Bloomberg News

Market-Makers Rules on Quotes Seen Focus in House Hearing

June 20, 2012

Rules governing the obligations of market makers on U.S. equity exchanges and how stock quotes are handled are among issues likely to be reviewed in a hearing today before the House Committee on Financial Services.

Securities and Exchange Commission policy makers should consider changes to trading regulations including widening quote increments from 1 cent and banning pricing that enables exchanges to collect fees from some traders to pay others, according to written testimony from Knight Capital Group Inc. (KCG:US) Chief Executive Officer Thomas Joyce. Market makers should also be forced to keep their bid and offer quotes in the market for at least a second before canceling them, he said.

Eleven firms offered recommendations to the panel, whose hearings today in Washington come five weeks after Nasdaq Stock Market’s mishandling of Facebook Inc.’s initial public offering revived questions about the reliability of U.S. stock markets. Most addressed the competition that has emerged between exchanges and brokers to handle equity orders and stability issues related to high-frequency trading and the flash crash of May 2010.

“The time has come for policy makers to bring perspective to the market,” NYSE Euronext CEO Duncan Niederauer said in written testimony. “We fear that as a result of too much focus on market microstructure incrementalism, there has been too little public discourse on the formidable reliability and resilience of the equity markets during crises and overall fairness to investors.”

Market Reform

The issues raised by Knight, Getco LLC and the owner of the New York Stock Exchange are part of a debate that developed in the mid-1990s with the SEC’s efforts to reform U.S. market structure, dominated at the time by the NYSE and Nasdaq. Today, trading is fragmented across more than a dozen exchanges and electronic communications networks and more than 40 dark pools.

Rules such as the decimalization of share quotes and the growth of competing trading venues have reduced the profitability of traditional market making, delivering more of the benefits to high-speed traders such as Getco. As the role of those firms has grown, so have efforts to codify their obligations to maintain orderly trading.

U.S. market makers need tougher capital requirements and stiffer rules to provide quotes at the best prices, according to Knight’s Joyce, whose company is based in Jersey City, New Jersey. Such rules should be keyed to the price and average daily volume for stocks, he said. Knight and Chicago-based Getco are market makers at NYSE.

Risk Management

The SEC should adopt risk-management policies for automated markets that it outlined more than 20 years ago but never made compulsory, and require public venues to communicate better during trading failures such as the IPOs by Facebook and Bats Global Markets Inc., William O’Brien, CEO of Jersey City-based Direct Edge Holdings LLC, the fourth-largest owner of U.S. stock exchanges, wrote in testimony. Computer malfunctions led Bats to withdraw its offering on March 23. Facebook shares began trading on May 18.

On both days, “we had no greater visibility into what was occurring than the average retail investor,” wrote O’Brien, whose venues compete with Bats. “No hotline, no market-wide escalation procedures, no nothing.”

The immunity exchanges have from financial liability for technology malfunctions should be removed, Dan Mathisson, head of U.S. equity trading at Zurich-based Credit Suisse Group AG, wrote in testimony. Requiring for-profit exchanges to be responsible for their mistakes would lead to fewer breakdowns in their systems, he said.

Equity Share

Technology advances and changes to regulations over the last 15 years have cut NYSE’s share of stock trading to 21 percent from 82 percent in 2002, according to data compiled by NYSE and Bloomberg. Competition and a congressionally driven reduction of the increments in which shares are priced to 1 cent from sixteenths of a dollar led to a pricing model known as maker-taker, in which exchanges pay firms for providing quotes to help compensate for a shrinking spread.

Fees that fund the credits come from firms that execute against orders already at the exchanges, with the markets earning the difference. Most exchanges offer pricing that targets specific types of investors or firms that trade a lot, including through volume benefits. The SEC capped the maximum fee to trade with bids and offers at 30 cents per 100 shares.

The Jumpstart Our Business Startups Act, signed into law by President Barack Obama April 5, requires the SEC to conduct a study about the effect of decimalization on IPOs and whether smaller companies should continue to be traded in 1-cent increments. Shares of emerging-growth companies, those with annual revenue of less than $1 billion, could be traded with a 5-cent increment, Joyce said.

Tick Sizes

Daniel Coleman, CEO of Getco, said in written testimony that the tick size should be correlated with a stock’s price, as in Europe, increasing for more costly shares and shrinking to less than a penny for lower-priced ones. The SEC doesn’t allow tick sizes smaller than 1 cent for shares above $1. Bigger increments may allow orders to pool at fewer price points, enabling investors to trade more shares and giving greater incentives to firms to supply bids and offers.

The SEC should start a pilot program to study the impact of larger tick sizes on smaller and mid-size companies as part of a broader examination of decimalization, Jim Toes, president and CEO of the New York-based Security Traders Association, said in written testimony. NYSE Euronext (NYX:US) also supports a pilot program to test larger increments.

Exchange Owners

NYSE Euronext and Nasdaq OMX Group Inc. (NDAQ:US), the biggest owners of American stock exchanges, urged legislators to support changes to rules that led to a proliferation of alternative venues that draw orders away from their markets, according to a written presentation to staff of the House Committee on Financial Services obtained by Bloomberg. Dark pools and brokers who match orders away from markets should provide better prices than those available publicly or offer quotes at the best levels if they want to trade outside exchanges, the companies said.

Such a requirement is known as a trade-at rule since brokers would have to meet more obligations to trade at the same prices offered on exchanges. NYSE Euronext, based in New York, also called for more orders to contribute to price discovery on exchanges instead of trading elsewhere.

“The SEC has permitted non-exchange trading centers to create a very sophisticated web of connectivity which allows them to give select groups of traders and clients access to those orders before anyone else -- each with its own level of conflicted interest,” Niederauer wrote. “It is only after select customers have determined they do not want to execute the order that the order finds its way into the public markets.”

Best Execution

While brokers have a duty to get the best execution for clients, their desire for profit and “lack of independence and objectivity” affect their decisions, he said.

Almost a third of U.S. equities volume occurs away from exchanges, according to data compiled by Bloomberg. This includes buying and selling in dark pools, by traditional human intermediaries at brokers or through so-called wholesalers who execute orders from individual investors sent by retail securities firms. Orders executed away from exchanges can’t trade at prices that are inferior to the best quotes available on exchanges and often get minimally better prices.

The largest U.S. dark pool is Credit Suisse’s Crossfinder. It traded 126 million shares daily in April, or about 1.9 percent of U.S. equities volume, while all dark pools accounted for 13.6 percent of trading that month, according to data compiled by Rosenblatt Securities Inc.

Broker Owners

The SEC should allow alternative venues to become exchanges without a limit on the ownership stake of a broker, Mathisson of Credit Suisse wrote. The agency should lift the 20 percent ceiling on a broker’s stake in a regulated exchange, he said.

Greg Tusar, head of U.S. electronic trading at Goldman Sachs Execution & Clearing, a unit owned by New York-based Goldman Sachs Group Inc. (GS:US), said in a phone interview last week that getting rid of maker-taker pricing would enable brokers to compare bids and offers across venues more fairly. It would also end the need for a market operator to own multiple exchanges to provide different pricing to attract orders from specific types of investors, he said.

“If you eliminate maker-taker fees, you could more easily say that all bids and offers are the same and should be treated equally, which would be an important prerequisite for any discussion of a trade-at rule,” Tusar said. “Different fees make it very difficult to compare bids and offers across venues.”

Trade Rebates

Outlawing pricing that permits exchanges to give rebates to market makers would cause the bid-ask spread to widen, forcing investors to pay more when they buy, Getco’s Coleman said. While transaction credits help market makers provide better prices, Getco doesn’t use “trading strategies that are designed solely to earn a rebate,” he wrote.

Brokers that send orders to exchanges offering rebates when a firm takes liquidity -- instead of when a firm provides orders against which others can execute -- should be examined by regulators to ensure the securities firms aren’t making decisions that hurt their clients, Coleman wrote. Market makers that supply orders on those markets that reverse the traditional pricing must pay to do so, instead of collecting a rebate.

“While the SEC has brought up certain issues of unfairness since about 2008, they’ve done very little,” Sal Arnuk, a partner at Themis Trading LLC in Chatham, New Jersey, said in a phone interview. “We wouldn’t be having this discussion if we hadn’t seen massive equity market withdrawals since the flash crash. Investors don’t trust the market.”

To contact the reporter on this story: Nina Mehta in New York at nmehta24@bloomberg.net

To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net


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