Take and Make

What if exchanges stopped paying fast traders to set prices? Oh, you didn’t know? Read on.

Off Salt Island in the British Virgins is the wreck of the HMS Rhone, a steamer that sank in an 1867 hurricane.  Even if you’re a snorkeler like me rather than a diver, in the clear BVI water you can see the ribs, the giant drive shaft, the shadowy hulk of a first-rate vessel for its day, 70 feet below the surface.  A storm surprised the Rhone, and after losing an anchor in the channel trying to ride out the squall, the captain ran for open water, unwittingly slamming into the teeth of the tempest.

What’s a 19th century Caribbean wreck got to do with high-frequency trading?  What seems the right thing to do can bring on what you’re trying to avoid by doing it in the first place.

On July 15, Senator Carl Levin called on the Securities and Exchange Commission to end the “maker-taker” fee structure under which exchanges pay traders to sell shares.  I’ve long opposed maker-taker, high-frequency trading and Regulation National Market System.

We have Reg NMS thanks to Congress.  In 1975, that body set in motion today’s HFT flap by inserting Section 11A, the National Market System amendments, into the Securities Act of 1934, and instead of a “free market system,” we had a “national market system.” What a difference one word made.

The legislation mandated a unified electronic tape for stock prices. The NYSE claimed the law took its private property – the data – without due process.  Regulators responded with concessions on how exchanges would set prices for trading. The result: The Consolidated Tape Association (CTA).

Today, the CTA is comprised of the registered US stock exchanges.  Its rules governing quoting and trading determine how exchanges divide roughly $500 million in revenue generated through data that powers stock tickers from Yahoo! Finance to  E*Trade.  If an exchange quotes stocks at the best national bid or offer 50% of the time, and matches 25% of the trades, it gets the lion’s share of data revenue for those stocks. And the more price-setting activity at an exchange, the more valuable their proprietary data products and technology services become. Data has value if it helps traders make pricing decisions.

Here’s where history meets HFT. Reg NMS requires trades to meet at the best price. Exchanges have no shares because they’re not owned by brokers with books of business as in the past. They pay traders to bring shares and trades that create the best prices.  In 2013, NASDAQ OMX paid $1 billion in rebates to generate $385 million of net income.  Subtract revenue from information services and technology solutions ($890 million in 2013, built on pricing data) and NASDAQ OMX loses money.  Prices matter.  NYSE owner Intercontinental Exchange (ICE) opposes maker-taker presumably because it made $550 million in profit without the NYSE in 2012, and half that adding the NYSE in 2013. For a derivatives firm, equities are a tail to wag the dog.

Senator Levin wrote to SEC chair Mary Jo White: “Clearly, eliminating maker-taker pricing would improve confidence in U.S. equity markets.”

Great! We concur. But the stock market is built on best price, by law, which in turn depends on HFT. Ironic, isn’t it?  Congress created rules that linked stock markets and forced data-sharing. Regulators tacked on a requisite of trading at the best price.  Now congresspersons like Carl Levin think the structure fosters distrust.

Say we strip out maker-taker. Our prediction? The NYSE and NASDAQ OMX both fail, and BATS remains to set prices, and 70% of trading will match anonymously in broker-owned dark pools.

There’s an alternative. The problem is the National Market System. Maker-taker is a byproduct. We should get rid of Reg NMS and its requirements that prices meet at the best bid or offer and that exchanges interconnect (the CTA also then goes away).  Bring back the word “free.”

Run straight for open water instead by ending maker-taker without other reforms, and the American stock market could founder on shoals of congressional construction.