June 17, 2016
In the draft law review article attached (pdf), "Finding – and Fixing – Flaws in Financial Market Microstructure" (a version of which was submitted earlier to the SEC as a working paper), I present arguments that are generally supportive of the IEX application to become an exchange. At this late hour, and on the assumption that the SEC has acted favorably on that application, I want to offer a few additional thoughts regarding the tasks that lie ahead as the Commission considers Reg NMS.
1) Innovation holds the most promise for resolving residual problems associated with predatory latency arbitrage, and competition is the best means of identifying the most useful innovations. The SEC need not come up with one best market structure rather, it should continue to accommodate innovation and new entry, and monitor the results.
2) The word "immediate" no longer conveys anything useful at the speed of todays markets it is not even possible to define it. As noted in the attached draft paper, the structure of space-time, described in Einstein's theory of relativity, does not allow for any absolute measure of time at spatially separated points. Even after the fact, it is not possible to re-construct an unambiguous sequence of events for rapid trading activity on spatially separated platforms. Nor is it possible to come up with a non-arbitrary definition of the "current" price, or a "stale" price, across a spatially distributed national market system – even one that is packed into a relatively small area of New Jersey. A new regulatory structure is needed that adapts to this reality of high-speed markets.
3) The use of a one millisecond de minimis exemption will create space in which needed innovation can occur, but it is not a permanent solution to the problem of timing. Regulators will need to come up with a more systematic solution that accommodates a complex and variegated market microstructure.
4) It will be possible for trading platforms operating at different speeds to co-exist and to compete – including those with and without speed bumps, using continuous or batched trading, or using innovations not yet contemplated. Competition will sort out those that are useful from those that are not, and different internal microstructures will likely appeal to different segments of the market. Arbitrage trading will keep different platforms in sync.
5) In seeking to achieve efficiency, stability, and fairness, regulators need not seek to impose uniformity. The challenge will be to come up with a set of rules that accommodates variety, while ensuring that they do not open up opportunities for counterproductive cross-platform exploits.
6) Under Reg NMS, and with the development of high-speed computing and communication technology, the national market has evolved into a massively parallel computing system. It makes consequential decisions that humans, including regulators as well as market participants, find out about only after the fact. Parallel processing is now commonplace our phones, and even our watches, now tend to incorporate multi-core processors. In order to ensure stability and efficiency, parallel computing systems incorporate various features (master clocks, wait states, buffers, hypervisors, etc.) that ensure the various components are cooperating with each other. This is not true of our financial markets, however. Reg NMS quite properly uses competition as its organizing principle. But what are the implications for the stability and efficiency of the system? It is a difficult question, and one that calls for additional expertise.
7) The SEC and the CFTC should seek outside advice on the design principles for a stable, fair, and efficient automated financial marketplace. The National Academy of Engineering might be one mechanism through which such expertise might be assembled. It should include, not only economists and financial experts, but also experts in parallel computer architecture, signal processing (including, e.g., experts from DARPA), and stability in complex systems. Competition should remain the touchstone of Reg NMS, but algorithmic competition needs additional organizing principles if it is to operate successfully.
Brian F. Mannix