The events of the past few days are sure to stir some activity in Washington. Congress will likely start asking questions and may even hold some hearings. The regulators will once again be put under the spotlight like they were after the May 6th Flash Crash. They will likely be pressured to take action. We urge them to be very careful here because their actions may bring upon an entirely new set of unintended consequences.
Why would we be suspect of our regulators? Because we have seen this movie before. Back in 1994, a paper titled Why Do NASDAQ Market Makers Avoid Odd-Eight Quotes was published by professors Christie and Schultz. This paper caused an immediate backlash of activity in Washington DC and ended up resulting in millions of dollars of fines for the industry. In addition to fines, the SEC embarked on a decade worth of new regulations which resulted in the fragmented equity market that we have today. Under the leadership of Chairman Arthur Levitt, the SEC implemented the Order Handling Rules, Reg ATS, eliminated Rule 390, implemented decimalization and allowed the stock exchanges to demutualize. After Mr. Levitt left office in 2001, the SEC continued their push with more regulations. In February 2004, they proposed Reg NMS that was fully implemented in 2007. After a decade long push of new regulations, we have ended up with a fragmented web of market centers held together by a very weak structure. This weakness was very apparent when the Knight software bug ripped through the market for 45 minutes.
For his part, Mr. Levitt, now an advisor to Goldman Sachs and GETCO, shockingly owned up yesterday on Bloomberg radio when he said:
“The irony of all this is that the change in order handling rules that were instituted under my watch at the commission has resulted in the proliferation of markets, technologies and automation that brought about the flash crash and yesterday’s events. I think public confidence is severely shaken by things of this kind.”
You read that right. Mr. Levitt said that the rules he helped implement have created the current market structure which brought about the flash crash and the Knight algo issue.
So, what do we do now? We have one simple suggestion that we think can fix many of the current problems in today’s market structure and it won’t require Congressional approval:
-Eliminate the maker/taker model
This one pricing mechanism has distorted the way stocks are priced and has distorted the order routing process. In a 2010 paper titled Equity Trading in the 21st Century written by Angel, Harris and Spratt, the authors state that the maker/taker model has:
“distorted order routing decisions, aggravated agency problems among brokers and their clients, unleveled the playing field among dealers and exchange trading systems, produced fraudulent trades and produced quoted spreads that do not represent actual trading costs.”
This maker/taker model was invented by the Island ECN back in the early 1990’s as a way to steal market share from other larger ECN’s. The model was copied and is used by almost every major exchange in the world now. This model has wrecked havoc on the price discovery process and has created artificial arbitrage opportunities that high frequency traders have exploited. It’s time for the maker/taker model to be abolished and replaced with a flat fee paid whether liquidity is added or removed.