Market Structure Series (Part I): Current State of Markets and Preventing Market Instability

Last week, SEC Chair Mary Jo White, announced the exploration of proposed changes to US Equities market structure. Contrary to the many attempts to portray the new proposals as a “crack down” on high frequency trading and dark pools, White’s recommendations are the result of  a well-measured, principles-based review of the entirety of the US Equities market.

According to Chair White:

“Our review of market structure must be comprehensive. We must test our assumptions about long-standing rules and market practices. Past decisions must be reevaluated in light of current conditions, and market-based solutions to issues should be explored. Barriers to such solutions must be reviewed, and removed when appropriate.”

The Modern Markets Initiative supports data-driven improvements to the market that benefit end investors and maintain the many benefits of the electronic market place. To this end, we will review Chair White’s recommendations in a series aimed to assess the current state of the markets and the potential pathways forward to strengthen the markets for all investors. While MMI does not purport to have all the answers to the many challenges facing markets today,  we believe Chair White’s remarks have provided the industry and stakeholders more broadly with an important opportunity to ask the vital questions necessary to ensure a continuation of today’s beneficial markets.

Current State of the Markets

Before a comprehensive review of the markets can be carried out, it is important to know their current state. As Chair White said, “Empirical evidence shows that investors are doing better in today’s algorithmic market place than they did in the old manual markets.” This evidence is:

• The cost (in terms of price) of executing large orders for institutional investors was 10% lower in 2013 than 2006;
• Intraday volatility has returned to low levels after the financial crisis and was no worse in 2013 than it was in 2006; and
• Retail investors benefit from spreads between bid and ask prices being as narrow as they have ever been.

The markets are not broken, but they can be made better. In Part I, we examine Chair White’s recommendations to prevent market instability.

Preventing Market Instability

Every market era has its own unique issues, and the recent markets, marked by the great benefits of automation and technological innovation, are no different. As Chair White said, “Technology can and has greatly increased the efficiency of our markets, but it can also allow severe problems to develop very quickly.”

To prevent the severe problems and slow their repercussions spreading through the market, she touched on three broad areas:

• Volatility dampeners: Limit up / limit down and market-wide circuit breakers;
• Regulation Systems Compliance and Integrity (Reg SCI); and
• Addressing single points of failure, most notably the securities information processor (SIP).

Volatility dampeners, such as Limit up / limit down and market wide circuit breakers are in place and helping, but this does not mean we can put them on a shelf and consider the issue resolved. Reviews should be constant, based on hard data to ensure they are providing the anticipated benefit. Furthermore, these measures have not been coordinated with other asset classes outside of the SEC’s purview to date, but multi-asset market movements can be highly correlated.  One cannot help but wonder if circuit breakers are the perfect place for regulators of different asset classes and geographies to work together.

Reg SCI requires that the backbone of the market, which includes exchanges, ATS, clearing agencies, and the SIP, should be well tested, carefully upgraded, and constantly monitored. While many, if not all, operators do this already, codifying such work and making it a requirement could help further minimize the chance of error.

SIP tends to be the most often referred to example of needing to improve the single points of failure in our market’s infrastructure (Also read MMI’s post “What is a SIP and What Role Should it Play?”). This is not surprising as it is one of the few key components of today’s market infrastructure that is not distributed and constantly improved upon by competing parties. As Chair White referenced in her remarks, it is a work in progress, but the market would be correct to question if it is the right work. Work is being done to improve SIP robustness, but work that makes a single point of failure more robust tends to be good money thrown after bad. It would make more sense to work towards having multiple SIPs that compete with each other on resiliency, speed, and depth of information.

Furthermore, work is being done to implement a “hot-warm” backup solution at exchanges, which comes with a “ten-minute recovery standard”. Recovery standards are good, but ten minutes is far too long for properly implemented hot-warm backup.

The omission of the interconnectedness of today’s exchanges in the discussion of “Preventing Market Instability” was a surprise. Exchanges currently connect to each other in ways that add a great deal of complexity to our markets and that quite frankly, are not well suited for an exchange’s business model or technological strengths, increasing the overall fragility of our markets.

Exchanges are not a single point of failure, but the routing requirements Reg NMS puts on exchanges create many single points that can quickly and negatively impact multiple points. One of the reasons that issues spread so quickly through the market is that regulation mandates exchanges to be highly interconnected: monitoring top of book at other exchanges and routing orders. Granted, this is a requirement of current regulations, but Chair White has said often of late that everything, including current regulatory requirements, is open for change.

If exchanges no longer had to route orders to each other, the spreading of issues would be slowed and a great amount of the complexity in today’s markets would be removed.  For example, many of the order types exchanges have implemented in recent years would no longer be needed, thus removing a great source of confusion from the markets.

It is important to remember that no matter what we do, there will always be room for error. The key to success for Chair White will be to focus on not only finding ways to minimize the number of errors, but more importantly, on making the market simpler so that when errors do occur, recovery and understanding can occur as quickly as possible. To this end, we wholeheartedly agree with Chair White when she says, “there is more to be done, and there is never room for complacency.”