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02:47 PM
Joe Saluzzi
Joe Saluzzi
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Follow The Money

Fragmentation, complex trading rules, rebate arbitrage and opaque venues are just a few of the reasons why the market is unnecessarily complex.

Follow the money. If you want to know why the US equity market is overly and unnecessarily complex, just follow the money. And if you want to know why "glitches" will continue to happen, then just follow the money.

One of the main reasons for the complexity is the number of exchanges. There are 13 exchanges each with their own rules, their own fee schedules, their own order types, their own data feeds, their own colocation facilities and their own profit goals. These exchanges all need to feed their quote and trade information to the SIP. Based on press reports, it's becoming apparent that the SIP got overloaded last week and that was the reason for the 3 hour market halt. With all 13 exchanges pumping in millions and millions of quotes per day, and with the SIP apparently having no backup, it was only a matter of time before they overloaded the system.

While the fragmentation of the equity market has created an enormous technical strain, it has also created an economic windfall for exchanges when it comes to selling market data services. While it is common knowledge that exchanges sell colocation space and data feeds, it is not common knowledge that they also collect millions of dollars per year in market data revenue. Last year, a paper written by a Federal Reserve researcher titled "Equity Trading and the Allocation of Market Data Revenue" investigated the market data revenue that exchanges have been collecting. They found:

"Data revenue constitutes an important source of income for securities exchanges. For example, sales of consolidated equity market data in the United States generated approximately $400 Million in 2004, representing about 10–15% of total revenues reported by the largest exchanges, and substantially more for some of the smaller exchanges. By 2008, consolidated data sales revenue had increased to approximately $450 Million."

Starting to see the picture now? Exchanges have fragmented so they can generate sales from new data feeds and colocation centers and also collect a larger percentage of the market data revenue pot. But while this has been going on for the last few years (with SEC approval), exchanges failed to spend enough money on the infrastructure that links them all together.

What happens now? How do we prevent another overload from happening? Most likely regulators will gather the heads of the industry and decide to throw more money and more complexity at the problem. There will be roundtables and white papers. There will be no shortage of new, complex answers to the complex problems (again, follow the money). This is not the answer. The answer lies in simplicity, not complexity.

We recommend the following:

1) Consolidation: The SEC should require consolidation of the 13 stock exchanges (Based on press reports of a BATS/Direct Edge merger, this is already happening). Consolidating the exchanges will lead to deeper pools of liquidity and a healthier price discovery process. Consolidating the exchanges will also dramatically reduce quotes and reduce the stress on the system. We can envision having three exchanges: NYSE, NASDAQ and BATS/EDGE. Having three exchanges will ensure redundancy and will also still foster competition.

2) Trade-At Rule: The SEC should implement a trade-at rule which would require a minimum price improvement increment (we recommend one penny or half the spread in penny spread stocks) before dark pools could trade ahead of a displayed quote. This trade at rule should move significant volumes back to the remaining exchanges and help build deeper, more robust liquidity pools.

3) Disclosure: Dark pools are a significant portion of today's volume yet have very little disclosure. The SEC should mandate that dark pools disclose their volume, largest participants, routing logic and order types. Once investors know more about where their order flow is directed, then they will be able to make more informed choices.

4) No More Rebates Eliminate rebates at all levels. No more payment for order flow. This should end the unnecessary rebate arbitrage games.

Rather than throwing more money and complexity at the problem, let's address it in a simpler more straight forward way and let the market solve the complexity issue.

Joseph Saluzzi is partner, co-founder and co-head of equity trading of Themis Trading LLC, a leading independent agency brokerage firm that trades equities for institutional money managers and hedge funds. He is also the co-author of Broken Markets -- How High Frequency ... View Full Bio
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