The Regulation of Trading Markets: A Survey and Evaluation

Paul G. Mahoney is a David and Mary Harrison Distinguished Professor at the University of Virginia School of Law, and Gabriel Rauterberg is an Assistant Professor of Law at the University of Michigan Law School. This post is based on their recent paper.

The U.S. equity markets have undergone profound changes in the past 15 years. In place of face-to-face or telephonic negotiation and execution of trades, electronic communications and information processing systems match incoming buy and sell orders automatically. Trading in listed stocks, which used to be heavily concentrated on the listing exchange, is now widely dispersed among multiple automated trading venues. Exchange specialists and over-the-counter market makers have been largely replaced by proprietary traders that offer liquidity to the automated markets by executing algorithmic trading strategies. Those strategies often rely on a menu of new and complex order types that trading venues have created to supplement the traditional market and limit orders.

Technological advances made these developments possible, but regulation has shaped them. In the Securities Acts Amendments of 1975, Congress authorized the SEC to adopt rules to create a “national market system” in which trading venues would compete with one another for order flow. The SEC responded with a number of major regulatory initiatives that required consolidated last-trade reporting and dissemination of quotations, electronic linkages among exchanges, and the exposure of certain customer orders. In its largest initiatives, Regulations ATS and NMS, the SEC created a regulatory framework for automated trading platforms that do not operate like traditional exchanges, regulated the way orders flow from brokers to trading venues, and capped the fees trading venues charge for executing those orders, among other things.

On objective measures of liquidity and execution quality, the resulting equity market structure is a great success. Retail investors trade with greater convenience and speed, and with lower commissions and spreads, than ever before. Nevertheless, numerous commentators, most notably Michael Lewis, have argued that the new stock market is rigged against the average investor. The argument, in brief, is that trading venues collude with “high-frequency” proprietary traders to help those traders identify changes in market prices, order volumes, and other market information before the rest of the trading public has access to it, to the ultimate detriment of other investors. Other commentators criticize so-called “dark pools,” trading platforms that do not publicly display their quotations, as well as the fee structures that exchanges have implemented to attract order flow in a highly competitive market.

It is unlikely that Congress or the SEC foresaw how technology-based competition would unfold in practice. Both saw technology as a means to achieve a longstanding objective of allowing long-term investors to trade directly with one another without paying a spread to an exchange specialist or over-the-counter market maker. Those traditional intermediaries have in fact disappeared in large numbers, but they have been replaced by high-frequency and other proprietary traders, not by a trading environment catering exclusively to long-term investors. The SEC required the traditional exchanges to open up their quotations to the public, but traders still hide their trading interest using dark trading venues and non-displayed order types. Competition among public trading markets is no longer based on different methods of bringing together buyers and sellers, like the old competition between the NYSE and Nasdaq, but on different incentive structures for attracting order flow. The SEC appears to be having second thoughts about some aspects of the equity trading markets.

This paper comprehensively surveys the regulation of secondary equity markets in the United States. In addition to the SEC’s market structure regulations, it discusses broker-dealer regulation and the antifraud and anti-manipulation rules to which both professional and non-professional traders are subject. It identifies elements of the current market structure that have attracted criticism, including the trading practices of high-frequency traders, the proliferation of order types, dark liquidity, and the way broker-dealers route customer orders.

We then discuss proposals to reform current market structures or to adopt entirely new ones. Readers may be familiar with the newly-registered IEX exchange popularized by Michael Lewis’s book Flash Boys. To implement a “speed bump,” or automatic delay between order entry and execution, IEX had to seek relief from certain provisions of Regulation NMS. Other innovations would similarly require regulatory change or relief.

We accordingly conclude by asking whether the concept of a national market system has outlived its usefulness. In an era when the New York Stock Exchange dominated trading in stocks of the largest companies, Congress and the SEC saw a need to give technology-driven competition a regulatory boost. Today, individual stocks trade on dozens of different venues. The detailed regulation of how those venues may and may not compete with one another has arguably contributed to seemingly wasteful investments in getting microsecond advantages over other traders, crafting complex order types, and concealing trading interest through dark pools, hidden orders, and other forms of non-displayed liquidity. A key question going forward is whether regulators should address these unintended consequences through tweaks to the existing regulatory structure or through a more fundamental rethinking.

This paper was commissioned as part of the New Special Study of the Securities Markets by the Program in the Law and Economics of Capital Markets, a joint program of Columbia Law School and Columbia Business School. It has a companion paper by separate authors addressing the financial economics literature, and thus focuses on the regulatory and legal aspects of trading markets.

The complete paper is available for download here.

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