Yesterday, at Trader Forum in NYC, recently appointed SEC Commissioner Kara Stein gave one of the best speeches that we have ever read from a SEC Commissioner.   We at Themis Trading have been studying and commenting on market structure issues for years now and this one speech summarizes some of our biggest concerns.  While the speech doesn’t pretend to have all the answers, it does seem to ask all the right questions.  We’d like to share a few excerpts but we urge you to read the entire speech :

How do we make our markets fairer?  The answer often depends on whom you ask.  For retail customers, they receive confirmations that their orders have been filled within seconds.  What most of them don’t know is that their orders likely never went to a stock exchange.  Rather, the orders were probably sold by their broker to a sophisticated trader who paid for the privilege of taking the other side. 

These retail customers are ostensibly better off because they got a fraction of a penny in price improvement from the National Best Bid and Offer (“NBBO”) price.  But, is a fraction of a penny per share enough of a price improvement to be meaningful?  Does it matter if the price improvement is measured against a NBBO, which might be stale by the time the trade is executed?  Would retail investors actually be better off if their trades were routed to the public execution venues?  Would that improve the quality of their executions or the value of the NBBO for the entire marketplace?  Some individual transaction costs may be cheaper, but what about others?  What about implied transaction costs?

For institutional traders, the questions get even more complex.  Institutional traders seeking to keep their trading costs low now have to scan dozens of execution venues in search of liquidity, and are increasingly at the mercy of broker-provided, smart order routers to slice, dice, and feed out their orders into the marketplace.  Do these routers send orders to the venues that are most likely to get them filled?  Or do they send the orders to the venues that have the lowest cost for the broker, even if it might not get the order filled, or get the best price?  When will an institutional broker commit capital to take the other side of an order?  Will an institutional investor’s order be seen by third parties, who may trade ahead of it, or otherwise take advantage of that information?  How should a trader measure execution quality?

Unfortunately, these questions are difficult to answer, in large part, due to a lack of available comprehensive data.  The Consolidated Audit Trail (or “CAT”) is intended to help fill that void.  In the meantime, the Commission last fall unveiled the Market Information Data Analytics System (fondly known as “MIDAS”), which is intended to help answer some of these questions.  The MIDAS system captures vast amounts of market data from the consolidated tapes and proprietary data feeds, and has already been used to help study how odd lot trading transparency may impact their use.  MIDAS collects over one billion records a day, and can help the Commission and the public better understand trends and market events.

But we need the deeper information that only the CAT will provide.  And we also need help in getting it up and running as soon as possible.  All market participants should be involved in helping to develop the CAT—it is not, nor should it be, the exclusive province of the Commission and the SROs.  And we must also move quickly.  Until regulators, buy-side traders, brokers, consultants, and the academic community can pore over the data, we simply don’t know what we’re missing. 

From a trader’s perspective, is it efficient to have to check dozens of pools of liquidity in order to execute a trade?  What are the costs and benefits of monitoring and accessing these multiple pools?  Does an institutional trader risk tipping off other market participants by just seeking to access these venues?  Finally, does the complexity unnecessarily increase traders’ reliance on brokerage firms or consultants? 

Again, good data and careful analysis is critical to answering these questions, which brings me back to the CAT.  We need to get it up and running as soon as possible.

As you may have guessed, I believe we should develop policy from the facts.  We should be gathering as much data as we can, and if we think an alternative approach should be considered, we should test and evaluate it.

For example, we should explore how the maker-taker pricing model impacts liquidity and execution quality.  Does the current rebate system incentivize or penalize investors?  I have heard from many investors, and even exchanges, who are worried about the incentives embedded in the current system, and if there are proposals to explore alternative approaches, we should consider them.  We should try to understand the various order types. Why would one exchange need 80-plus order types?  What is the purpose for each?  How do these order types interact with others, and how do they impact market liquidity and functioning?  We should be willing to re-examine the roles of these order types in the market. 

Some of you may be familiar with Kara Stein  and may even have met with her to discuss market structure issues.  After reading this speech, it is obvious to us that Commissioner Stein is ready to tackle the tough market structure issues that have been overhanging the equity market since Reg NMS was implemented in 2007.  We’re thrilled that she seems open-minded and has stated that she is willing to make modest reforms now.  While we were very happy with this speech, we’re sure that the status-quo, entrenched industry insiders must be very concerned.