Fixing the U.S. Equity Markets: Limit Exchange/ATS Licenses and Other Steps

With all the whining and complaining that's been going on over high-frequency trading firms disadvantaging investors and rogue algorithms causing mayhem in the financial markets, the debate over U.S. equity market structure seems to drone on and on. There are many critics of the labyrinth-like structure that has developed, but it's rare to find anyone who proposes a course of action that would begin to simplify it.

Yet, yesterday in testimony before the Senate Subcommittee hearing, industry analyst Larry Tabb, founder and CEO of Tabb Group, put some concrete recommendations on the table for consideration by Congress and the SEC, which could push the conversation forward.

Although Tabb cautioned against "radical re-shifting of the market," noting that "the markets are very complex and interrelated" -- and because small changes could cause a huge impact. He cited many changes initiated by regulators in the past decade such as penny pricing, which forced automation, led to fragmented markets, filled the profits of HFT firms, and forced many other to invest millions in infrastructure. With the caveat of "do not harm," Tabb proposed that someone actually do something, which in itself is radical.

No. 1: Defragmentation Number one on Tabb's list is to start defragmenting the market by stopping the granting of new exchange and ATS licenses, immediately, as well as limiting the number of internalizing brokers. Tabb calls on the SEC (presumably) to figure out the optimal number of venues that are needed to operate a competitive marketplace. While he doesn't want to limit competition too much, Tabb says, 13 exchanges and 50 ATS (alternative trading system) licenses, is too many. Few industry professionals would disagree with him even though some claim that smart order routers connect all the market and find hidden liquidity. But it's worth noting that most of the exchanges, including NYSE Euronext, Nasdaq, BATS and Direct Edge, actually operate multiple equity trading platforms with different rebate/liquidity "maker" or "taker" fees for high frequency traders. A similar pattern has developed in options. Can we force these markets to merge, retire or consolidate their platforms?

No. 2: Information Leakage Number two on Tabb's list pertains to managing "broker/ATS solicitations" which is a nice way of saying, firms are routing orders to a zillion places before they can be executed and, by doing so, are leaking information all over the place. Because an institutional order with 50,000 shares is now being executed in 200 trades in smaller pieces, Tabb testified, orders could be routed to many exchanges before they are executed. "An order may be seen by 50 to 100 firms before it is routed to an exchange for execution," noted Tabb.

Institutional money managers are still in the dark when it comes to knowing where their orders have been routed. "Between brokers soliciting the other side, ATSs routing to each other, and exchanges routing to ATSs -- virtually everyone that may have wanted to trade against an order will have seen it before it is executed."

No. 3: Bigger Spreads? The third item on Tabb's "to do" list focuses on widening the minimum price variation (MPV) or spread on stocks that are less liquid. It seems to make sense that high-priced stocks like Apple whose shares are priced near $700, shouldn't have the same spread as Bank of America's stock trading at $10. So, Tabb is suggesting that the market evaluate the spreads of individual stocks based on "pricing bands, liquidity and capitalization."

If MPVs were wider, wouldn't that slow down the trading of high frequency trading firms because it would be more expensive for them to rapidly move in and out of positions? It would also enable them to earn bigger profits from fewer trades. But the benefits of HFT for buy-side institutions, which are narrower spreads and higher volumes in more liquid, high-cap stocks, would be turned upside down.

No. 4: Transparency For No. 4, Tabb calls on ATSs, ECNs, internalizers and even brokers to provide more transparency with descriptions on how their order types and routing mechanisms work. They should provide "concrete examples of how these order types work, how fees/rebates are generated, where they show up in the book queue, how and when they route out and how these order types change under various market conditions," he said in his testimony. Deciphering the complexity of rebates, order types and order books is mind boggling for the novice, and is really something that appeals to low latency traders who shift their strategies to profit from the fees.

No. 5: Follow the Trail No. 5, Tabb urges the industry to "quickly" develop a market-wide consolidated audit trail for equities, options and futures markets. Given that the consolidated audit trail was proposed about three years ago, I'm not sure if "quick" is possible. He also talks about giving the regulatory bodies, SEC, CFTC and various SROs incentives to cooperate on "harmonious oversight," which to me, implies they are silos, protecting their own vested interests. Perhaps his most important recommendation is "to provide the regulators with the tools and people needed to understand the market and find the people/and or machines that are driving manipulative behavior."

To be fair, the SEC is moving in this direction as it has recently licensed a market data analytics and research platform from Tradeworx, an HFT firm and technology provider, which should accelerate its skills. Clearly, the agency needs to hire/and or train people with quantitative skills and market knowledge to use these tools.

But there are several big issues that Tabb didn't tackle in his recommendations, which are critical, because they are operating beneath the surface of the electronic marketplace.

On Twitter today, Joe Saluzzi, partner at Themis Trading, went for the jugular. "We should think about eliminating internalization, payment for order flow, and rebate maker taker," tweeted Saluzzi, who has been a staunch critic of high frequency trading, and the author of a new book "Broken Markets."

Another issue that wasn't covered at the hearing, but was mentioned to me recently at an agency brokerage firm, is the practice whereby exchanges sell the order ID numbers to low latency trading firms. By tracking these numbers, it's possible to know within 10 minutes, who is trading which stocks, the agency brokerage CEO told me.

Then there is the reality that HFT firms are the main liquidity providers in today's market, accounting for 40- to-60 percent of daily volume. While they are often under attack, and the subject of headlines, they should also be part of the conversation to fix the markets.