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Who Created This Mess, Anyway? Hint: It Wasn't the Exchanges.

November 9, 2018

Justin Schack
Managing Director/Partner at Rosenblatt Securities

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I’ve been thinking a lot lately about how intense the debate is getting over potential equity-market-structure reforms, as big banks and brokers, with support from many buy-side firms and upstart exchange IEX, line up against the big three exchange groups. And I think some historical perspective is essential to understanding what’s going on right now and what should be done, if anything, to modernize market structure.

So I dug up an Institutional Investor cover story I co-authored, which ran all the way back in January 2000 – nearly 19 years ago — and appropriately carried the title “Trading Meets the Millennium.” The piece runs 17 pages (practically unthinkable in today’s media landscape), with quotes from two future US Treasury Secretaries (Paul O’Neill, then chairman of Alcoa and an NASD board member; and Hank Paulson, then Goldman Sachs CEO), then-Senate Banking Committee Chairman Phil Gramm, then-NYSE Chairman Dick Grasso (and future NYSE CEO/then Goldman President John Thain), then-NASD chief Frank Zarb, then-Merrill Lynch CEO Dave Komansky, Vanguard Group’s Gus Sauter, Knight Securities founder/then-CEO Ken Pasternak (and future Knight CEO/then-Merrill trading executive Tom Joyce) and even Bernie Madoff. It is not available online but I photographed each page earlier and am posting here for anyone who wants to have a read (yes, that’s a 27-year-old me with the glasses in the editor’s note).

Re-reading this story brought back both fun and foul memories: Talking to an array of innovators in electronic trading (both for this story and in the previous three years of reporting for II and its newsletter division) about how the world was changing and being present for the birth and early gestation of modern market structure; Sitting in Dick Grasso’s office in a suit and tie, with the heat characteristically turned up to about 90, while former colleague Hal Lux and I grilled him on how he’d respond to pressure from his biggest member firms to revamp the NYSE; Countless late nights with Hal in former II Editor Mike Carroll’s office, where I think we probably ripped up our story and started all over again at least 10 times during months of reporting, writing and editing. Mike brought us to exasperation and exhaustion many times but, as happened with many of my II stories from that time, also made the finished product dramatically better. He got so involved with this piece that he took a byline with Hal and I. Despite a few passages that now feel cringy for obvious reasons (like the idea of exchanges running “on a few mail-order Dell computers”), I think it holds up really well.

It also drove home, however, that today’s market-structure battles are not new. And it shows, importantly, that the major exchange groups which currently find themselves fending off attacks from other market participants did not create the status quo that so many find so objectionable. Other market participants — mostly the same big brokers attacking them today — foist it upon them.

During the recent market-data roundtables held at the SEC and in other discussions about potential change I’ve been part of, for example, it’s often said that much of today’s structure was put in place before exchanges “became” for-profit, publicly traded entities. That’s not the whole story. They didn’t just “become” for-profit, listed companies. Their members — including many of the very same firms decrying the current state of affairs with outrage — effectively forced them to. They created what they’re now calling a mess that they want the government to clean up. First, they literally rigged the OTC dealer market (where Nasdaq stocks used to trade) in the 90s, artificially inflating spreads and systematically overcharging their investor customers. That triggered a Justice Department investigation and new rules which compressed those spreads while opening the market to competition (a.k.a. fragmentation). Then, sensing they were losing control of the market, they began investing in the new competitors, helping create an array of nimble, for-profit, technologically savvy startups that were taking order flow from Nasdaq dealers and, later, the NYSE.

These big Wall Street power brokers raised the idea then of a “super NMS,” or “virtual limit order book,” as former SEC Chairman Arthur Levitt put it. This illustrates plainly that in the late 1990s the industry was already grappling with how to re-structure a market that was rapidly fragmenting and automating, with a greater emphasis on speedy, automatic execution. Reg NMS, adopted about five years later and implemented in 2007, was not the starting point for the evolution that gave us today’s market structure. It was a midpoint, made necessary by market participants, not the exchanges. The NASD dealers’ market rigging and subsequent Justice Department settlement was the Franz Ferdinand moment. After the Feds broke up the price-fixing cartel, new 1997 rules narrowed spreads and facilitated the rise of ECNs that had taken about a third of the market share in Nasdaq stocks by the time we wrote this article in late 1999.

At that time big “wirehouses” like Merrill, Smith Barney, Dean Witter, PaineWebber and Prudential Securities still dominated retail brokerage in the US. But they were rapidly losing out to discounters like Schwab and E*Trade, who were harnessing the power of the Internet amid a booming bull market to attract a new generation of direct retail investors and traders (remember E*Trade’s “Stuart” commercials?). And those upstart firms diverted their non-marketable limit orders from slow, manual NASD dealers and the NYSE to automated ECNs like Island and Archipaleago, who had already begun paying rebates and delivering faster, often better executions for such orders.

The aforementioned wirehouses (Morgan Stanley owned Dean Witter at the time), along with some big investment banks and trading houses like Goldman, did not want to lose control of NYSE-listed trading the way they had on what was then called the over-the-counter market for Nasdaq stocks. They also wanted to gain back some of what they’d lost in the OTC world. So they started buying stakes in ECNs and pushing regulators and legislators to re-structure the markets. This backing of their competitors by major member firms with massive order flow forced the NASD and NYSE to de-mutualize and go public – how else could they compete with nimbler, for-profit rivals that were starting to register as exchanges themselves and didn’t need approval for any strategic or tactical changes from dozens of owner/members with disparate interests?

It’s particularly interesting to note that Merrill, Goldman and Morgan Stanley (everyone in market-structure circles called them MGM at the time) were the prime movers here, and later received support from retail/advisory firm Edward Jones and asset managers Fidelity and American Century. Together these firms formed a behind-the-scenes working group to develop plans for a new market structure they’d present to Levitt. These discussions occurred at a very high level, started at a lunch meeting between ex-Merrill CEO Dave Komansky and ex-Goldman chief Paulson. The exchanges were not involved.

So how did this millennial story end? Over the next several years, Nasdaq and NYSE went public (the latter in a deal to acquire Archipelago, in which Goldman infamously represented both sides) and bought the last and most powerful of the surviving major ECNs, effectively reestablishing their historic duopoly over US stock trading. Decimalization put the nail in the coffin of manual-dealer profits, forcing big Wall Street firms to become electronic agents — using algorithms and routers to source liquidity provided by a new generation of automated market makers on dozens of exchanges and off-board venues — alongside their shrunken principal trading operations. Then Regulation NMS came along, bringing to the market for NYSE-listed shares the same kind of competition, fragmentation, automation and speed that had ripped open the Nasdaq market over the past decade.

Big broker/dealers responded by taking advantage of 1998’s Regulation ATS, originally passed to accommodate the ECNs that operated displayed order books, to launch an array of dark pools, where they systematically internalized as much customer order flow as possible, free-riding off of and detracting from exchange price discovery — all with substantially lighter regulation. That only exacerbated fragmentation and complexity, by creating a host of new, less-transparent and less-regulated venues (many of which have paid hundreds of millions in fines in recent years for defrauding and misleading investors) and forcing exchanges competing for the same order flow under stricter regulation to launch additional exchanges and order types in a mostly feeble attempt to match brokers’ ability to precisely segment order flow and customize client experiences. The big BDs also funded and seeded with order flow two new challengers to the major exchanges, BATS and Direct Edge, which they later took public for hundreds of millions in capital gains, adding four exchanges and dozens more order types to an already complex market. None of this was done for the benefit of the buy side. It was for the big broker/dealers’ own bottom lines.

For five years or so following the adoption of Reg NMS, booming market volumes (at first helped by the electronification of NYSE-listed trading and later by extreme volatility and low share prices brought on by the financial crisis) and bigger concerns facing major banks preserved a somewhat uneasy peace between the two sides. A raft of unintended consequences, including the aforementioned proliferation of dark ATSs, continued to transform market structure in ways the MGM group and Levitt likely did not anticipate in 1999. Many of these increased costs for broker intermediaries. Yet all the while, outcomes for end investors improved, with implementation costs for asset managers plummeting, meaning everyday Americans saving for retirement, education and other goals keep more of their returns, with middlemen taking less.

But as oft-uninformed hysteria built over the rise of high-frequency trading, dark pools, flash crashes and the like, banks and regulators were putting the crisis in the rearview mirror. At the same time, importantly, volatility and volume dried up. Suddenly, the Rube Goldberg system of for-profit, automated execution venues linked by a national market system that they created no longer suited the big brokers, who were facing a cost and revenue squeeze. So they went after the exchanges again, asking government for another restructuring to suit their business interests and ease pressure on their profit margins.

First, they attacked Rule 611 — the so-called order protection rule that is the very foundation of Regulation NMS. This was the very first item on the agenda of the now-defunct Equity Market Structure Advisory Committee, at its inaugural meeting in May 2015 (notably, NYSE and Nasdaq were not represented on the EMSAC). When it became clear there was no consensus for a rollback of OPR, focus shifted to Rule 610 — which, among other things, caps exchange fees to access order-book liquidity at 30 cents per 100 shares. And other critics of modern market structure joined forces with the giant banks and brokers, coming at the debate from a slightly different angle, bemoaning complexity as putting ordinary investors at a competitive disadvantage to sophisticated market participants. This helped turn EMSAC’s recommendation for a pilot program to reduce the Rule 610 access fee cap into a broader Transaction Fee Pilot that would extend government price controls to exchange rebates for certain orders, rather than just the fees to access quotes that are protected by Rule 611 against trade-throughs at inferior prices. That proposal has proven highly controversial, with the major exchange groups mounting a vigorous fight against it and dozens of listed companies also expressing serious concerns. More recently, the anti-exchange forces argued during two days of SEC-facilitated public roundtables for fundamental changes to market-data regulations that would reduce big-broker costs.

It remains to be seen how the fee-pilot and market-data battles will play out. But if these issues are not resolved to the big BDs’ satisfaction, they surely will seek to open new fronts in the war. What’s next? And will investors benefit from the unintended consequences that are sure to follow any fundamental reforms? One thing I’ve learned over more than two decades studying market structure is that predicting the future with precision is impossible.

All of this is not to say that some reforms may not be warranted, or that asset managers are not indirectly affected by some of the big-broker pain points. But the current narrative of fat-cat exchanges benefitting from a playing field tilted unfairly in their direction is both false and lacking very important context. Yes, the playing field is not level. But it tilts in both directions, not just toward exchanges. The current effort to reduce exchange power ignores substantial competitive advantages enjoyed by brokers that are just as responsible for the complexity and fragmentation so many market participants find undesirable. For example, nearly 4 of every 10 shares traded change hands away from exchanges, with far lighter regulation and less transparency. This is a huge competitive advantage for big banks, brokers and market makers operating ATSs, single-dealer platforms and central risk books. The current narrative also conveniently ignores the fact that exchanges did not create today’s structure. Rather, their former member-owners did. If we truly want to address complexity and fairness, this side of the story must also be considered in any update of market structure. Let’s not create another monster we want to kill again a few years down the road.

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