Modern US Markets: Does Complexity Damage Investor Trust?

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1 May 21, 2015 Putting Investors First Symposium Modern US Markets: Does Complexity Damage Investor Trust? Robert W. Dannhauser, CFA, FRM, CAIA, Head, Global Capital Markets Policy

2 THE STATE OF US EQUITY MARKETS the real truth about the stock market is that a small consortium of players is making billions by skimming and scalping unaware investors and in so doing, they ve transformed our markets from the world s envy to a fragmented mess rife with conflicts of interest. Sal Arnuk and Joe Saluzzi, Broken Markets (2012) 2

3 THE STATE OF US EQUITY MARKETS High-frequency traders are gaming the system, reaping billions in the process and undermining investor confidence in the fairness of the markets. It s a growing cancer and needs to be addressed. If confidence erodes further, the fuel of our freeenterprise system, capital formation, is at risk. Charles Schwab and Walt Bettinger, Schwab Statement on High Frequency Trading (April 4, 2014) 3

4 THE STATE OF US EQUITY MARKETS Rigged Michael Lewis Flash Boys (2014) 4

5 THE STATE OF US EQUITY MARKETS The market is not rigged, that s clear. Peter Kovac, November 26,

6 THE STATE OF US EQUITY MARKETS Intelligent people can make sound arguments on either side of the issues around high frequency trading. Walt Bettinger, as recounted by Richard Repetto (April 28, 2014) 6

7 THE STATE OF US EQUITY MARKETS Empirical evidence shows that investors are doing better in today s algorithmic marketplace than they did in the old manual markets. For institutional investors, the costs of executing large orders, measured in terms of price, were more than 10 percent lower in 2013 than in 2006.[1] This is true even though fundamental volatility which in general is positively correlated with such costs was slightly higher in 2013 than it was in 2006.[2] The level of intraday volatility also has returned to low levels after spiking during the financial crisis. Intraday volatility of the S&P 500 Index was nearly the same in 2013 as it was in 2006 for both average and maximum volatility.[3] The spreads between bid and ask prices for the broader market also are as narrow as they have ever been.[4] These narrower spreads are particularly important for retail investors because they reflect the cost of trading immediately at the best prices, which is generally the objective of retail investors. All of these market quality metrics show that the current market structure is not fundamentally broken, let alone rigged. SEC Chair Mary Jo White, Enhancing Our Equity Market Structure (June 5, 2014) 7

8 DOES IT HAVE TO BE COMPLICATED? Buyer: - 1,000 Shares XYZ at $20.00 Seller: Shares XYZ at $

9 NATIONAL MARKET SYSTEM 1975 Amendments to the Securities Exchange Act of 1934 Reg ATS (1998) Reg NMS (2005) - 80% of trading in NYSE stocks occurs on exchange - trade through order protection rule (Rule 611) - Order execution information reporting (Rule 605) - Order routing information reporting (Rule 606) Today - 25% of trading in NYSE stocks occurs on exchange (2009) - 11 exchanges - 44 ATS (Alternative Trading Systems) broker/dealers that internalize 9

10 DOES IT HAVE TO BE COMPLICATED? Buyer: - 1,000 Shares XYZ at $20.00 E E E E E E E E E E E ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS Seller: Shares XYZ at $20.01 E E E E E E E E E E E ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS ATS 10

11 LATENCY ARBITRAGE Investor Buy 1000 (1 ms) Exchange A 0.3 ms HFT Buy 1000 (2 ms) Exchange B 0.2 ms 11

12 Circuit Breakers RESILIENCE OF EQUITY MARKETS - Single stock 5 minute halts with 10% price movements in 5 minute period (2010) - Revised market thresholds to 7/13/20% based on prior day S&P 500 close (2013) Rule 15c3-5: Market Access rule (2011) - Pre-trade automated risk controls Rule SCI (2015) - Follows on Automation Review Policy Inspection Program NMS Rule 613 Consolidated Audit Trail 12

13 TRANSPARENCY AND MARKET QUALITY 13

14 CONFLICTS OF INTEREST UBS Securities Dark Pool - $14.4 million fine by SEC - Sub-penny price improvements and trade info not protected Barclays LX Liquidity Cross vs. State of New York - Exposed trades to predatory HFT Payment for Order Flow Maker/Taker Pricing 14

15 - Trade-through rule (Rule 611) BEST EXECUTION - Trade-at rule - Experiences in Australia and Canada - Increased spreads - Didn t result in increases in lit liquidity 15

16 INITIATIVES TO WATCH Tick-size pilot program for small cap stocks US Equity Market Structure Advisory Committee NYSE/Credit Suisse Grand Bargain - Trade-at rule for <5,000 share trades - Eliminate maker/taker - Lower exchange trading fees Luminex consortium of buy-side firms form ATS 16

17 GOOD QUESTIONS REMAIN Are so many order types useful? What is behind the high number of cancelled orders? What does it mean for liquidity in the markets being largely provided by high frequency traders? How can investors better understand the cost and quality of their trade execution? How does the changing ecosystem affect retail investors? 17

18 A USEFUL FRAMEWORK Prioritization suggested by Luis Aguilar, SEC Commissioner: 1. Investors and issuers who utilize equity markets to meet underlying economic goals 2. Public benefits of highly liquid markets which produce the most accurate prices 3. Support interests of market participants that support our markets, to the extent that they support priorities 1 and 2 4. Disfavor traders that seek to take unfair advantage of other traders 18

19 FOR MORE INFORMATION CFA Institute Market Integrity Insights blog SEC Equity Market Structure Advisory Committee Bob Dannhauser, CFA 19