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Time for a Fresh Look at Equity Market Structure?

05

October, 2012

Yesterday, SEC Commissioner Daniel Gallagher gave a speech to a conference which could be looked backed upon as the turning point in the market structure debate that has raged over the past few years.  The title of the speech was “Market 2012: Time for a Fresh Look at Equity Market Structure and Self Regulation” . Commissioner Gallagher started the speech by essentially saying that regulations that have been adopted over the past few years are responsible for the current mess of a market structure.  He said:

“In short, understanding the structure of our capital markets today requires acknowledging that in recent years, changes to the structure of our equities markets have been driven as much, if not more by legislative and regulatory action than by the private sector.

Wow, that could have been a line in Chapter 4 “Regulatory Purgatory” of our book “Broken Markets”

Commissioner Gallagher wants a comprehensive market and regulatory structure review which specifically will look at the role of SRO’s.  He questions the fact that the market is regulated the same way it was since the Exchange Act of 1934:

How relevant is the 1934 view of exchanges in a world of demutualized, public company exchange operators? What problems do the 1975 Act amendments solve in today’s markets, when there is no longer an exchange monopoly or fixed commissions? Do the 19(b) SRO rule filing requirements, a legacy of the 1975 Act amendments, still make sense after almost four decades of fundamental changes to the SROs and the markets within which they operate?”

As most of you know, we have long questioned the role that stock exchanges now play in the market.  Once thought of as quasi-government utilities, exchanges have morphed into for-profit, highly competitive entities that are no longer member owned.  Commissioner Gallagher also questions the role of an exchange:

Should exchanges still be SROs? In developing an answer to that question, we should keep two key facts in mind. First, as I discussed earlier, the SRO framework was developed in the context of private, mutualized exchanges – a context that no longer exists. Second, at the risk of stating the obvious, the “S” in SRO is for “self.” We need to ask whether allowing exchanges to outsource the bulk of their regulatory responsibilities to FINRA through regulatory services agreements risks implicitly transforming the meaning of SRO to “selectively regulatory organizations.”

Did you know that every year a pot of approximately $500 million from market data fees is divided up amongst the exchanges based on their market share?  This is one of the reasons why some ECN’s over the past few years decided to convert to exchange status.  Commissioner Gallagher questions these market data fees:

“Given the historical role of market data fees in funding exchanges, what would we do with the market data fees in a world in which exchanges aren’t SROs?”

Chapter 6 of Broken Markets is titled “The Arms Merchants”.  In this chapter, we question why exchanges are constantly disadvantaging one class of investor over another.  We wrote:

The stock exchange business has more responsibilities than just profits.  It has the responsibility to help facilitate capital formation for companies.  And it has the responsibility to protect individual investors.  The new competitive, for-profit exchange landscape has caused the exchanges to forego these responsibilities in order to focus on their bottom lines.”

Apparently, Commissioner Gallagher has the same concerns about the exchanges:

“Another key question is whether the SROs have the resources – and, just as importantly, the willingness – to perform sufficiently rigorous analyses to support their rulemaking. If self-regulation is to continue to play a central role in securities regulation, SROs must be committed to ensuring that the rules they send to the Commission for approval are the result of the same degree of rigorous analysis as the Commission applies to its own rules.

Hmm, might he be talking about the frequent submissions of conflicted order type proposals by the exchanges?

We hope that Commissioner Gallagher is successful in swaying the SEC to conduct a full review of the role of SRO’s.  But we fear that like most things in Washington DC, this review will take far too long and will be influenced by the usual suspects from the industry.  If the SEC wants to take a stand and show that they are serious about market reform, they can start by submitting a proposal to eliminate the maker/taker pricing model.  The series of market disruptive events over the past few months has the world watching and waiting to see what the SEC will do.  But many folks, including us, are getting restless and are demanding change now.  We anxiously await the SEC’s next move.

 

 

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