November 16, 2010

Why We Have Eleven Exchanges and Counting

Blaise Pascal, the 17th century French brainiac, is reputed once to have said in a post script: “I’d have written a shorter letter, but I didn’t have time.”

We wonder what Pascal would think of the 523-page Final Rule for Regulation National Market System (Reg NMS), published August 29, 2005. Step forward a half-decade, and it explains why deep and liquid markets that were thought to foster the interests of long-term investors have instead fed a fragmented maker/taker market system florid with high-frequency traders moving the same shares from place to place.

And why we have eleven stock exchanges, and counting, on the fruited plain. Word has it that more are in the pipeline from each big operator.

One of the five aims of Reg NMS was to re-write the “Market Data Rules” governing trading data and revenues derived from it. Did you know that Reg NMS dates to Congress in 1975, which passed legislation calling for a managed national market system to “improve competition?” Thirty-five years later, the carnival continues.

Trading generates data. Data flow to a consolidated facility for dissemination, so folks getting information at Bloomberg, Yahoo and elsewhere can know how many shares of a stock have traded. That data generates fees. Exchanges and markets share the revenue.

Congress and the regulators wanted to shift focus away from the number of trades, a key driver of the old revenue-share model. By 2005, when Reg NMS was passed –implemented in 2007 – the SEC opted to allocate revenues by share of volume and quotations, rather than by trades, to minimize “order shredding.” Only automated quotes would be eligible, to prevent manual quote-manipulation for more revenue from the data.

We realize this is the kind of gripping stuff that keeps you on the edge of your seat. Like that new Natalie Portman movie “Black Swan” (also a trading term) that Karen and I saw in preview, courtesy of the Denver Film Society. Riveting and bizarre at the same time.

Back to the data. Reg NMS said tape revenue would be shared, but also that everybody could now own and monetize their “proprietary” data, the nuanced information on each platform. Thus every alternative system, every broker-dealer, every market center, could offer data products. And market share and quotes would drive the basic, consolidated data, such as volume.

The blizzard hit. The more market share you have as an exchange, the bigger your share of the pie from the consolidated tape. FINRA, the regulatory body that succeeded the NASD, proposed and received approval for a revenue-sharing scheme that depends on total market share for each Tape: Tape A for NYSE issues; Tape B for all the regional and electronic markets (lots of ETF and derivative quotes here); and Tape C for Nasdaq stocks.

How to get greater share if you’re an exchange? Operate more exchanges with specialty focuses, so you can increase your revenue from the tapes by rolling up a market-share number. The more entry points in a maker/taker environment, the better for exchange operators. Every sell can generate an incentive payment and each buy generates a “take” fee. Fragmentation helps exchanges lift the take fee and control the make payments, and every little transaction expands the marketable proprietary data stream, and at the same time reduces access fees paid to other exchange operators.

In short, you get what we’ve got. Fragmented data. A labyrinthine path to liquidity that masquerades as efficient and deep, through the guise of penny spreads and millisecond trades. And a colossal data cloud of such obtuse and opaque dimension that even Blaise Pascal the mathematician would probably wad up his letter and throw it away.

And issuer data? Not better, worse. Despite rules requiring parity for all capital-markets participants, issuer data have not kept pace with market behavior.

It’s the opposite of what regulators expected. This is a frequent result of well-intentioned efforts to manipulate human behavior around what’s “good” or “bad” rather than letting people and markets decide. Perhaps someday, we humans will learn that lesson before it’s too late.

And that’s why we have eleven exchanges, and why you know so very little about your trading. Somebody isn’t jobbing you; the system is.

The Buttonwood Agreement, in two sentences, worked better than every arcane machination we’ve manufactured since. Simple is best. We’ve all bought the bogus argument that a complex age requires elaborate rules. Really? How’s that working?

Karen and I are off to New York this week. Hope you on the east keep it warm for us!

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