Wednesday, 28 June 2017

U.S. Equity Market Structure Part I: A Review of the Evolution of Today’s Equity Market Structure and How We Got Here

If you have three hours and forty-six minutes of time to kill then you should probably not watch the Committee on Financial Services testimony from earlier today, Huonville time:

This is the Committee web reference reproduced:

Hearing entitled “U.S. Equity Market Structure Part I: A Review of the Evolution of Today’s Equity Market Structure and How We Got Here” 
Tuesday, June 27, 2017 10:00 AM in 2128 Rayburn HOB 
Capital Markets, Securities, and Investment

Click here for the Committee Memorandum.
Witness List
Panel I
Panel II
I think Mr Larry Tabb summed up the prospects for reform nicely in one of his recent Market Structure Weekly video pieces,
"Tabb dissects the debate over US equities market structure and Reg NMS, and the difficulties in reaching a consensus."
That is, there is unlikely to be any consensus anytime soon. However, some rays of hope did appear. I interpreted there to be general support for:
  • getting more companies public;
  • tick size variation;
  • depth of market being added to SIP and further SIP improvements; and,
  • support for better disclosure on market performance and routeing.
Otherwise, most of the committee testimony pointed to differences of opinion. Even though most parties suggested a thorough review should take place, Mr Joe Saluzzi suggested this should not happen and only certain aspects should be reviewed. Mr Saluzzi spoke well but dropped a little clanger when he misled the committee and told them that SIP feeds could be used for pricing PFOF when that has been against regulation since Nov 2015.

The only truly bad behaviour was from Mr Brad Katsuyama. His referral to rebates as kickbacks and talk of syphoning off $2.5B in kickbacks as part of a corrupt system was at best an inconsiderate use of language and at worst libel. I've discussed this previously here:
Near the end, Mr Chris Concannon showed some backbone and started to dig into Mr Katsuyama's falsehoods with a muted degree of fury but the time pocketed format didn't really allow much debate.

It is quite impressive the delusion IEX continues to suffer from. They really don't understand the harm they are doing to the market and their own customers. I've more than covered that to death in the past and it is getting tired, so here are the highlights from older meanderings:
Mr David Weisberger wrote a more pointed criticism of Mr Katsuyama's testimony, "ViableMkts ANNOTATION of the Testimony of Investors Exchange Chief Executive Officer Bradley Katsuyama."

You have to give credit to Mr Katsuyama, he really believes he is doing the right thing. He doesn't understand the harm he is doing:
  • Lack of price discovery via a preponderance of dark liquidity;
  • Speed-bump flaws that expose client orders to others before they may receive their own notifications exposing their clients to latency arbitrage in a way that is worse than all other exchanges;
  • Expensive transaction costs for majority of their orders;
  • Complex order types instead of the "three only" simple order types they originally made the case for in "Flash Boys";
  • Unfairness of a lack of co-lo where traders can game POP access and get latency advantages;
  • The need for sophisticated infrastructure including multiple sites with RF or laser required to maximise information and minimise leakage from IEX;
  • A large degree of false positives from a poor one size fits all Crumbling Quote Indicator (CQI) that will lose priority too easily;
  • The CQI preventing the ability to trade in a moving market - increasing risk;
  • Excessive potential to miss fills and let the market move away;
  • Preventing innovation with the wrong kind of flawed innovation;
  • Misleading market statistics due their dark reliance and lack of trade on market ticks;
  • Poor displayed liquidity with only CHX having shorter queues showing the difficulty with, and fragility of IEX's displayed market; and,
  • MM-Peg latency issues, despite it being a post only order that is not expected to trade.
IEX has real problems, but not that you would know from their marketing.

On the consensus points, Mr John Comerford from Instinet chose to focus on the problem with the one size fits all tick size. He pointed out that the current tick size was only really appropriate for a third of the market. Tick sizes for other stocks were both too big, or too small. This was a great focal point and one that didn't see much disagreement. Mr Tom Wittman supported the idea of "intelligent tick sizes" that Nasdaq had also raised at the last EMSAC. This is an obvious thing that needs to be done.

PFOF was politely contentious. Without tick size adjustment there is no real way that public exchanges can compete against dark sub-penny increments, including PFOF. Retail would be worse off if PFOF were simply eliminated, see:
Sub-pennies rule!
Another important point that seemed to engender consensus was the need for better information and analysis around routeing and trade reporting. That would be a good thing to move forward as too much remains in the dark or is too onerous to analyse.

I was a bit surprised by the olive branch that seemed to be held out by the exchanges on the SIP. There seemed to be non-opposition for adding depth to the SIP. That would be an advance. Perhaps it is a deferment to try to take the heat of their ongoing market data fee argument?

One exchange was a bit misleading with the idea that direct feeds from exchanges were subject to competition. That claim was a bit cheeky. Mr Saluzzi quite correctly disputed that idea. There remains much consternation around market data costs and fees. The exchanges will stoutly defend this territory.

Mr Ari Rubenstein from GTS made a host of decent points. The one that showed an unfortunate bias was the claim that the BATS closing auction would harm the market. That is a hard proposition to support. Mr Rubenstein's position as a large DMM at NYSE is an obvious conflict.

Mr Jeff Brown spoke well as a representative of Schwab but lost his way for a moment in the defence of PFOF. I'm not fond of PFOF but do accept that it delivers unassailable benefits to retail thanks to the sub-penny rule despite intermediation of best execution responsibilities. This should be better articulated. Mr Comerford's tick adjustments will be the way public exchanges assail that fortress for the public good, in time.

Mr Thomas Farley lost his way on listing standards which was understandable but otherwise handled most questions deftly. He raised an excellent point about not enjoying getting the blame for SEC deferment for proposals to committees. The exchanges expressed a preference for the SEC to do the work so the exchanges don't get the blame for unpopular decisions. It seems both the SEC and the exchanges would prefer the tenure that comes from being able to blame someone else. This perhaps needs a rebalance. Exchange SRO responsibilities were also contentious.

I disagreed with Mr Matt Lyons from The Capital Group on rebates but he put his case well. Mr Saluzzi agreed. Mr Katsuyama undermined this argument with his hysterical and harmful approach to demonising rebates with his silly kickback diatribe. Others made the strong case for the need for rebates for liquidity, especially for small to medium stocks.

There was a good conversation around the lack of companies going public. This certainly needs more attention but the difficulties in preventing the private market from gazumping the public market should not be underestimated. The "why bother" question is not easy. Forcing companies to be public is not realistic. Now that particular genie is out of the bottle, getting rid of impediments may help but it may be too late,
"the new higher level was not reduced when the fine was removed" [p 15]
The CAT received both support and disdain. I'm in a camp that says it is needed but I'm slightly horrified by the "Crazy CAT" implementation NMS has been lumbered with:
Crazy CAT approved by SEC.
Exchange resistance to market data feed expense mitigation in the face of overwhelming opposition looks like fair picking for regulatory reform. PFOF should be a thing that goes away but it needs to wait for the public market's ability to perform just as well, which for now it can not.

It is going to be difficult to progress, especially with evident support for the alternate facts in "Flash Boys" from some of the committee questioning. Disinformation has a long shadow.

Where there is civil debate, there is hope.

Happy trading,


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