Speech by SEC Staff
Luncheon Address at the SIFMA Market Structure Conference 2008: Maximizing Liquidity in the U.S. Equity Markets
Erik R. Sirri1
Director, Division of Trading and Markets
U.S. Securities and Exchange Commission
New York, New York
May 9, 2008
Thank you for the invitation to talk today about U.S. equity market structure. The past few years have been the proverbial "interesting times" for the equity markets. In March of last year, the securities industry capped a two-year implementation effort when it entered the trading phase of Reg. NMS. During the implementation period, nearly every exchange adopted a new, more automated trading system. In addition, industry participants overhauled their order-routing and execution systems to comply with Reg. NMS and to trade effectively on the new exchange systems. Then, after just a few months of trading under Reg. NMS, the crisis in the credit markets began in earnest, which caused a sudden doubling in fundamental volatility. Trading volumes spiked higher — particularly on those high stress days when the market responded to unexpected news.
Happily, the equity markets and industry participants have handled both the implementation of Reg. NMS and the difficult trading conditions remarkably well. Enough time has passed that we now seem to have reached a zone of relative comfort with the new trading rules and exchange systems. I want to take this opportunity today to spend a little time taking stock of where we are now, but then focus on a market structure issue that I believe will receive more and more attention in the coming months — efforts by markets to maximize their liquidity. In particular, how can markets attract liquidity providers across the wide range of trading conditions and stock characteristics?
Before I go any further, though, let me remind you that the views I express are my own and not necessarily the views of the U.S. Securities and Exchange Commission, the individual Commissioners, or my colleagues on the Commission staff.
The Post-NMS World
I would like to begin by noting some of the key characteristics of the post-Reg. NMS equity market structure. For me, its distinguishing feature is its exceptionally strong competition among a variety of markets to attract order flow and trading volume. No single U.S. exchange executes more than one-half of the volume in its own listed stocks. Last month, for example, NYSE Hybrid executed 34% of the volume in NYSE-listed stocks, and Nasdaq executed 42% of the volume in Nasdaq-listed stocks. Indeed, Nasdaq now executes more share and dollar volume in NYSE-listed stocks than it does in Nasdaq-listed stocks.
This competition among markets is quite evident when one examines the displayed quotes in NMS stocks. In actively traded stocks, there generally will be at least three and often as many as five markets that quote aggressively on price and size. For Nasdaq stocks, these quoting markets include Nasdaq and NYSE Arca, as well as the National Stock Exchange acting as the quoting vehicle for BATS Trading and Direct Edge ECN. In NYSE stocks, there often will be five markets that quote aggressively. These include NYSE Hybrid, NYSE Arca, and Nasdaq, as well as the International Stock Exchange and the National Stock Exchange acting as the quoting vehicle for BATS and Direct Edge.
The presence of two ECNs as aggressive quoting markets highlights another noteworthy characteristic of the post-Reg. NMS market structure. Despite the considerable publicity and attention devoted to dark pools of liquidity, the most successful gainers of market share in recent years have been markets that compete for order flow by publishing aggressive quotes. To some extent, the success of publicly quoting ECNs may have been shielded from public view because of their regulatory status as ATSs. As I noted, ECNs typically display their quotes in the consolidated quote streams through exchanges. Most of their volume, however, results from orders executed internally rather than through orders executed on the exchanges. Accordingly, most of their trades are reported to one of the TRFs operated by FINRA rather than by the exchanges. This disconnect between displayed quotes in the consolidated quote stream and reported trades in the consolidated trade stream could lead to a mistaken belief that the exchange quotes do not have real substance behind them. In fact, however, the two ECNs offer substantial liquidity. The top five markets by executed volume in NMS stocks right now include BATS and Direct Edge, as well as Nasdaq, NYSE Hybrid, NYSE Arca.
Both BATS and Direct Edge have declared their intentions to register as national securities exchanges. If the Commission were to approve them as exchanges, they would have their own unique identifiers in the consolidated data streams, which would improve the transparency of quoting and trading in NMS stocks. Importantly, it would also provide them with a protected quote in the consolidated quote stream, an attractive benefit conferred by NMS. I believe that their desire to register as exchanges reflects a positive feature of the U.S. regulatory structure, and its accommodation of organic growth. The ATS regulatory status offers an inexpensive entry point into the U.S. equity markets that reduces barriers for new competitors. As an ATS becomes increasingly successful, it may register as an exchange, which not only can benefit the market itself, but also can enhance the integrity of U.S. market structure as a whole by promoting transparency and a more equal sharing of self-regulatory responsibilities.
Another notable characteristic of the post-NMS market structure is the proliferation of so-called dark pools of liquidity that are organized as ATSs. As I mentioned in February at SIFMA's symposium on dark pools, they do not appear to have materially reduced transparency in the U.S. markets. Historically, quoting venues generally have executed approximately 80% of U.S. listed volume, and they continue to do so. In addition, the consolidated displayed size at the inside quotes in NMS stocks remains quite high by historical standards, especially when scaled by the size of trade executions. An explanation for the concern one hears expressed about dark pools could be a mistaken assumption that the significant volume currently reported through FINRA's various TRFs is primarily dark pool volume. As I noted above, however, a large portion of TRF volume is executed by ECNs that publicly display quotes. Moreover, the term "dark pool" is unfortunate because it may lead one to conclude that they operate outside the U.S. regulatory structure. In fact, dark pools are fully incorporated in the national market system. Dark ATSs report all of their trades to the consolidated tape so they are fully transparent on a post-trade basis. In addition, dark ATSs must comply with other market structure requirements, such as the Order Protection Rule of Reg. NMS.
Best Execution of (Non-Marketable) Limit Orders
Equity markets need to serve the broad cross-section of issuers for both small and for larger companies, and for both retail and professional customers. Both issuers and traders desire markets with high liquidity that serve to lower all-in economic transactions costs, and thus costs of capital to the firm. Consequently, I'd like to spend a few minutes today talking about the steps that trading venues may take to maximize liquidity as they compete for order flow.
One important aspect of this inter-market competition is the effort and creativity market centers expend to attract the liquidity provided by public customers in the form of non-marketable limit orders. The order-routing determinations of brokers acting as agents for customers on where to route these orders may decisively affect this competition. While brokers owe an agency duty of best execution to their customers when routing all types of orders on their behalf, most discussions of best execution to date focus on the routing of marketable orders. Today, I want to address briefly the issue of best execution for a customer's non-marketable limit orders and highlight an admittedly incomplete set of factors that brokers should consider in determining where to route these orders.
When choosing to submit a limit order with a non-marketable price, one could view the customer as adopting a relatively passive trading strategy. The customer is willing to accept the risk of potentially missing an execution in exchange for a chance of obtaining an execution at a more favorable price than currently available to a liquidity taker. Accordingly, the customer's primary objective is to obtain an execution at the limit price or better, and a key factor for best execution of these orders is the relative likelihood that the order will obtain an execution at the different venues to which it could be routed. As a practical matter, it is almost certain that a non-marketable order will in fact be executed at any venue if quoted prices subsequently move through the order's limit price and it becomes a marketable order. General market forces, as buttressed by the Order Protection Rule, dictate this result.
The more difficult determination is the order routing calculus that occurs to manage the possibility that the order never becomes marketable. In this context, there potentially are significant differences in the likelihood of execution at different venues. Assessing these differences can be very complex. I will briefly mention some of the more important factors that can bear on the likelihood of execution at different venues. One is the extent to which a venue displays its non-marketable orders to a wide range of market participants. The wider the display, the greater chance that an order will attract contra side interest. If an order would set or match an exchange's best price, for example, it will be displayed in the consolidated quote stream as the exchange's BBO. The order also will be entitled to trade-through protection under Reg. NMS and therefore is likely to be executed if any market participant conducts an intermarket sweep through the order's limit price.
Another important factor affecting the likelihood of execution of a non-marketable limit order is the volume of incoming marketable flow at a venue and the relative priority of the non-marketable order in interacting with such flow under a venue's trading rules. Venues that handle a large volume of orders in a stock may be first on the routing table of those who control marketable order flow. Moreover, if the non-marketable order would set a new best price for a market, it may receive first priority for trades at that price until it is satisfied in full. Other venues may not extend full time priority to orders that set their best prices and instead put these orders on parity with other trading interest that arrives later in time.
I know that the developers of algorithmic trading tools for institutional investors have devised sophisticated techniques for placing non-marketable limit orders in the best possible venues to obtain an execution. Brokers that are responsible for handling the non-marketable limit orders of individual investors also should carefully consider the relevant factors in making their routing decisions. The better the treatment that individual investors experience when submitting non-marketable limit orders, the more likely they will be to use them. Best execution of non-marketable limit orders therefore would benefit both the investors themselves and the markets in general by maximizing a distinct source of displayed liquidity.
Though I have, until this point, focused on the behavior and obligations of brokers and trading venues, I believe that regulators have a part to play as well, particularly when assessing exchange proposals for new trading rules and mechanisms. For us, market dynamism does not mean departing from the public policy principles that have been cornerstones of the Exchange Act for many years. The U.S. equity markets must continue to be fair and orderly markets that are efficient and promote the public interest and the protection of investors. Our challenge is to consider whether their current interpretation and application of these principles continue to reflect economic and technological circumstances, and, if not, how they should be updated to better promote underlying Exchange Act principles.
Turning to the particular types of initiatives that markets have used to attract liquidity providers, they appear to fall within four broad categories. First, markets have offered direct economic inducements to liquidity providers, such as reducing or eliminating fees or costs and making payments or rebates. Maker-taker pricing is one example of such competition. Second, markets have offered advantageous access to trading mechanisms, such as those granted to specialists on manual trading floors. Third, markets have given trading rule advantages to designated liquidity providers, such as the parity and guaranteed allocations often found in the options markets. Fourth, markets sometimes have given designated liquidity providers information advantages over other traders, such as the "look" that NYSE Hybrid gives specialists of incoming order flow. And finally, markets have sought to parse their public customer base by providing differential treatment to professional and non-professional orders.
Some of these initiatives obviously can be in tension with Exchange Act principles, including the requirement that exchange rules not be designed to permit unfair discrimination between customers, brokers, and, dealers. The Exchange Act requires that the national securities exchanges operate in the public interest. In 1934, for example, Congress emphasized that the exchanges are "public institutions which the public is invited to use for the purchase and sale of securities," and are not "private clubs to be conducted only in accordance with the interests of their members." Clearly, this congressional imperative must be respected. To pass muster under the Exchange Act, an exchange initiative should not merely advantage its own competitive interests or those of its liquidity providers at the expense of public customers, in the absence of a good reason to believe that the public ultimately will benefit from more efficient trading.
I recognize that exchanges face a difficult dilemma in developing innovative ways to attract professional liquidity providers. On the one hand, exchanges would like to encourage liquidity providers to accept certain responsibilities for the quality of trading in their market. But given that high-velocity off-floor professional traders can trade very effectively without such responsibilities, exchanges will need to offer some sort of inducements to professional liquidity providers. Few, if any, trading firms would be willing to accept increased responsibilities that would only put them at a disadvantage with their competitors. On the other hand, an exchange must remain an open market that, among other things, promotes the interests of public customers and market efficiency. Offering valuable inducements to its designated liquidity providers that will advantage them compared to other exchange participants could run afoul of Exchange Act principles.
Clearly, balancing these considerations can be a challenge for both exchanges and regulators. But beyond the relevant regulatory requirements, we are fortunate in the U.S. to have such vigorous competition among markets. When investors and traders have a variety of choices of markets in which to participate, they often will simply vote with their feet if a particular exchange adopts an initiative that they do not like.
I believe that regulators should be open and diligent in assessing whether the balance of public policy objectives and liquidity provider advantages remains appropriate in the context of electronic markets. We need to ask how will public customers be affected, how will professional traders be affected, and how will the efficiency of trading on the particular market be affected. Ultimately, we must consider how an initiative would affect the overall efficiency of the equity markets. For example, if one market adopts a proposal to attract professional liquidity providers that might arguably promote efficiency and trading on that particular market, would the overall efficiency of the equity markets be helped or hurt if the initiative led to a competitive dynamic under which every market was forced to adopt a similar advantage for its liquidity providers?
In the coming months, I anticipate that the U.S. equity markets will continue to innovate and present new proposals for Commission review and public comment. The proposals will provide a valuable opportunity for a public discussion of market structure policy and ways to maximize liquidity for investors and public companies. I look forward to hearing your views on these important issues. Thank you.