Monday, August 24, 2009

U.S. Senator Calls for "Comprehensive" Market Structure Review

It's always disheartening when politicians wade into market structure issues. Their motivation is, naturally, political, and they assume they know more than the regulators with day-to-day experience. The recent tirades against short selling are an example. I have not seen one study suggesting that short sales in any way contributed to the economic meltdown, yet regulators were threatened with a legislative response if they didn't "do something" (which they inevitably do). Senator Ted Kaufman (D, Delaware) has sent a letter to SEC Chairman Mary Schapiro calling on the SEC to mount a comprehensive, independent review of "questionable market structure issues" before "piecemeal changes to the current market structure make things worse."

Senator Kaufman is concerned that advances in electronic trading have created an unlevel playing field where "questionable practices threaten to further erode investor confidence in our financial markets." There is certainly an unlevel playing field, but it would be difficult if not impossible to level it without creating a highly inefficient market.

He raises concerns about the latent disparities in the market. In particular, high volume traders often co-locate their servers with a marketplace's in order to cut the latency in receiving and delivering order and trade information to a minimum. Their trading strategies depend on low latency, so they know immediately if an order has been filled.

Latency also raises other issues: is the national best bid and offer accurate in reflecting quotes from various venues? The short answer is no. No two users (be they traders, dealers or market data vendors) will get the same datum at exactly the same nanosecond. It will always take a bit longer to get to some parties.

This is not a new issue. Back in the days of trading floors, order and trade information was always more complete and up-to-date in the trading square than it was on the data feeds.

I will tackle some of the particular issues he raises in later posts (and I agree some need to be looked at) but want to make one general comment. His motivation, like many other politicians, is that retail investors are being disadvantaged. But are they? The high-speed traders are interested in shaving pennies as they buy and sell in different markets to take advantage of the market. An investor with a longer-term outlook shouldn't care about slight price variations. They know their price and it they get it, they are happy. Retail investors who take aggressive short-term positions and try to time the market are competing directly with the professionals and they simply don't have the information or computer algorithms to do it successfully. To level the playing field would mean that the markets are so inefficient and slow the professionals move on to something else.

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