In January we wrote about the SEC’s new formal forum, the Equity Market Structure Advisory Committee (EMSAC), through which it wants to receive advice and recommendations on equity market structure issues. EMSAC contains seventeen members – which is larger than allowed by the Jeff Bezos “Two Pizza Rule.” EMSAC includes a few wise investor-friendly representatives – like Kaufman, Cronin, Kinak, Katsuyama, and Stone. However, it also includes only one member from a bulge bracket broker – Barclays, only one member from a stock exchange – although that exchange does not list public corporations, and it includes one member from an” agency brokerage firm” that has just received the largest SEC fine for a dark pool announced to date (where that member voted to approve an HFT pilot prop trading unit to trade against clients).

We also wrote a note to you in May about EMSAC’s 1^st meeting, which discussed and debated REG NMS’s Rule 611 (trade-through, or order protection rule). In that note we shared the letter we had sent the SEC, which advised them that they needed to encourage diverse public liquidity on the exchanges. We warned them that without public exchanges containing diverse limit order books with healthy retail and institutional investor participation, we all will continue to have flash crashes, mini flash crashes, and even events like the subsequent August 24^th ETF Flash Crash. We were correct in our thinking.

The SEC has just yesterday announced a second meeting date – October 27^th 2015, where ESMAC will discuss REG NMS Rule 610, regulatory disparities between dark pools and exchanges, and  recent market volatility:

“The committee will discuss the impact of the access fees and rebates that today are widely used by exchanges and other trading venues.  This fee structure generally provides rebates to those placing resting orders on the exchange and charges relatively higher fees to those trading with resting orders.  The committee will also discuss the current regulatory model for exchanges and other trading venues, including the different regulatory frameworks applicable to exchanges and other trading venues.  In addition, the committee will discuss recent market volatility and any market structure issues it may have revealed.”   

We are not sure how many remaining EMSAC meetings are planned. We do know that already there are two SEC commissioners that have turned over since the first one was announced. We hope that these meetings will not continue at the pace of one every six months, and that the entire Commission staff will not have turned over by the time all their sought input and advice is received. That would sort of make these exercises somewhat futile.

Finally, while our offer of participation on this EMSAC was declined as it was being conceived, we hope they will re-read our open letter that we sent them back in May. We reproduce a portion of it here:

Today, market participants have been segmented and cordoned off.

• Retail Investors:Their orders rarely make it to a public exchange. Instead, they are “internalized” by large proprietary traders, who view their order flow as non-toxic, and are traded off-exchange. These trades are given prices that reference pricing on the public markets.
• Institutional Investors (retail in managed money, such as: mutual funds, ETFs, 401ks): Their orders interact with a complicated web of public exchanges and dark pools through an order routing mechanism (ORM) that tends to whirl them around in the dark, in a fleeting manner. These orders also are not highly represented or traded on public exchanges.
• Market Makers(evolved prop traders that trade with great speed, attempting to make money through spread capture subsidized by exchange “maker” rebates): While significant players in the plethora of US dark pools, market maker orderstend to dominate the public limit order books.

The combination of all of the above means that the public orders books are dominated by high frequency participants that tend to be very short term in nature. Their liquidity can be very fleeting in times of stress. Their participation and liquidity provision is very wary of short term adverse selection. Their pricing is referenced by up to 40% of the trades that take place in the US stock market.

The results are highly visible liquidity vacuums and mini-flash crashes.

Shouldn’t a marketplace with the most accurate price discovery – where public pricing is closely matched to an asset’s underlying value, have diverse participation? 

Only when the SEC decides to make diverse investor participation on public stock exchanges a priority will we stop having a stock market that behaves unpredictably and badly during times of stress. Only then can we avoid these wild and undesirable rides.

Mark your calendars, as the meeting will be live webcast.