Rob Daly: Throwing the Baby Out with the Bath Water—Not Such a Bad Idea

As the first anniversary of the Flash Crash approaches, the joint advisory committee to the US Securities and Exchange Commission (SEC) and the US Commodity Futures Trading Commission (CFTC)­—charged with examining the causes of and recommending possible solutions for the events of May 2010—announced recommendations aimed at preventing another Crash.

The recommendations appear to have been written by academics and lawyers who do not have skin in the game: They typically draw the distinction between changes the markets can make the next time a similar situation occurs, and changes to the overall market structure that can be made to prevent it from happening in the first place. Of the two categories, the first tends to be the least onerous to the sell-side and exchange communities.

The least painful suggestions include extending the industry-wide circuit-breakers to all but the most thinly traded stocks and exchange-traded funds (ETFs), deciding whether derivative instruments should trade while the underlying instruments on which they are based are in a “limit up” or “limit down” situation, and shortening the trade-halt period to as little as 10 minutes, but allowing them to occur up to 30 minutes before the markets close.

Obligations
Other suggestions, such as the elimination of stub quotes—the practice of placing a quote far away from current trading levels with the intention of it never being hit in order to meet market-maker obligations, come as no surprise. Eliminating this practice was one of the first things tossed around by regulators days after the Flash Crash.

The painful news for broker-dealers is that the committee wants as much liquidity returned to the displayed market as possible. It recommends the implementation of the “trade-at” rule, which will force dark liquidity pools to provide a “significant price improvement” over the national best bid and offer (NBBO). In the SEC’s market structure concept release, the regulator suggests a minimum allowable quote size of typically one cent.

The committee also recommends a similar change in simple order internalization where broker-dealers would have to provide a price “materially superior”—e.g., half a cent for most securities—to the quoted best bid or offer. This tiny improvement will wipe out most of the incentive to internalize trades in the first place. It is close to double what most exchanges currently charge for taking liquidity at NBBO.

Although it might sound rosy for the exchanges to have all of this new liquidity on their matching engines, they are going to have to make some of their own changes. As part of their recommendations, the committee proposes that exchanges introduce an order kill fee that would be based on the ratio of the number of orders canceled to the number of orders executed—in other words, the higher a firm’s cancellation ratio, the higher its kill fee.

Reduced Profitability
These order kill fees will wipe out the aggressive high-frequency trading strategies that rely on one order fill per 1,000 or 10,000 orders entered. Toss in a kill fee or two on liquid stocks that trade at a penny or sub-penny spread and it destroys these strategies’ profitability.

The resulting decrease in quotes will hurt the exchanges when it comes to their respective share of the consolidated tape revenues—which are in part based on the number of quotes generated by an exchange—but since most exchanges are making more money from direct feeds these days, it will not hurt them too much. In fact, it should bring the growth curve of trades and quotes more in line than they have been in the past several years.

The SEC–CFTC recommendations fall in line with the SEC’s market structure proposals, which is no surprise. It is stiff medicine, but hopefully it will help the market stability overall.