SEC Commissioner Aguilar Discusses U.S. Equity Market Structure (with Lofchie Comment)
In a public statement titled "U.S. Equity Market Structure: Making Our Markets Work Better for Investors," Commissioner Aguilar asserted that the SEC must undertake a holistic review of the United States' current equity market structure in order to reconcile competing claims by experts and market participants that U.S. equity markets are not only "the most liquid, transparent, efficient and competitive [markets] in the world," but also "broken," "a complete mess" and "rigged."
Hierarchy of Policy Goals
According to Commissioner Aguilar, the SEC's review should begin with the simple realization that "no market structure is optimal for all market participants," and trade-offs are unavoidable. In order to determine which trade-offs to make, Commissioner Aguilar provided the following hierarchy of policy goals:
(i) promote the interests of investors and issuers who utilize the equity markets to meet underlying economic goals;(ii) maximize the public benefits that derive from highly liquid markets, which produce the most accurate prices;(iii) support the interests of market participants, such as registered dealers and market makers, that support the markets; and(iv) reprehend the interests of market participants that seek to take unfair advantage of other traders (e.g., algorithmic traders that rely on cutting-edge technology to exploit fleeting price discrepancies that last for only milliseconds).
Commissioner Aguilar focused on two overarching aspects of the United States' current equity market structure that have been the subject of significant debate: (i) the proliferation of trading venues and (ii) the competition for order flow.
The Proliferation of Trading Venues
Commissioner Aguilar discussed the significant transformation of the U.S. equity markets in recent years, and how their decentralization has resulted in 11 registered exchanges, approximately 44 alternative trading systems and over 200 broker-dealers that internalize customer orders.
Commissioner Aguilar asserted that while the proliferation of trading venues in recent years has not yet harmed investors in any meaningful way (given that today's markets enjoy historically narrow spreads, low transactions costs and increased displayed liquidity), it is still an issue that deserves the SEC's attention. To illustrate why the issue deserves attention, he cited academic literature that has identified "real and acute risks [such as impairing price discovery and overall market quality] if trading activity continues to be dispersed across a growing web of trading centers." Accordingly, Commissioner Aguilar stated, the SEC should monitor the levels of dark trading in the U.S. equity markets closely and consider implementing a number of steps to address increased dark trading, such as (i) asking trading centers to clarify how order types operate in practice, (ii) studying how hidden order types may affect the price discovery process, (iii) exploring ways of exposing off-exchange trades to more competition, and (iv) reconsidering the Regulation of Non-Public Trading Interest Proposal issued in 2009, which would require (a) alternative trading systems ("ATSs") to display smaller-sized indications of interest, (b) the reduction of the 5% threshold for ATSs to display publicly their best-priced orders and (c) ATSs to disclose their identities when disclosing trades to the consolidated tape (except in the case of block trades).
Commissioner Aguilar dismissed concerns that the order protection rule of Regulation NMS (i) increases the fragility of the equity markets by requiring trading venues and broker-dealers to use complex IT systems to connect and monitor the prices of stocks on all registered exchanges and (ii) props up exchanges that would not otherwise be economically viable. According to Commissioner Aguilar, Regulation Systems Compliance and Integrity will address market fragility concerns. In response to the concern that the order protection rule props up exchanges that are otherwise not economically viable, he noted that in the past year, two registered exchanges have been closed down.
Commissioner Aguilar did recognize that the increase in trading venues has made it difficult for investors to monitor the quality of their trade executions, since they do not know where their orders are routed generally, and that investors need better information about order execution quality and routing practices.
The Competition for Order Flow
Commissioner Aguilar also focused extensively on the intense competition for order flow in the U.S. equity markets, and how trading centers have used various strategies, such as maker-taker pricing and payment for order flow, as ways to attract order flow.
According to Commissioner Aguilar, "[n]o issue in the market structure debate has proven more polarizing than the maker-taker pricing model – with the possible exception of high frequency trading." Maker-taker pricing occurs when an exchange imposes a fee on traders that remove or take liquidity from the exchange and then use a portion of that fee to pay a rebate to traders who provide liquidity to the exchange. After pointing out a couple of studies that resulted in conflicting or surprising outcomes, Commissioner Aguilar proposed that the Commission address maker-taker pricing concerns by implementing a carefully constructed pilot program based largely on recommendations from certain market participants. Commissioner Aguilar said that he supported using a pilot program with a tiered approach to maker-taker pricing, wherein maker-taker fees could be eliminated entirely for the most liquid stocks, since public trading in these stocks appeared sufficiently robust for rebates not to be required to attract liquidity to exchanges. Meanwhile, maker-taker rebates would remain in place for less liquid securities, and could be tiered in order to rise when a given stock's liquidity falls.
Additionally, Commissioner Aguilar stated his belief that the SEC, together with FINRA, must provide additional guidance immediately on brokers' best execution obligations as they relate to maker-taker rebates and routing decisions, and require brokers to provide additional information to help investors gauge the quality of the executions they receive.
Commissioner Aguilar also addressed concerns relating to the practice of certain dealers that attract order flow by purchasing the orders that retail brokers receive from their customers – a practice otherwise known as "payment for order flow." Commissioner Aguilar proposed that the SEC study the economic consequence of payments for order flow more closely and take prompt steps to ensure that payments for order flow do not impair brokers' ability to deliver best execution to their customers, starting with mandating an increase in the transparency of payment for order flow. Specifically, Commissioner Aguilar stated, brokers should be required to disclose to customers the total amount of payments for order flow that the brokers receive, as well as the average amount of price improvement that customers receive on such orders. He added that brokers should be required to disclose the total execution costs of their customers' trade so that investors can see how payments for order flow and other factors affect their trading costs.
Lofchie Comment: In an important and substantive article, Commissioner Aguilar dismisses the negative consequences of NMS, including the fact that it adds significant complexity to the market and props up small exchanges. One may certainly argue that the benefits of Regulation NMS exceed the negative consequences, but that is quite different from asserting that there are no negative consequences. Ultimately, in order for there to be meaningful discussion as to regulatory policy, the regulators must be open to conceding that not all rules work entirely as intended (and further that the best regulatory response to rules that do not work as intended may not be more rules).