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A Year After Flash Boys, Is Equity Market Structure Healing?

A Year After Flash Boys, Is Equity Market Structure Healing? by Matt Waldner, ColumbiaManagement

  • Last year’s headlines about high-frequency trading cast a shadow over the U.S. equity market and forced the investment community to respond.
  • We believe the U.S. equity market is well on its way to defragmenting, and that “managing the conflict” is now a common theme at the regulator, exchange, broker and asset manager level.
  • As the U.S. market simplifies and defragments, confidence of participants will return and a return of true price discovery will fast follow.

For the last 10 years, institutional traders have battled against a fragmenting U.S. equity market. Combing through data, venue examination and extensive trade cost analysis became a key requirement of our trade. It wasn’t until early 2014 that the war broke through the front lines (read: institutional investors) and penetrated deep into retail investor channel. “Rigged” newspaper headlines landed on the doorstep of Main Street, USA and author Michael Lewis found himself at the epicenter of a movement that sent shockwaves through the halls of Congress and regulators’ offices. Although much of Flash Boys was not new information to us in the institutional community, we do think that Lewis’ socialization was effective and accelerated positive change for U.S. equity market structure.

The high-frequency trading (HFT) knee-jerk reaction cast a shadow over the entire industry. Within a short period of time, strategies were studied and the toxic vs. non-toxic market participants identified (Exhibit 1). Coinciding with the identification of toxic HFT strategies, IEX (a new, safe dark pool) launched and quickly gained traction in the institutional trading channel.

Exhibit 1 – Gradation of high-frequency trading: IEX eliminates advantage of yellow- and red-shaded strategies

Flash Boys Equity Market

Source: IEX Group, Inc., May 2015

With toxicity of strategies identified, the investment community and regulators began to standardize and measure. Their measurements ultimately forced the choice between winners and losers (Exhibit 2). Rather quickly:

  • Brokers began to realize the conflict of owning their own dark pool and deemphasized or closed them entirely
  • Exchanges began to feel the pressure from regulators’ questions and quickly adjusted the amount of order types and eliminated advantages provided to toxic high-frequency players
  • Retail brokers were forced to answer difficult questions about “payment for order flow”
  • Buy-side institutional desks tested their client protection metrics and simplified their process.

Exhibit 2 – Managing the conflict: Brokers, exchanges and regulators all act and push for a simple structure

Flash Boys Equity Market

Source: IEX Group, Inc., May 2015

Where from here?

We truly believe there is a positive story to tell about U.S. equity markets. Although Humpty Dumpty will never be fully put back together again, we do believe the U.S. equity market is well on its way to defragmenting. “Managing the conflict” is now a familiar theme at the regulator, exchange, broker and asset manager level. The common goal will fuel continuation of the current trend. As the U.S. market simplifies and defragments, participants’ confidence will return. With confidence, we predict that markets will deepen and a return of true price discovery will rapidly follow. Simple common rules, deeper markets and conflicts managed are all critical to ensuring that the U.S. equity market is extremely liquid and remains the center of global equity capital formation.