While the U.S. equity market structure looks more like a Rube Goldberg creation than a logical blueprint, it works. Our markets allow for the efficient and effective valuation and trading of assets among a wide number of market participants, whether they are trading 100 or 1 million shares.
That said, from an outsider's perspective our markets are challenged. Legislators are posturing, regulators are investigating and even Nobel laureates are pontificating about the value of trading (or the lack thereof). Given this inquisition, we as an industry need to take a step back and help the regulators, the public and even professional investors better understand how our markets and orders work as well as their effectiveness and fairness.
I am a firm proponent of our current market structure given our desire to keep spreads tight and commissions low, manage risk, and provide direct retail access, as well as protect institutional investors' need for anonymity. I think dark pools are important, market linkage critical, algorithms a must, high-frequency trading a value, and arbitrage a public good. Call me naive, but I even think there is a place for flash orders. But if we don't do something to shine a light on some of these practices and prove their value, many of these "innovations" may just get regulated out of existence.
We need to focus on transparency. Not the transparency of individual orders, but the transparency of markets, order handling and execution quality.
Let's start with execution venues. Currently the SEC mandates the registration of non-exchange matching venues, but the existence of these systems is confidential. For one, let's lift the veil of secrecy on alternative trading systems (ATS) registration. Second, an aggregated place to locate these venues would be great -- and while we are at it, let's consistently count volume and provide execution statistics on how these venues perform.
A mutually agreeable set of execution statistics would go a long way toward helping traders understand execution quality and timeliness. And if we could have a better sense of where each pool's liquidity comes from (i.e., retail, institutional, exchange, other ATS, liquidity provider, etc.), it would help traders determine which pools to swim in and which to avoid. We probably don't want to be too specific on flow characteristics; but if we can break order flow down into four or five fairly amorphous categories, it would give traders a better idea of where they were trading and whom they were trading with. It would also allow individuals, regulators and legislators to monitor these venues and ensure their fairness.
This is not a diatribe against dark pools. We also should begin to require exchanges and ECNs, as well as brokers handling agency flow, to publish execution statistics, define conflicts of interest, detail their routing mechanisms, provide insight into where liquidity is directly sourced and highlight payment for order flow arrangements. While providing a significant level of detail could violate trade secrets and compromise execution quality, finding a way to define these high-level schematics without jeopardizing execution quality would give clients the information they need to trade while providing the public with confidence in our markets.
While innovation is good, it is the innovation's effectiveness that should determine success. How do we know whether flash orders are good if we can't measure their effectiveness and can't easily opt out? How do we know that indications of interest (IOIs) or dark pools are safe if we don't know if there are predators in the pools? How do we know if an order placed into a router is being directed to the market with the best price rather than the market with the largest rebate?
While I am not a firm believer that transparency solves all, when it comes to our market structure, transparency may be just what the doctor ordered. If we don't take the lead, the prescription may just be written by Washington.