One-Step National Market System Reform

Introduction

The SEC has proposed amendments to reform Regulation NMS. But there are better ways to reform the NMS. This article lays out the first of two NMS reform agendas. Both these proposed reform agendas obey my three rules of thumb for improving the financial market structure.

• The reformed system should be safer, with lower systemic risk.
• Provide a tighter bid-ask spread to retail investors.
• Provide greater investor transparency than the old one.

The proposal is for the SEC to simply require its approved exchanges to co-locate. The article analyzes the effects of a single multi-exchange location on the costs and efficiency of the equities market.

The current system

The current NMS is characterized by many exchanges that do not compete. They are near-identical and multiply the total resource cost of all exchange trading. Setting aside the irrelevant low-volume not-publicly-held new exchanges (IEX, MEMX, and LTSE) there are 12 SEC-approved stock exchanges owned by three publicly held exchange management companies (ICE, NASDAQ, and CBOE Global Markets). The three big firms own multiple exchanges to multiply the firms’ receipt of SEC payments and broker-dealer payments resulting from the SEC’s NMS requirements, promulgated in its present form in 2005.

There are two symptoms of failure the current system displays.

• The exchanges now primarily provide execution services to high-frequency algorithm-generated transactions. Retail investors go elsewhere. The multiple SEC-approved exchanges are no longer an important source of fills for retail investors. The bid-ask spread from exchange market makers is too wide to compete with the bid-ask provided by OTC broker-dealers known as wholesalers. In short, the NMS does nothing to meet the SEC’s mandate to provide low-cost efficient trading for retail investors.

• Retail brokers no longer consider the use of exchanges to execute customer orders. These brokers typically bundle their orders, thereby creating large enough order sizes to attract broker-dealer wholesale trading firms that pay retail brokers for their order flow (a practice known as Payment for Order Flow (PFOF)).

The NMS unintentionally rewards exchange management firms for adding to the number of exchanges. There is nothing magic about the existing 12 exchanges. The SEC realizes that if permitted, the exchange management firms would add even more exchanges.

The regs of NMS add to the resource cost of retail investor transactions because profit-maximizing market makers will set bid-ask spreads wide enough to allow their own High-Frequency Traders (HFTs) to make a profit on inter-exchange arbitrage while paying the exchanges’ colocation fees.

The bid-ask spreads generated by exchanges, known as National Best Bid and Offer (NBBO), are so wide that wholesale broker-dealer firms make a profit from buying retail orders and filling them at prices inside the NBBO, then arbitraging the retail prices by covering them in the chaos of the NMS.

The effect of high-frequency trading and exchange colocation on retail investors

Exchange management firms have two primary incentives for owning multiple exchanges. First, every major broker-dealer is pressured by its customers and the potential for transactions from arbitrage to co-locate at every SEC-designated exchange. The result is that exchange management firms can reap colocation fees and maker-taker fees from each added exchange, no matter how many there are. HFTs in turn, increase arbitrage profits with each added exchange. The only way the system can pay for all these added costs is through the bid-ask spread paid by retail investors.

The current HFT procedure is to co-locate broker-dealer-owned computers separately at each of the 12 major exchanges. HFT profits are directly related to:

• The distance between exchanges
• The number of exchanges
• And the number of colocated broker-dealers

Both the cost of colocated computers and the profits of HFT firms add to the bid-ask spread exchange market makers show to retail investors. The bid-ask spread reflected in NBBO must be large enough to cover these profits and fees.

The colocation-related profits and fees are a major share of the resource cost of modern equities trading. Yet they are a cost that yields no offsetting benefits to retail traders. They have a negative effect on the quality of market prices shown to retail investors and the resource costs of trading.

This stylized map of Northern New Jersey, where the stock exchange computers are located, shows how the complex NMS-created market structure creates income for both exchanges and wholesalers that can only be paid by greater bid-ask spreads to retail investors.

The SEC seeks to encourage competition among exchanges. But according to the theory of competition, competition will reduce the cost of production to a minimum. The cost of production in equities trading is the bid-ask spread. With the current system, this competition never happens as evidenced by the fact that multiple exchanges are owned by each major firm.

The colocation market structure

But as the graphic below displays, colocated exchanges return equities trading to the competitive model. Because the exchanges are colocated, every broker-dealer sees the best bids and offers of all exchanges instantaneously. This eliminates the incentive for market makers to quote different bids and offers on each exchange. That means bids and offers on all exchanges will be identical, eliminating the need to shop the exchanges.

Moreover, the effect of a single bid-ask spread from all exchanges eliminates the incentive for retail brokers to pay wholesalers to find the best bid or offer. This will result in the return of retail brokers to the exchanges since wholesalers are no longer arbitraging retail orders against a poor NBBO. Once retail brokers get a better deal trading directly with the exchanges, payments to wholesalers for order flow will be nonsense. No SEC regulatory involvement is needed to eliminate PFOF.

Allowing competitive forces in a colocated exchange environment to eliminate the PFOF that competition in the multi-exchange environment created is far better for the retail investor than leaving the NMS essentially unchanged other than adding another layer of resource cost resulting from a second SEC-mandated marketplace where wholesalers compete with each other to minimize the payment for order flow of the NMS. On its face, the addition of another marketplace will increase the resource cost of equities trading – exactly the wrong direction to send the equities market structure.

Another implication of the return to competition between exchanges is that equity market-makers will no longer see any reason to make markets on more than one exchange. This in the end will bring markets back to the fundamental conundrum confronted by the Commodity Futures Trading Commission (CFTC) in futures trading. If the cost-minimizing structure of trading is a single exchange clearing every trade, how is the regulator going to prevent the exchange from seizing monopoly profits?

Conclusion

How do we escape this retail-investor-unfriendly NMS? Some think that retail investors cannot help themselves. Due to their numbers and heterogeneity, retail investors are an unruly lot. The meme frenzy of January 2021 displayed the reality that retail investors are not well thought out. Motives for buying a stock such as punishing Wall Street short sellers and the entertainment value of buying something in the belief that you will find someone more foolish to buy the stock at a higher price do not encourage dispassionate policymakers to allow retail investors to manage their own financial markets.

On the other hand, the success of Vanguard Securities’ model, ownership by its own investors, and the highly successful passive stock index funds that followed show that retail investors can sometimes solve their own problems.

The NMS, on the other hand, shows that government regulation is not necessarily a better source of investor assistance. The NMS has inadvertently abandoned retail investors. A regulation like the current SEC proposal to perversely add another layer to the already excessive resource cost of retail trading, intending to reduce the cost of PFOF (??) is not an intuitive solution.

This much simpler proposal would eliminate PFOF without any added resource cost, in fact removing billions from the resource cost of retail investing.

In a follow-up article, I will show how retail investors can dramatically reduce the cost of clearing, a second way for retail investors to improve their access to financial market services at a lower cost. This change would begin to put retail investors’ financial market structure in the hands of the investors themselves.