We have long blamed the fragmentation of market centers as the number one culprit for our broken markets.  Fragmentation has bred practices such as rebate and latency arbitrage.  Fragmentation has encouraged exchanges to create conflicted order types.  Fragmentation drives smart order routers to access the cheapest market center first but not necessarily the best market center.  Fragmentation drives exchanges to enhance their data feeds so high frequency traders get extra information about cancellations and revisions.

Back when the wizards at the SEC were drafting Reg NMS, they noted that fragmentation could be a problem but concluded that the benefits of competition would outweigh the problems that fragmentation would breed.  In a 1999 speech at Columbia University , then SEC Chairman Arthur Levitt said:

“Greater competition in all of our markets, however, has not arisen without debate. Depending on whom you talk to, the growth in new market entrants has induced “fragmentation.” Others favorably characterize it as providing “heightened competition.” In reality, neither description tells the whole story. We are living in a formative period in the next stage of our markets’ development.”

Well, now years later, IOSCO (the International Organization of Securities Commissions) has published a consultation report titled “Regulatory Issues Raised by Changes in Market Structure”  which addresses the problems surrounding fragmentation.  IOSCO has been trying to take the regulatory  lead over the past few years with some thought provoking reports on market structure issues.  IOSCO is urging regulators to take another look at the fragmentation problem:

“Securities regulators bear the responsibility for striking an appropriate balance between a market structure that promotes competition among markets, and one that minimizes the potentially adverse effects of fragmentation on market integrity and efficiency, price formation, and best execution of investor orders.”

To assist them, IOSCO is asking for public comment on their recommendations surrounding the fragmentation problem.  We highly recommend that everyone take a few minutes to comment on this critically important issue.  Here are a few of their questions:

–          Does the evolving market fragmentation challenge the relevance, effectiveness or implementation of current regulatory requirements?

–          Are you aware of material differences in regulatory requirements between different trading spaces that from your point of view are not justified and create regulatory risks and unfair competition?

–          Do you think that the price formation process has been deteriorated or has been improved as the result of market fragmentation?

–          Should existing order handling rules, such as best execution, be re-examined in the context of fragmented markets?

Back in 2001, IOSCO warned that “while competition among trading spaces may improve market efficiency, it may, in some circumstances, have a detrimental effect. This would be the case where, for instance, competition results in fragmentation that leads to significantly different transparency levels across the market and/or high search costs for market participants and their customers.”

 What would the market look like today if regulators around the world had heeded IOSCO’s 2001 warnings?  Let’s all make sure that this time we let IOSCO and the global regulatory community know what we think about fragmentation.  Themis Trading will be filing a comment letter by the May 10, 2013 deadline and we hope that you do as well.