The Security and Exchange Commission’s 151 page treatise on the “Flash Crash” may seem like a meek effort compared with the Affordable Care Act and Dodd Frank. However, I have the feeling they are just getting warmed up. Expect a sequel in the form of new regulations on how stocks are traded. You can simply substitute “high frequency trader” and “algorithm” for “insurance company” and “banker” and otherwise retain the gist of the same old plot. Bad guys exploit good guys, regulator-politician rides in, pen in hand, and saves the day.
If it were only so easy. To understand some of the underlying problems exposed by the Flash Crash we have to rewind the clock a bit. In the 1990’s the regulators had an idea. To help investors do better they decided to change something called the “minimum tick”. For those not in the know, the minimum tick is the smallest price increment used in trading stocks. Think of it like a penny when you go into the store. Back in the old days the minimum tick was 12.5 cents, better known as one-eighth of a dollar. Stocks were quoted and traded in “eighths”. Too bad if you wanted to pay $50.05 to buy a share. You couldn’t do it.
Over the turn of the millennium the regulators succeeded in reducing the minimum tick from an eighth to a penny. In a tip of the hat to the American consumer, trading stocks could now feel just like going to Walmart. Everything seemed peachy until the Flash Crash occurred. Like red-faced parents whose kids have acted out in the playground, Mary Schapiro at the SEC and Gary Gensler at the CFTC demanded to know “who done it”. Angry politicians couldn’t pass up the opportunity to stick another pin into the Wall Street voodoo doll. Now that the culprits have been fingered all we have to do is sit back and wait for the rule makers to fix the problem. I am going to submit to you that the regulators have it all wrong, and argue that they themselves are to blame.
The move to trading in pennies was a bad idea. A sound market is defined by a relative balance between those who consume liquidity and those who supply it. In addition, it is a place where no one can jump ahead in the line and check out first. When we went to pennies the liquidity suppliers quickly became discouraged. They found that whenever they tried to post a meaningful order someone would soon jump in front of them for the cost of a mere penny. To make things worse, current rules allow orders to be filled away from the exchanges, using exchange prices as a guide, without any regard for the people taking the risk to set the prices in the first place. The combination of these two has proven to be toxic to market quality as the number of bona fide liquidity providers has shrunk and the number of liquidity consumers has grown.
Don’t blame the high frequency traders. They are rational and innocent actors in this drama. The change to pennies placed a premium on speed, both for quotes and orders, as the number of price points increased dramatically. It significantly reduced the compensation for providing liquidity by granting free options to free riders. Order sizes shrunk and message overhead grew, prompting exchanges and their clients to invest in technology and cut deals to put computer servers close to the action.
Confusing and ever evolving order priority rules have allowed off-exchange venues to flourish as it is relatively costless to transact in front of existing orders on the exchanges. For folks like internalizers, the SEC decided it was OK to cut the penny.
There is a way to fix this mess.
First, increase the minimum tick to five cents. With a mandated minimum spread that makes some economic sense the relative balance between liquidity consumption and provision can be restored.
Second, those who seek to internalize order flow or participate in dark pools need to satisfy similarly priced existing orders on major exchanges before participating in the trade themselves. Allow no splitting of the minimum tick and require all trading venues to honor the same minimum tick.
Third, define what an exchange is and what it does. It seems that we have gone from one bad extreme to another; from insider owned exchanges with special privileges to a tangled mess of communication networks. We need to find a middle ground where exchanges serve their utility purpose with adequate competition and minimal complexity.
Fourth, ensure a level playing field by making no distinction between different players in the market.
Fifth, Reduce the complexity and number of order types. The fancier the order type the more likely it is that someone is getting ripped off. Consider banning the market order. An investor needs to state a minimum or maximum price or they are not an investor.
Finally, regulators and investors have to accept that the world is fraught with risk. Investor confidence comes from a market that is fair and easy to navigate. Sure, there will be times when imbalances result in volatility. A good regulator should not try to hide this fact but instead should ensure that it creates the price signal necessary to find a new equilibrium. The fact that the Flash Crash lasted only minutes and not days is testimony to the fact that prices do convey information that motivates investors to trade. The key is creating an environment that favors price discovery over a frenzy of prices.