In light of the ruckus high frequency trading debate, the Securities and Exchange Commission appears to be re-considering a key component of market structure.
Speaking at the Mutual Fund Director’s forum, a platform for independent board directors to share best practices, SEC commissioner Luis Aguilar indicated the regulator is considering changes to the “maker-taker” system of exchanges providing rebates to certain HFT participants.
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SEC reveals its much-anticipated take on “market structure”
Immediately after the publication of Michael’s Lewis’ tome on HFT, Flash Boys, the SEC had remained generally silent on their actions, only saying they were considering “market structure.” Yesterday’s speech puts a focus on the SEC’s target. The question is: does this focus tackle the central problem or further protect the HFT establishment?
Brokerage firms route trades to firms that provide rebates
In focusing on the “maker-taker” issue, the SEC is considering the relationship between brokerage firms routing orders to sources that provide the brokers a “rebate” on the trades they receive. “any have observed that the maker-taker model may present a conflict of interest between brokers and their customers because broker-dealers are incentivized to send customer orders to the venue that pays the best maker-taker rebate, and not necessarily the venue that provides best execution,” Aguilar said in his comments to the audience of those who would be paying these fees but not receiving benefits.
It is instructive to note the Commodity Futures Trading Commission has long since addressed this issue by requiring all customer orders to route through exchanges and appear in a competitive market place.
“Bait and switch”: Aguilar
Continuing to outline the problem, Aguilar addressed what some consider a “bait and switch” in equity trading. “Another criticism of maker-taker is that it produces quoted spreads that do not represent actual trading costs, thereby decreasing transparency, and could potentially confuse investors about the true costs of trading.” Professional investors such as fund managers have complained that when they look to purchase a stock, the “advertised” price of that stock displayed on the screen is quickly withdrawn and replaced with a higher price by HFT firms who see the trade coming and get in front of the stock by a nanosecond.
“Others claim that maker-taker has contributed to a market structure in which order execution is too fragmented among exchanges, dark pools, and broker-dealers that execute orders internally and that it has incentivized some market participants, including high-frequency traders, to trade primarily, if not solely, to profit from collecting maker-taker rebates,” Aguilar continued, tackling two critical topics in one sentence. In the first sentence component, he is addressing the issue that there are 13 public exchanges and now 40 dark pools – a market development that analysts such as Larry Tabb observed the SEC did not anticipate, as reported in ValueWalk yesterday. Some fragmentation is considered a positive, as it creates competition, but with over 50 exchanges being lightly regulated dark pools the system has become unwieldy and could stand to be consolidated to a degree.
Call to refund little-disclosed rebates to customers
The second component that Aguilar addresses is HFT firms being motivated to trade based on rebates. Rebates have been used as a method to motivate true market makers to provide two sided liquidity, firms that were not making directional bets. A key concern is HFT firms, however, who make directional bets and also “pile on” to major market moves and are said to exacerbate “flash crash” moves. As a sidebar, in the SEC’s flash crash report missed the impact that directional HFT firms had in “piling on” to exaggerate the market move.
Then Aguilar pointed to a potential solution sure to rile the powerful HFT financial lobby: “Some have argued that in order to mitigate this conflict, broker-dealers should be required to pass the maker-taker rebates they receive to their customers.” Such proposed changes would require regulators open examination of what is known as “Regulation NMS,” which guides order routing processes and whose rule writing was influenced by the financial lobby during its development.
What Aguilar is proposing is that investors would be the beneficiary of regulatory focus. That would be interesting.