There has been much discussion about the practice of co-location by exchanges as a crucial factor in high-speed trading in equities and options. Many commentators have said that the time, speed, and information advantage inherent in co-location has been in existence as long as exchanges have been trading. This had been true for many years and through different iterations of market structure, but these commentators fail to recognize the different conditions in which this practice took place.
Floor traders always had a time and place advantage in the equity or options markets. By being present on the floor where orders were being held and executed physically, they could act before that information left the floor. Even with the advent of electronic trading and the maintenance of electronic order books, access to the depth in the order book was restricted to certain persons registered as market makers or specialists.
However, the exchanges and the SEC imposed stringent requirements on those present on the floor. Floor traders, brokers, market makers, and specialists all had to be broker dealers; they were registered with the exchange and were subject to its regulatory scrutiny. Most importantly, market makers and specialists had affirmative obligations to make two-sided markets in the products they were trading. This provided liquidity to the customers of the exchange. Furthermore, floor brokers and traders/specialists/market makers had stringent rules about front running, trading ahead, and customer priority. All these issues draw complaints today about HFT practices by firms that are not broker dealers or subject to similar exchange oversight.
We could debate how effective these rules were in corralling unethical or illegal practices, such as trading ahead of your customer, or in ensuring a liquid market in times of volatility. But at least the principle was that traders with built-in advantages would have regulatory responsibilities that would be monitored by the exchanges.
However, with demutualization, the exchanges have substituted cash for regulatory responsibility as the tradeoff for firms wanting that time and place advantage. They gain that advantage by co-locating their servers on the new "floors" -- the server rooms of each exchange. The SEC recently fined the NYSE for allowing this practice without submitting a rule change to the commission, but it did not deal with the lack of regulatory responsibility associated with the practice of co-location.
Any trading firm at any exchange that wants co-location in an exchange's server room should have formal market-making responsibilities, be registered as a broker dealer, and be actively monitored for compliance with exchange and SEC rules. All others should be required to go through a broker. If that broker wants to co-locate its servers in the exchange's server room, it would be placed where it is at a slight millisecond disadvantage to the registered firms that are making markets.
The return of SEC registration and market-making responsibilities might not solve all the issues being raised by the market structure the SEC has created. However, it would be a big step in dealing with the time and place advantage that is now being sold to the highest bidder without any respect for the market responsibilities traditionally associated with that privilege.Doug Engmann is President of Engmann Options Inc., a San Francisco private investment and securities consulting firm owned by the Engmann brothers, and Chairman of Sage Brokerage Holdings, LLC which is the parent of a broker-dealer servicing active professional traders. He ... View Full Bio