Monday, March 26, 2012

Bats IPO: A Gift to Critics of Modern Market Structure

From this Bloomberg article on the errors that forced Bats to withdraw its IPO and some of the implications of the failure:

The malfunctions will refocus scrutiny on market structure in the U.S., where two decades of government regulation have broken the grip of the biggest exchanges and left trading fragmented over as many as 50 venues. Bats, whose name stands for Better Alternative Trading System, expanded in tandem with the automated firms that now dominate the buying and selling of American equities.

The withdrawal also raises questions about the reliability of venues formed as competitors to the New York Stock Exchange and Nasdaq Stock Market since the 1990s.

Themis Trading LLC has been shedding light for some time on some of the things that led to changes in market structure. I've included excerpts from some of their prior posts and one of their white paper's:

Regulations That Contributed to Existing U.S. Market Structure
Beginning with REG ATS in the late 90′s, the SEC has had the stated goal of transparency, and equal access to pricing by all market participants. Unfortunately, with decimalization and Reg NMS, the velocity of trading has skyrocketed. While this spawned some innovative products, nevertheless it has fragmented the market place and hurt the price discovery process in an unintended way. - From Themis Trading Comments on SEC Dark Pool Proposal

Unintended Negative Consequences
To regain public trust and confidence in our equity market, the SEC must undertake major reform. Such change faces two major challenges, however. It means admitting that the past decade of regulations have had serious unintended negative consequences. And it means going up against the HFT community, which is likely to do everything in its power to slow or water down the reform process.

The HFT community will claim that if any serious reform is implemented, they will be driven out of the market, spreads will increase and liquidity will dry up. We agree that spreads will widen, but liquidity will not vanish; only HFT volume will. And if a slightly wider spread is the cost of getting our market back into the hands of the owners who are responsible for price discovery, then that is a cost that most investors will gladly pay, we believe. While explicit costs will go up, the implicit costs of reduced market confidence will plummet. - From a White Paper by Sal Arnuk and Joseph Saluzzi

Those implicit costs may be hard to measure but that doesn't make the costs of reduced market confidence any less real.

Threat to Market Stability?
The first step in fixing a problem is admitting that you have one and that is exactly what this committee did last week. The unintended consequences of Reg ATS, the Order Handling Rules, Decimalization and Reg NMS have emerged into a serious threat to the stability of our market and they need to be addressed immediately. - From Great Expectations and the Frankenstein Market

Beneficial to Capital Formation?
Were these regulations beneficial to the markets? Were they beneficial to capital formation? Which is larger today: the cash equity business (ownership in real economic corporations), or more profitable market for derivative instruments of those equities? Is today’s Frankenstein market a result of “unintended consequences”, or is this market exactly the intended plan of the insiders, given that the current market participants had literally years to tool up to prepare (and take advantage of) for that very Frankenstein market? - From The Revolving Door

What's at stake seems straightforward enough but the fix won't be easy.

Does the market structure that exists today facilitate anything near the most effective capital raising and formation capability possible?

Are participants who invest primarily with longer term economic effects in mind being pushed aside in favor of more short-term oriented insiders?

I'm pretty sure that answers aren't likely to come from those with entrenched interest in the status quo. Pressure from places with fewer conflicts obviously have the better chance of getting us closer to more a desirable outcome.


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