Additionally, the paper discusses issues raised by transmission distance and systemic latency, and proposes a new solution based on an “information transmission zoning concept” that would require “minimum financial information flow re-architecting and no major changes in regulation NMS.”

Commissioned by the Investor Responsibility Research Center Institute, the research for the paper was conducted by Khaldoun Khashanah, Ph.D., Ionut Florescu, Ph.D. and Steve Yang, Ph.D., all of whom are from the Stevens Institute of Technology’s Financial Engineering Division.

See: White Paper titled “On the Impact and Future of HFT.” 

 

SIFMA Publishes Recommendations to Enhance U.S. Equity Market Structure

SIFMA published a set of recommendations on equity market structure for “enhancing fairness, stability, and transparency” in the U.S. stock market. 

According to the press release, SIFMA has long called for a comprehensive review of equity market structure.  SIFMA stated that the recommendations are designed to “promote fair and timely access to market data, address the complexity and fragmentation caused by the current order system, and enhance transparency for retail and institutional investors.”

The recommendations include changes to current business practices, as well as proposals for regulatory reform, and fall under three areas: (i) promoting fairness in market data dissemination, (ii) addressing market complexity and fragmentation, and (iii) encouraging robust transparency and disclosure for both retail and institutional investors. 

The featured recommendations include that:

  • access fees charged by exchanges should be dramatically reduced or eliminated;
  • regulators should eliminate the requirements for broker-dealers to connect to trading venues that do not add substantial liquidity to the market;
  • all users of market data should have access to data at the same time;
  • regulators should direct brokers to provide public reports of specific order-routing statistics and metrics; and
  • over time, the central SIP structure should be replaced with multiple processors that would distribute public market data and compete on performance and costs to better serve the marketplace. 

Lofchie Comment: Market structure is largely a creature of market regulation rather than market forces, since both the revenue of the exchanges (see the first bullet above) and the number of exchanges (see the second bullet point above) essentially are the products of SEC regulation.  Allowing market forces more space to be forceful almost certainly will reduce the number of exchanges, as smaller exchanges will no longer be viable unless firms are forced to trade on them.

See: SIFMA Equity Market Structure Recommendations; SIFMA Press Release.

 

Senate Banking Committee Hearing on HFT and Market Structure

The Senate Banking Committee held a hearing titled “The Role of Regulation in Shaping Market Structure and Electronic Trading”. Panelists discussed the regulation of high-frequency trading and offered proposals for technology improvements.  Witnesses at the hearing included representatives from exchanges and other financial institutions, including Citadel LLC, Intercontinental Exchange Inc. and BATS Global Markets, Inc. 

In general, panelists agreed that high-frequency trading should not be banned, and that technology provides significant benefits to the equity markets. They advocated for increased transparency and disclosure regarding order routing practices and dark pool operation.

Lofchie Comment:  Panelists offered a variety of suggestions for addressing high frequency trading and market structure issues. A number of the proposals advocated for very significant changes in the securities markets and securities regulations including eliminating or reducing the role of the securities exchanges as regulators. There were also advocates for reducing tick sizes on securities with substantial liquidity, eliminating maker-taker fees and imposing trade-at rules.

Given the diversity of views, it would seem prudent for the SEC to consider a series of empirical tests of various trading regulations before determining how to amend our current trading rules. In this regard, it may be worthwhile for the SEC to delay launching its test of expanding the tick size rule for small stocks until it can design a more comprehensive program of experimenting with various sets of trading rules. (See commentary on running empirical tests.)

See: Senate Banking Committee Press Release; Archived Webcast of the Hearing

 

Future of Computer Trading Report

CFS Advisory Board Member Charles Goodhart highlights a report by the Foresight Committee of the UK Government Office of Science on the Future of computer trading in financial markets: an international perspective. Professor Goodhart was a lead expert in the group overseeing the Project.

The key aim of the Project was to assemble and analyze the available evidence concerning the effect of High Frequency Trading (HFT) on financial markets.

Professor Sir John Beddington (Chief Scientific Adviser to HM Government and Head of the Government Office for Science) notes that:

“Analysis of the available evidence has shown that computer-based trading (CBT) has several beneficial effects on markets, notably relating to liquidity, transaction costs and the efficiency of market prices. Against the background of ever greater competition between markets, it is highly desirable that any new policies or market regulations preserve these benefits. However, this Project has also highlighted legitimate concerns that merit the close attention of policy makers, particularly relating to the possibility of instabilities occurring in certain circumstances, and also periodic illiquidity.”

For the full report or an abridged version click:
https://www.gov.uk/government/publications/future-of-computer-trading-in-financial-markets-an-international-perspective

FIA and FIA Europe Issue Special Report on Transparency

The Futures Industry Association (“FIA”) and FIA Europe submitted the ninth and final Special Report in a series covering specific areas of the ESMA consultation process for the implementation and recast MiFID II and MiFIR.  The final Special Report provides an overview of the proposals relating to transparency, set out in the recently published ESMA Discussion Paper and Consultation Paper

According to the Special Report, transparency is a theme that permeates the primary legislation and the ESMA Discussion Paper.  The Discussion Paper covers topics including (i) pre-trade and post-trade transparency requirements for equities; (ii) pre-trade and post-trade transparency requirements for non-equity instruments; and (iii) the systematic internalizer regime; and (iv) the definition of a “liquid market”, which is a key component of the transparency provisions.

Additionally, the ESMA Consultation Paper has eight sub-sections on transparency, spanning over 30 pages and analyzing, among others: (i) liquid markets for equities; (ii) the systematic internalizer regime; and (iii) pre-trade transparency requirements for systematic internalizer in non-equity instruments.

The Special Report on transparency briefly outlines these issues. 

See: FIA Special Report: “Transparency”
Related news: FIA Issues Special Report: “Defining High Frequency Trading” (June 25, 2014).

 

FIA Issues Special Report: “Defining High Frequency Trading”

The Futures Industry Association (“FIA”) released its’ sixth report in a series covering the specific areas of the European Securities and Markets Authority’s (“ESMA”) consultation process for the implementation of the Markets in Financial Instruments Directive (“MiFID II”) and the Markets in Financial Instruments Regulation (“MiFIR”). The report, titled “Defining High Frequency Trading,” provides an overview of key interpretations relating to high-frequency and algorithmic trading.

See: FIA Report, “Defining High Frequency Trading.”

 

CFTC Releases Research Paper on Electronic Markets, Trader Anonymity and Market Fragility

The CFTC released to the public an authorized research paper titled, “Electronic Market Makers, Trader Anonymity and Market Fragility.”  The paper, which was written by third-party professors, analyzes the impact of electronic market-makers on the reliability and the consistency with which financial markets provide transactional liquidity services, based on monitoring intraday position-level data from the WTI Crude Oil futures markets collected from NYMEX between 2006 and 2011. 

Researchers found “strong evidence that electronic market makers reduce their participation and their liquidity provision in periods of significantly high and persistent volatility, in periods of significantly high and persistent customer order imbalances, and in periods of significantly high and persistent bid ask spreads.”

Lofchie Comment:  The study assumes the inevitability that trading by so-called “locals” will disappear or become irrelevant. Put differently, the study does not call for a doomed-to-fail requirement that the markets reverse themselves and go manual. As to its “praise” of locals for staying in markets during volatile times, the study did not provide any understandable information as to whether the locals were able to trade profitably during periods of market volatility, and, if so, how. 

While the study questions whether electronic market makers should be subject to mandatory market-making obligations, it does not suggest that market makers receive any reciprocal benefit. It is unlikely that firms would be willing to become subject to extensive burdens of forced market-making in the absence of receiving a benefit. In fact, one of the defining characteristics of the old NYSE specialist system was that specialists received such a benefit. While there seems to be considerable nostalgia for the willingness of the specialists to limit market volatility, they were generally well rewarded for their willingness and typically earned returns that were viewed as disproportionately high relative to their investment and risk.

See: Electronic Market Makers, Trader Anonymity and Market Fragility.