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Great Expectations and the Frankenstein Market

23

February, 2011

Nine months after last years “Flash Crash”,  the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues made 14 recommendations to the SEC and CFTC.  In our note on Friday, we stated that we were pleasantly surprised by some of these recommendations.  We thought that the three recommendations that dealt with a cancellation fee, internalization and a trade-at rule were particularly newsworthy.  Along with many others in the industry, we were not expecting to get any substantial recommendations like these from this committee.  But the Joint Advisory Committee has set themselves apart as a committee that is looking for change.  They realize the fragility of our equity markets and want to act before the next crisis.  By making some bold recommendations, they also have acknowledged that the “Frankenstein” market, that has evolved due to more than a decade worth of regulation, needs fixing.  The first step in fixing a problem is admitting that you have one and that is exactly what this committee did last week.  The unintended consequences of Reg ATS, the Order Handling Rules, Decimalization and Reg NMS have emerged into a serious threat to the stability of our market and they need to be addressed immediately.

 While we were pleasantly surprised by this report, we haven’t heard much from the industry on it other than a few grumblings on how a trade-at rule would be anti-competitive.  Our guess is the HFT lobby didn’t expect this and are now busy organizing their talking points for a memo and gathering the troops.  We expect to hear from them soon.  You can bet that they will say:

1 -A cancellation fee is unfair and is just another tax.  If enacted, they will claim that the cancellation fee will not allow “market makers” to manage their risk and will result in a loss of liquidity

2- Trade-at rule will be vilified as anti-competitive.  They will claim that this will disadvantage dark pools where many retail orders are currently enjoying sub-penny price improvement.

3- A half penny price improvement mandate for internalizers will result in these market participants exiting the business and there will be a loss of liquidity.  They will also claim that spreads will widen.

 We are sure this memo is being finalized right now and headed over to Capitol Hill by some well-dressed and well paid lobbyists.  We expect to hear shortly from Rep. Spencer Bachus, the Chairman of the House Financial Services Committee, on how these recommendations will potentially harm our markets and increase costs to investors.  Spreads will widen and liquidity will suffer, they will say.  We expect to hear from exchange executives once they finish their kabuki merger dance.  They too will be outraged at a cancellation fee but they will support the trade-at rule.  We expect to hear from the visible high freaks.  They will threaten the market that if these changes go through, then they will take their liquidity and go home.

 So, that is what we expect will happen.  But what will the SEC and CFTC actually do now?  Well, first they will seek public comment.  Anybody who wants change in our equity market and is tired of the disappearing liquidity game should make sure they write a public comment letter (http://comments.cftc.gov/PublicComments/CommentForm.aspx?id=976) Then, the SEC and CFTC will review the comments.  And then maybe, just maybe, they will make some rule proposals.  We certainly hope they do.  Because could you imagine that if a year from now, we experience another financial crisis which leads to a breakdown in the equity market and nothing was done by our regulators.  Doing nothing after they commissioned a panel of experts that took 9 months to make 14 recommendations would be a very tough thing to explain to the politicians.

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