In Tuesday’s note we told you about the House Financial Services Committee hearing to discuss Reg NMS. It takes place today, Friday February 28^th 2014 at 9:30AM in the Rayburn HOB. The stage is set for this hearing in this memo prepared by the FSC Majority Committee Staff, and the hearing is notable in that the gentlemen testifying are not industry participants and insiders per se (who might be tempted to “talk their own book”); indeed, three of the four panelists worked at the SEC in the recent past. These gentlemen are: Raoul Campos, Erik Sirri, Chester Spratt, and Steven Lofchie.

All of the panelists are highly distinguished- not only for their careers but also for their wealth of knowledge about US equity market structure.  We are privy to prepared written remarks made by two of the panelists – Sirri and Lofchie, and you can read those remarks here and here. The purpose of this morning’s note is to highlight their remarks, especially those of Steven Lofchie.

Erik Sirri’s Prepared Remarks – Key Points

–          When evaluating market structure we must first start with how well our US markets function. They are deep, liquid, and have performed remarkably under stress.

–          Our liquidity is very fragmented – exchanges, ATSs, institutional matching systems, dark pools, and internalizing broker dealers.

–          There is an expected natural level of fragmentation, as less-informed traders will always seek to avoid trading with informed traders, no matter the infrastructure.

–          Market Makers today make as little as 1-2 hundredths of a penny; one cannot force them to provide liquidity and not make money.

–          Very small changes in market structure can have large effects – consider routing decisions: if one venue changes rebates by just 1 mil, large amounts of order flow gets re-routed.

–          Equity markets are in fantastic shape. Fixed-income markets on the other hand have very wide spreads and should be addressed. Perhaps they should be remade to look like our equity markets.

–          Brokers ultimately own best execution and customer relationships – not exchanges. They should have more guidance on best execution – they seem to route based on their economics.

Our comments – Erik’s remarks are reasonable, and Erik does his best to highlight the positive in our modern markets, particularly how well stock exchanges work today. As an SEC employee for 13 years, and head of SEC Trading and Markets during Reg NMS implementation and the Financial Crisis, one would expect Erik to be happy with the structure created while he served at the SEC.

Steven Lofchie’s Prepared Remarks – Key Points

–          Assumptions underlying Reg NMS may be well-intentioned, but they are, if not wrong, at least unproven. And today’s issues are not due to monopoly power of exchanges, but rather of fragmentation. Times have changed!  A rule to trade with the best-priced order may have created competition in 1975, but today it exacerbates fragmentation.

–          Today exchanges thrive, and even multiply, not necessarily because they add value and provide a place for bids and offers to interact, but because they provide a way to generate fees, directed by the government, that result from those bids and offers.

–          Trade-through allows market participants choice. If participants do not find value with an exchange’s bids and offers, we should allow them to “trade-through”. If we want to let the market dictate the correct number of trading venues, then we have to give them choice to avoid exchanges that don’t serve their needs – and allow them to fail.

–          What if we had called “Dark Pools” “Protective Coves” instead? What if we had called exchanges “Naked Bazaars”? If you are a long term institutional investor, would you rather send your order to be “hung out in a naked bazaar exposed to the glare of high frequency algorithmic momentum traders equipped with laser-speed co-located flickering quote transponders or sheltered in a protective cove?”

–          Maybe we should not just assume as a given that transparency is good. Maybe we should recognize it for what it is – a forced transfer of knowledge from those with information to those who want it.

–          During the Flash Crash, when markets got stressed quotes vanished. Quotes lasting between a millisecond and a second are not quite as valuable as one might think – certainly not akin to a bid on a house that is good for one week.

–          Consider Reg NMS… Limit orders have somewhat of an option value attached to them. What if the size of a limit order was more important than the price? Why do we always have to favor the small limit order? We may be valuing the order with less option value over the one with greater option value.

–          While the SEC is in the process of creating and implementing a CAT – it is reasonable to ask what they are doing with information they already have and collect. Information is like a race car – it is of little use sitting in a garage. Can the SEC use information it already has to examine why firms “trade through”? Why is “trade through” inherently bad? If we use collected data to just reaffirm our beliefs, instead of questioning them, then what good is that?

–          Regarding “the Regulation of Non-Public Trading Interest”, it starts with the premise that forcing transparency on the markets is always good.  It should be called The Forced Transparency Proposal. That proposal started off by claiming that the SEC believes that forcing investors to display their quotes would benefit market participants by increasing transparency. What if that proposal instead was framed with the knowledge of what it actually did:

The Commission preliminarily believes the proposed amendment would benefit momentum traders by increasing transparency and so facilitating the ability of these opportunistic market professionals to anticipate the actions of, and front-run, institutional investors, thereby increasing the costs of long-term investments. The Commission also preliminarily believes that the proposed amendment would help encourage market fragmentation in the form of more dark pools as institutional investors seek to move their quotations from well-established, larger dark pools that would be forced to exhibit quotes under the  Commission’s proposal to newly created smaller dark pools that would not be required to show their bids in the public market.

Our comments – Steven’s remarks certainly appear to favor the value of choice, and of dark pools and ATSs, over the value of exchanges. We believe there is a value of public quotes – after all those quotes are used to derive the pricing in trading that represents between 35-50% of today’s volume. We know as practitioners and institutional traders that the value of a public quote reflects much less the true value of the asset than it did in times past. While we may not fully agree with all of his prepared remarks, his letter is remarkable in its ability to make one rethink their own preconceived notions about how markets can and should work. It is brilliant.

We will keep you abreast of today’s hearing. The prepared remarks highlighted in today’s note guarantee that it will be a most worthwhile one.