January 25, 2013

Editor's Note: The following is an excerpt from a letter from Themis Trading to the nominee for SEC Chairman. Themis Trading, an independent institutional agency brokerage firm specializing in equities, is critical of the current equity market structure.

Dear Mary Jo,

Congratulations on your nomination for SEC Chairman.  As you may know, we at Themis Trading are, and have been, very critical of the current US equity market structure.  We believe that a series of rule changes begun under the stewardship of one of your predecessors, Arthur Levitt, are largely responsible for turning deep, centralized, and diverse pools of liquidity into our current fragmented mess of a market, which includes thirteen stock exchanges and dozens of dark pools. These fragmented trading venues are shallow and non-diverse in their participation, have non-uniform matching rules, and in many cases are extremely non-transparent. And in times of market stress, this current fragmented system has an Achilles heel, which has been exposed in the May 6th Flash Crash, as well as in the countless mini-flash-crashes, botched IPOs, and algo-glitches.

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Ironically, the SEC has been very aware of so many conflicts of interests and flaws in our modern market structure. It recognized many of these flaws back in the actual Reg NMS 2007 document, but chose to implement Reg NMS anyway. In 2009 it proposed banning "flash-style" orders, although it has never followed through. In that same year it proposed regulating dark pools, recognizing that publicly displayed market quotes are important for the price discovery process, although again it had never followed through.

Since May 6th 2010, the SEC has proposed some marginal patches for the exposed market structure flaws, including the removal of stub quotes and the addition of single stock circuit breakers, which are soon to be replaced by a limit up limit down safety mechanism. These actions, however, amount to little more than band aids on an infected wound. These actions do not address root plumbing issues and instabilities in our structure. They did not prevent the Knight algo disaster last August, and they will most likely not prevent the next flash crash.  While our regulatory bodies are quite adept at holding roundtables, and "looking into" troublesome issues, they need to follow through in order to command respect from the investing public.

While markets are currently near historic highs, there exists a temptation to ignore problems as complex as market structure. However, we think it is precisely at this point in time that we need to fix our capital-raising system’s plumbing. We think that you have a great opportunity as the new Chairman to take a holistic approach to market reform. We hope you will seriously consider:

--Banning payment for order flow at all levels. --Eliminating  the maker-taker exchange pricing model. --Mandating that exchanges route to each other when fragmented markets become "locked". --Simplifying/eliminating complex and unnecessary exchange and dark pool order types. --Instituting dark pool regulation. --Changing the SRO rule-making process so as to include input from investors, and not just traders.

The time has come to recognize that the Frankenstein market that has been created, perhaps unintentionally, does not possess a sound foundation. While technology has been a crucial and cherished driver of good for investors, the SEC must make sure technology is leveraged in alignment with the goals of investors, and not traders -- no matter how fast they are.

[To read Themis Trading's entire letter, visit Themis Trading's Blog: An Open Letter to Mary Jo White.]

ABOUT THE AUTHOR
Joseph Saluzzi is partner, co-founder and co-head of equity trading of Themis Trading LLC, a leading independent agency brokerage firm that trades equities for institutional money managers and hedge funds. ...