One Way to Unrig Stock Trading

by Jonathan Macey and David Swensen
December 24, 2015

AMERICA’S equity markets are broken. Individuals and institutions make transactions in rigged markets favoring short-term players. The root cause of the problem is that stocks trade on numerous venues, including 11 traditional exchanges and dozens of so-called dark pools that allow buyers and sellers to work out of the public eye. This market fragmentation allows high-frequency traders and exchanges to profit at the expense of long-term investors.

Individual investors, trading through brokers like Charles Schwab, E-Trade and TD Ameritrade, suffer first as the brokers profit by hundreds of millions of dollars from selling their retail orders to high-frequency traders and again as those traders take advantage of the orders they bought.

Market depth, critically important to investors who trade large blocks of securities, also suffers in the world of high-frequency traders. Startling evidence for the lack of robustness in today’s market comes from a 2013 Securities and Exchange Commission report that found order cancellation rates as high as 95 to 97 percent, a result of high-frequency traders’ playing their cat and mouse game. Market depth is an illusion that fades in the face of real buying and selling.

Securities markets work best as a central clearinghouse where all buyers and sellers of stocks come together. Not so long ago, when the New York Stock Exchange and the Nasdaq operated as virtual monopolies, American equity markets were the envy of the world. Until 2000, Nasdaq was wholly owned by a nonprofit corporation; the New York Stock Exchange was nonprofit until 2006. To ensure that they would operate in the public interest, they were treated much like public utilities.

The unfairness of trading markets became a subject of intense focus with the publication in 2014 of Michael Lewis’s book “Flash Boys: A Wall Street Revolt,” which describes the way these markets are rigged in favor of high-frequency traders. Fortunately, Mr. Lewis provides a hopeful ending, predicting that the book’s hero, a trader named Brad Katsuyama, would save the day by forming his own exchange to serve real investors.

Mr. Lewis was right. Mr. Katsuyama’s company, IEX (in which Yale has a small indirect investment), has filed an application to become a national securities exchange. Exchanges are the key to price discovery — the determination of the true price of an asset — because the National Market System requires brokers to route trades to the exchange displaying the best price. Right now, brokers and their larger exchange competitors can ignore IEX and other regulated alternative trading platforms, even if they display the best prices.

Its exchange competitors, which include the New York Stock Exchange, Nasdaq and BATS, cater to the interests of high-frequency traders, which typically provide more than 50 percent of all trading volume. In addition to trading fees, exchanges charge fees for high-speed proprietary data feeds that provide privileged access to market data.

Exchanges advance the interests of traders by sponsoring esoteric order types, which for hard-to-understand reasons receive the approval of the S.E.C. An example is the New York Stock Exchange Day Intermarket Sweep Add Liquidity Only Order. Regular investors have no idea such an order type exists or what it means. Yet order types like these are essential to the dirty work of the high-frequency trader.

High-frequency traders pay to locate their computer servers inside of exchanges’ order execution centers, where they get early access to trade information that they use to jump in front of — front run — other clients. These co-located computers detect orders to buy and sell on one exchange and then rapidly send cancellations and orders to other venues where their servers are also co-located. Does this sound like a fair system?

IEX’s plan is to forgo the high profits earned by the major exchanges from selling speed advantages on the theory that they can make money more ethically by attracting long-term investors.

Its strategy is simple. IEX will not allow traders to reap the benefits of speed, instead slowing down all participants by 350 microseconds. This prevents the front-running facilitated by exchanges, which has led to vigorous and vitriolic opposition from groups that profit from the current arrangement.

An unholy alliance of exchanges (including the New York Stock Exchange, Nasdaq and BATS) and high-frequency traders like Citadel have petitioned the S.E.C. to reject IEX’s current application. In essence, the petitioners argue that it is consistent with commission rules for an exchange to sell certain customers an advantage over others, but IEX should not be allowed to remove these advantages.

The New York Stock Exchange, Nasdaq and BATS seek to block IEX from competing, when they collectively own 10 of the 11 national stock exchanges. By creating (and receiving S.E.C. approval for) so many exchanges, the current infrastructure fragments the market without providing the benefits of real competition.

Maybe IEX’s business model will work and maybe it won’t, but the S.E.C. should act in the public interest. Approval of IEX’s application will not fix America’s equity markets; it will make them less broken. The commission should not succumb to the special interests of competitors and their fellow travelers. It should approve IEX’s application and provide a real alternative for long-term investors.

Jonathan Macey is a professor of law and David Swensen is the chief investment officer at Yale.