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Losing Faith In The Arms Merchants

13

January, 2012

Over the past few years, we have tried to help investors understand how the equity markets have changed. In addition to highlighting a “few” problems with high frequency trading, we have often set our sights on the stock exchanges. We have referred to them as “arms merchants” who will sell sophisticated weapons like colocation space and data feeds to the highest bidder. Often, we feel like we are just yelling into a forest and no one hears us. But finally it appears that our regulators have caught on to the conflicts of interests that exist at our nations stock exchanges.

In an article titled, “SEC tightens leash on exchanges post “flash crash”,  Reuters has unveiled some information about what is ahead for the stock exchanges:

“Shortly after the flash crash, regulators pushed NYSE Euronext, Nasdaq OMX Group and other market operators to craft new trading rules to avoid future breakdowns. Reuters has learned the SEC took the unprecedented step of serving those exchanges with non-disclosure agreements, effectively muzzling them to prevent further public bickering and to get the fierce competitors to work together.”

“People who knew of the agreements, and spoke on condition of anonymity, said they were intended to compel exchanges to leave their differences aside for the good of the public markets. Some said they were also meant to stop leaks to the media about the preliminary, and sometimes patchy, plans for new rules.”

“More cases involving stock exchanges are pending, according to a person familiar with the matter, suggesting the SEC’s leash will grow tighter this year. This time around, sources said, the SEC’s focus has shifted to issues such as data feeds and whether certain market players may get an information advantage, as well as adequate investments by exchanges into technology and infrastructure.”

Based on this Reuters article, the SEC appears to have finally realized that the exchanges are at the center of many problems with today’s equity market. It appears that the SEC no longer trusts the stock exchanges. They had to step in and slap gag orders on them because they knew if left to their own devices that they would do what’s best for their bottom line and not what’s best for the market.

In 2000, NASDAQ demutualized and six years later, the NYSE did the same. Demutualization altered the structure of exchanges from member owned facilities to private corporations. At the time, the SEC did not seem to have a problem with this switch. In a 1999 speech, Arthur Levitt, then Chairman of the SEC, said: “In the wake of this heightened competition from ECNs, Nasdaq and the NYSE are pushing forward with their plans to demutualize. The Commission has no intention, whatsoever, of standing in the way of a movement towards for-profit status.”

The SEC now seems to see the damage that this for-profit exchange model has done to the market. Unfortunately, it took a flash crash to wake them up and hopefully it doesn’t take another flash crash for them to act.

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