The industry debate regarding equity market structure change continues with another entrant in the field of would-be saviors, this one teaming an exchange conglomerate with a Wall Street bank, and the banks dark pool. On the surface, as its name suggests, ICEs Grand Bargain provides for concessions on all sides. In reality, the proposal is not as virtuous as exchanges would have market watchers believe.
Lets compress the six points of the Grand Bargain proposal down to three topics for discussion.
Grand Bargain points 1 and 3: Trading costs. Lower access fees to 5 mils; eliminate maker/taker
Grand Bargain points 2 and 5: Exchange reach. Force a trade-at rule so business must go to the exchange; eliminate protected quote for exchanges under 1 percent market share.
Grand Bargain points 4 and 6: Transparency. Increase disclosure around market operations and the rules of the SIP.
Up front, we need to agree on a basic assumption: Providing liquidity is a service, and like any service in a capitalistic society, service providers are compensated. The direct consumers of the liquidity service are investors looking to change their capital allocations. A broader effect of specifically providing liquidity is lower costs of capital for businesses, because participating in capital markets is made cheap and efficient for investors.
Trading Costs
The average profit for an electronic market maker in 2014 was about 4 mils per share, or $0.04 per hundred shares traded. The typical rebate was 28 mils, or $0.28 per hundred shares. So of the $0.28 rebate, about $0.24 was lost to adverse selection; the market maker only kept about 15% of the rebate. This would also mean that the principal profit and loss from trading was negative by $0.24 per hundred.
If there is no rebate to be captured, the market makers principal trading strategies will have to be profitable on their own. Given the razor thin margins that now exist in market making, this can only be achieved through higher spreads. Wider spreads will translate into higher market impact costs for investors, so they might “save money” from the reduced take fees proposed in the Grand Bargain, but they will give it back through higher market impact. Its very interesting that the number thrown out as a potential savings estimate, $850 million, is not far from the overall estimated profits of $1.1 to $1.3 billion from electronic market making in 2014. There is no free lunch.
Now lets lower the access fee to 5 mils. When its 5 mils to take and there is no rebate, what are the smartest and fastest guys going to do? It would make sense for them to build their models to watch the market and wait to snipe resting orders when the market is about to turn. There would be no reason to post liquidity with such a small fee to take, and no rebate.
What would we accomplish? We would take the fastest and sharpest traders and turn them into takers instead of makers. They would compete directly with any true investor who is looking to take liquidity, or in other words, everyone would move to the same side of the boat. The remaining providers of liquidity will be adversely selected by investors and also by the fastest guns in the west. Survival of the fittest would ensue.
Exchange Reach
Step Two: Lets create an artificial trade-at rule and allow the bypassing of any small exchanges that are now included in routing options as part of Regulation NMS requirements. In other words, lets impose the stock exchange monopoly, which the SEC has spent the last 20 years breaking down for the benefit of all investors, and put all the orders in one place to make them easier to pick off. This will also choke any attempt at innovation from startups in the space and allow the exchanges to reestablish their exclusive clubs and special privileges.
Meanwhile, consumers will have to shop at the regulator-approved exchange. Think of it as mandatory shopping at Neiman Marcus-no one is allowed to go to Macys or Walmart, and preference and choice of venue are eliminated by mandate. The Grand Bargain would argue that just because an exchange is small, even though it has all the regulatory obligations and compliance of the larger exchanges, it serves no purpose and can be ignored. Reading between the lines, ICE would prefer the smaller exchanges to disappear and allow the survivors to strengthen their monopolies.
Transparency
Any venue worth its salt understands that its clients need to know what is happening on its watch, and most clients do understand the specifics at hand. The solution is simply for clients to demand more information and to vote with their feet if any venues or brokers cant or wont stand up to the light.
Consistency and clarity around market data feeds is important, but not every market needs the same feed, or wants to pay for it. Liquidity providers are happy to pay for expensive high-speed data so they can best meet their obligations as market makers and stay competitive. Longer-term investors dont need to spend valuable dollars on pricy feeds, but with some education, can utilize other market solutions to level the playing field when it comes to best execution. Venues like PDQ ATS provide solutions in this regard, though the Grand Bargain would disregard ATSs as a valuable source of change in todays equity markets.
In conclusion, ICEs Grand Bargain would provide for a market structure where weve forced everyone to trade at the large exchanges by imposing the trade-at rule. Everyone has to pay a take fee to the exchange with the 5 mil expense and there is no incentive to post because rebates have been eliminated. Finally, privileges for anyone small have been discarded so they cant grow up and one day compete with ICE and the other legacy exchanges. Sounds a lot like a futures exchange, which is not so surprising when you consider the source.
Yes, a Grand Bargain to be sure, but for whose benefit?
D. Keith Ross, Jr. is CEO of PDQ Enterprises, the operator of PDQ ATS, a high-speed equity trading venue.
