The New Stock Market: Sense And Nonsense

Merritt B. Fox

Columbia University – Law School

Lawrence R. Glosten

Columbia Business School – Finance and Economics

Gabriel V. Rauterberg

Columbia Law School

March 17, 2015

Duke Law Journal, Forthcoming

Columbia Law and Economics Working Paper No. 513


How stocks are traded in the United States has been totally transformed. Gone are the dealers on NASDAQ and the specialists at the NYSE. Instead, a company’s stock can now be traded on up to sixty competing venues where a computer matches incoming orders. A majority of quotes are now posted by high-frequency traders (HFTs), making them the preponderant source of liquidity in the new market.

Many practices associated with the new stock market are highly controversial, as illustrated by the public furor following the publication of Michael Lewis’s book Flash Boys: A Wall Street Revolt. Critics say that HFTs use their speed in discovering changes in the market and in altering their orders to take advantage of other traders. Dark pools – off-exchange trading venues that promise to keep the orders sent to them secret and to restrict the parties allowed to trade – are accused of operating in ways that injure many traders. Brokers are said to mishandle customer orders in an effort to maximize the payments they receive in return for sending trading venues their customers’ orders, rather than delivering best execution.

In this paper, we set out a simple, but powerful, conceptual framework for analyzing the new stock market. The framework is built upon three basic concepts: adverse selection, the principal-agent problem, and a multi-venue trading system. We illustrate the utility of this framework by analyzing the new market’s eight most controversial practices. The effects of each practice are evaluated in terms of the multiple social goals served by equity trading markets.

We ultimately conclude that there is no emergency requiring immediate, poorly-considered action. Some reforms proposed by critics, however, are clearly desirable. Other proposed reforms involve a tradeoff between two or more valuable social goals. In these cases, whether a reform is desirable may be unclear, but a better understanding of the tradeoff involved enables a more informed choice and suggests where further empirical research would be useful. Finally, still other proposed reforms are based on misunderstandings of the market or of the social impacts of a practice and should be avoided.

The New Stock Market: Sense And Nonsense – Introduction

“The United States stock market, the most iconic market in global capitalism, is rigged.” With this provocative statement on 60 Minutes, Michael Lewis, best-selling author of Flash Boys: A Wall Street Revolt, brought to the forefront of public consciousness a growing controversy concerning the way stocks are traded in the United States. Such trading has been totally transformed over the last twenty years. There is a truly new stock market and not everyone is pleased with the results. This paper addresses these dissatisfactions and, in doing so, develops a framework for analyzing more generally the wide variety of policy issues to which the new stock market has given rise.

The various actors whose interactions make up the new stock market have come in for tremendous scrutiny. Particularly sharp criticism has been aimed at high-frequency traders (“HFTs”), which are said to use their speed in finding out changes in the market and in altering their own orders to take advantage of other traders in the market. HFTs are believed now to participate in about half of all trades. Other features of the new stock market have been the subject of attack as well. “Dark pools” are off-exchange trading venues that promise to keep secret the existence of the orders sent to them and to restrict the kinds of parties allowed to trade. Dark pools are said to often break these promises, to the disadvantage of traders sending orders to these venues. A trader is also hurt if her broker fails to send her order to the trading venue where it will execute at the best price or in the most timely and reliable fashion. Critics suggest that brokers often fail in this way, sending the order instead to the venue that pays the most to the broker through practices such as “payment for order flow” or “maker fees.” Polls now indicate that “roughly two-thirds of Americans believe the stock market unfairly benefits some at the expense of others,” a belief that some commentators think explains what has been a sharp drop in the percentage of Americans directly or indirectly owning equities.

Actors in the nation’s legal, regulatory, and political arenas have reacted rapidly to the growing furor over the new stock market. The U.S. Department of Justice, the FBI, the Securities and Exchange Commission (“SEC”), and the Commodity Futures Trading Commission have all confirmed investigations into HFTs. Plaintiffs’ class action lawyers have filed several civil lawsuits based on various controversial market practices. The New York Attorney General has brought a high-profile lawsuit against the major investment bank Barclays, alleging that it misrepresented to investors the extent to which its dark pool was free of HFT activity. Several Congressional hearings have been held, after which U.S. Senator Carl Levin wrote to Mary Jo White, the Chair of the SEC, demanding significant changes to market structure and the elimination of “[c]onflicts of interest [that] erode public confidence in the markets.”

It is time to step back and take a serious, dispassionate look at how the new stock market functions and the implications of the regulatory choices we face going forward. Legal scholars have done an able job of applying the insights of many economic theories to law. This has not been true, however, of the now well-established field of microstructure economics. Its foundational models of trading behavior in financial markets are rarely cited in legal scholarship and never discussed in depth. The literature of the field itself, while empirically sophisticated, lacks a broad-scope, institutionally nuanced look at the basic dynamics shaping the modern equities market. Thus, we still lack a comprehensive framework for understanding the new stock market. The absence of such a framework acts as a serious obstacle for legislators, regulators, judges, and the public in deciding how to seriously think about regulating our markets. Much is at stake. The performance of the equities market has important effects on the efficiency with which goods and services are produced in our economy and on the real economy’s rate of growth. Equities also play a vital role as a place for ordinary individuals to invest their savings. This article brings the insights of microstructure economics to bear in order to provide a comprehensive framework for thinking about the new stock market. We demonstrate the usefulness of this framework by applying it to the new market’s most controversial practices. While these practices may seem completely unrelated to each other, they can all be understood through just three basic mechanisms: adverse selection, the principal-agent problem, and a multi-venue trading system.

We ultimately conclude that there is no emergency requiring immediate, less-than-fullyconsidered action. Some reforms proposed by critics, however, appear after analysis, to be unambiguously desirable. We conclude, for example,

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