What Will It Take to Regulate the Stock Markets?
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Finance & Accounting Data Analytics Strategy Policy Jan 5, 2015

What Will It Take to Reg­u­late the Stock Markets?

Bet­ter data and bet­ter coop­er­a­tion are needed.

A police officer attempts stock market regulation.

Based on insights from

Torben Andersen

Past efforts to reg­u­late the U.S. stock mar­kets have brought mixed suc­cess and more than a few unin­tend­ed consequences.

With momen­tum build­ing after the 2008 cri­sis to imple­ment fur­ther reg­u­la­tions to finan­cial mar­kets, Tor­ben G. Ander­sen, a pro­fes­sor of finance at the Kel­logg School, thinks now is the time to push for a bet­ter under­stand­ing of the mar­kets as they exist today. If this ongo­ing reg­u­la­tion is to have bite and be sen­si­ble and be struc­tured the right way, we do need to under­stand what is right and wrong in the cur­rent way things are orga­nized,” says Andersen.

Once schol­ars have a bet­ter idea of how dark pools oper­ate, for instance, or how high-fre­quen­cy traders behave in the cur­rent mar­ket land­scape, they could work with reg­u­la­tors to deter­mine the impact of dif­fer­ent kinds of reg­u­la­tions before they are put in place.

It’s very dan­ger­ous to throw reg­u­la­tion out there, because you don’t want to kill trad­ing in the U.S.,” says Ander­sen. This is why exper­i­men­ta­tion will be so impor­tant, he con­tin­ues: We take a sub­set of the mar­kets, a sub­set of the stocks, make them sub­ject to some reg­u­la­tion, fol­low it for 3 or 6 months, see what hap­pens, and then decide whether you want to do this for all the stocks and all the exchanges.”

But before this kind of exper­i­men­ta­tion can hap­pen, researchers will need access to bet­ter datasets — and the right tools to deal with this data.

A His­to­ry of Stock Mar­ket Regulation

The U.S. stock mar­kets used to be dom­i­nat­ed by just a few exchanges, each of which had a near monop­oly on cer­tain stocks. The mar­kets relied heav­i­ly on human inter­ac­tion to oper­ate. But as tech­nol­o­gy for trad­ing secu­ri­ties began to improve around the world, the U.S. was slow to change.

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Ner­vous that elec­tron­ic exchanges else­where would over­take the U.S. finan­cial mar­kets, in 2007 the SEC imple­ment­ed reg­u­la­tion designed to pro­pel domes­tic mar­kets into the dig­i­tal age. They want­ed to make the sys­tem bet­ter,” says Ander­sen, more com­pe­ti­tion and more access.”

This reg­u­la­tion, known as Reg NMS, spelled out a num­ber of ground rules for both exchanges and bro­kers. Some of these rules have worked large­ly as expect­ed. For instance, reg­u­la­tions on tick size — the min­i­mum incre­ment in which a price can move up or down — have suc­cess­ful­ly pre­vent­ed bro­kers from jump­ing ahead of oth­er traders by frag­ment­ing prices fur­ther and fur­ther, and in the process mak­ing price com­par­isons near­ly impossible.

But oth­er rules, says Ander­sen, have placed unin­tend­ed bur­dens on bro­kers and mar­ket infra­struc­ture: You’re forc­ing an inter­con­nect­ed­ness that doesn’t nec­es­sar­i­ly have to be there.”

More Trans­paren­cy, More Complexity

The most sub­stan­tial reg­u­la­tions prod­ded the exchanges to pub­li­cal­ly post the best price at which a par­tic­u­lar stock could be bought or sold and forced bro­kers to check all of these prices to get the best deal for their cus­tomers. The goal was to increase trans­paren­cy and access to the mar­kets, spurring competition.

But as straight­for­ward as these rules sound, they actu­al­ly made the mar­kets con­sid­er­ably more com­plex. Unfore­seen con­se­quences have made the sys­tem poten­tial­ly a lit­tle unsta­ble,” explains Ander­sen. “[Reg­u­la­tion] should induce com­pe­ti­tion, and it cer­tain­ly has — but it almost made it too easy to get on the map as an exchange.”

The amount of mes­sage traf­fic in the sys­tem, because of the way it’s struc­tured, is absolute­ly enormous.”

Because bro­kers are now com­pelled to seek out the best prices for their cus­tomers no mat­ter where those prices are post­ed, even rel­a­tive­ly new exchanges can gen­er­ate a lot of order traf­fic, espe­cial­ly if they use finan­cial incen­tives to lure bro­kers to post orders there instead of else­where. By offer­ing rebates and open­ing up an elec­tron­ic plat­form,” says Ander­sen, sud­den­ly you can go from being noth­ing to being a fair­ly big exchange.”

And the boost in the num­ber of exchanges, in turn, has increased the bur­den on bro­kers charged with find­ing the best prices for their cus­tomers. We now have thir­teen exchanges. Not two or three or four as we used to have,” Ander­sen explains.

The increase in order traf­fic neces­si­tat­ed by the reg­u­la­tions also strains the mar­kets’ elec­tron­ic infra­struc­ture. You can see how it gets com­pli­cat­ed,” says Ander­sen. If NAS­DAQ has a tech­no­log­i­cal prob­lem, and every­body wants to go and check their quotes and they can’t, the mar­ket will start grind­ing to a bit of a halt.”

Pro­lif­er­a­tion of Dark Pools

While some trad­ing plat­forms embraced trans­paren­cy, becom­ing prop­er exchanges, oth­er trad­ing plat­forms essen­tial­ly went into hid­ing. In dark pools, orders are placed not pub­li­cal­ly but inter­nal­ly, mean­ing they are seen only by the insti­tu­tion run­ning the pool. This insti­tu­tion then match­es buy­ers of a giv­en stock with sellers.

Dark pools offer some ben­e­fits to cus­tomers. If I want to sell IBM and you want to buy IBM and we have the same bro­ker, we could actu­al­ly just trade on the mid­point” in a dark pool run by a bank, Ander­sen explains. I don’t pay any com­mis­sion and you don’t pay any com­mis­sion — they can just clear it inter­nal­ly at min­i­mal cost. Could save us both money.”

But dark pools offer the biggest ben­e­fits to mutu­al funds and oth­er traders who wish to place very large orders with­out alert­ing oth­ers to their pres­ence. To get the best prices on the pub­lic exchanges, these traders would have to split their orders into much small­er pieces and shop them around all over. But because they are forced to head to so many exchanges, it is pos­si­ble for high-fre­quen­cy traders to pick up on what they are try­ing to do. This may lead to front-run­ning,” where a high-fre­quen­cy trader’s quick­er trad­ing tech­nol­o­gy allows him to see” oth­er traders’ cur­rent and like­ly future orders before they arrive at the intend­ed des­ti­na­tion. The high-fre­quen­cy trad­er can then exploit his knowl­edge of impend­ing order imbal­ances, mak­ing prof­itable trades and dri­ving up exe­cu­tion costs for fund managers.

Dark pools appear to offer wel­come cov­er. If you go into a dark pool, those pur­chas­es are not imme­di­ate­ly revealed,” says Ander­sen. Over the course of a day you can do these pur­chas­es and only at the end of the day will it be revealed to the rest of the world that at these and these and these prices, these shares were traded.”

Dark Pool Dilemma

But the secre­cy has its down­sides. Name­ly, very lit­tle is under­stood about how the pools operate.

The issue is that there’s no direct reg­u­la­tion as to how you actu­al­ly got matched up in the dark pool,” says Ander­sen. This makes it near­ly impos­si­ble to deter­mine just how a trade was made — and thus whether a cus­tomer was giv­en the best pos­si­ble deal. Per­haps a bro­ker is drawn to the pool not by prices, for instance, but by expect­ed kick­backs. It may also be they own the dark pool, so they can get some of the fees asso­ci­at­ed with trad­ing there,” says Ander­sen. It gets com­pli­cat­ed. How do you tru­ly enforce the NMS?”

It is also dif­fi­cult to deter­mine the extent to which the dark pools are filled with high-fre­quen­cy traders. The peo­ple run­ning the dark pools have a huge inter­est in get­ting the trades done inter­nal­ly,” says Ander­sen. In order to do so, they need to attract liq­uid­i­ty. Do they invite high-speed traders into the pools to bring that liq­uid­i­ty — and if so, are these traders giv­en infor­ma­tion that oth­er mar­ket par­tic­i­pants are not? For exam­ple, traders could use knowl­edge about the ratio of insti­tu­tion­al orders rel­a­tive to retail orders in the pool to deter­mine the like­li­hood that their trad­ing part­ner is well informed about the under­ly­ing secu­ri­ty values.

It’s not reg­u­lat­ed,” says Andersen.

Cur­rent­ly, com­pe­ti­tion from oth­er pools and exchanges is all that exists to keep the dark pools hon­est. They have an inter­est in being trans­par­ent to their cus­tomers to reas­sure them that things are func­tion­ing fair­ly,” says Ander­sen. And, of course, results mat­ter too. If you keep, for a month or two months, get­ting what seems to be a poor exe­cu­tion out of these dark pools, you can just say, I don’t want to send it to dark pools. I will go to anoth­er bro­ker who promis­es not to send it there.”

Still, just how well dark pools serve cus­tomers remains unclear — even on aggre­gate. Accord­ing to Ander­sen, the results of past aca­d­e­m­ic stud­ies are all over the place” in terms of whether dark pools pro­vide bet­ter or worse prices than the pub­lic exchanges.

Resis­tance to Regulation

A num­ber of reg­u­la­tions are cur­rent­ly on the table to improve trad­ing and fur­ther pro­tect cus­tomers. These include rules about the types of rebates avail­able to bro­kers, the trad­ing doc­u­men­ta­tion bro­kers are required to show their cus­tomers, how high-fre­quen­cy traders are allowed to oper­ate, and how dark pools can be run. Reg­u­la­tors might also con­sid­er slow­ing down trad­ing from once a mil­lisec­ond or microsec­ond to once a sec­ond in an effort to thwart the tech­no­log­i­cal arms races that may offer very lit­tle social val­ue in return.

But, Ander­sen cau­tions, before any new reg­u­la­tions are put in place, researchers and reg­u­la­tors need to have a bet­ter under­stand­ing of how the mar­kets cur­rent­ly operate.

Com­ing to this under­stand­ing will not be easy. Many traders and trad­ing plat­forms are reluc­tant to give schol­ars access to data from trad­ing accounts. Mutu­al fund man­agers do not want oth­ers to know how they split their orders. High-fre­quen­cy traders do not want oth­er high-speed traders to know how they oper­ate. They ping, they jump in front of each oth­er and place and can­cel orders at light­ning speed to explore the state of the mar­ket,” says Ander­sen. If com­peti­tors learn your strate­gies, that can remove the prof­itabil­i­ty very quick­ly because they will do exact­ly the same thing, or even front-run you!”

Even the pub­lic exchanges are resis­tant to change. The exchanges ben­e­fit from a lot of order traf­fic,” says Ander­sen. So any­thing that hurts the high-fre­quen­cy trad­ing firms might hurt the exchanges,” he says. They have a lit­tle bit of an alliance.”

A Big Data Solution?

Of course, reg­u­la­tors could nonethe­less insist on access to real-time data from trad­ing accounts. But this would still leave anoth­er large prob­lem, accord­ing to Ander­sen. Name­ly, in order to be of any use to researchers and reg­u­la­tors, the data would need to be acces­si­ble in a man­age­able way.

The amount of mes­sage traf­fic in the sys­tem, because of the way it’s struc­tured, is absolute­ly enor­mous,” explains Ander­sen. It’s almost infi­nite­ly com­pli­cat­ed to fig­ure out … what are the opti­mal strate­gies, what are peo­ple doing, where are the vul­ner­a­bil­i­ties in the sys­tem if some­thing breaks down?”

Ander­sen rec­om­mends that a sin­gle enti­ty — be it the gov­ern­ment, a reg­u­la­to­ry agency, or anoth­er non­prof­it orga­ni­za­tion — estab­lish and man­age a sin­gle data­base, which would then be made acces­si­ble to schol­ars for a mod­est fee. This would free indi­vid­ual insti­tu­tions of the bur­den of han­dling such large amounts of data, instead spread­ing the labor and cost across as many research orga­ni­za­tions as possible.

Evi­dence of change is already in the air. The inde­pen­dent, non­prof­it orga­ni­za­tion FIN­RA recent­ly announced that it is mak­ing some anonymized, fixed-income mar­ket data sets avail­able to researchers with approved projects — a good first step.

Featured Faculty

Torben Andersen

Nathan S. and Mary P. Sharp Professor of Finance, Department Chair of Finance

About the Writer

Jessica Love is Editor in Chief of Kellogg Insight.

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