At the heart of our markets is the idea of fragmentation and speed. The faster and more fragmented our markets are, the more competitive they are. And competition is good ... right?
But, at some point, does a market become too fast, too fragmented and too competitive? Does the technology needed to trade in this market make that market too fragile? To answer this, we need to examine fragmentation.
Most think about fragmentation in terms of trading venues. And yes, the U.S. equity market has a number of trading venues. There are 13 exchanges, about 50 dark pools, and many internalizing brokers that can match buyers and sellers. To ensure the best match, sophisticated order routers need to examine many trading venues. And without being in two places at once, the more venues checked, the greater the chance buyers and sellers miss each other.
While checking many venues complicates execution, markets also can fragment in other ways, including price and time. The more price points, the more missed trades. This is especially true as liquidity providers spread orders across more price points and venues. As fractions turn to pennies, and pennies to sub-pennies, through dark pools and the NYSE Retail Liquidity Program (RLP), trading volume becomes fragmented from 16 price points per dollar to 100, or to 1,000.
[Knight's CEO Admits Software Bug Related to NYSE RLP Was Cause of Market Mayhem.]
The same problem exists with time. The quicker the quote timeframe, the more messages I need to produce and analyze. If I am quoting across 13 exchanges and 20 dark pools, then I need to manage my quotes across 33 venues. If my quoting frequency changes from seconds to tenths, to tens of milliseconds, to milliseconds, then my quoting rate increases from 33, to 330, to 3,300, to 33,000 quotes per second. Multiply that across 5,000 stocks trading at pennies or possibly sub-pennies, and think about the massive technology and message infrastructure needed to trade.
This is why quotes flicker and quote-to-trade ratios are through the roof. So, does something need to be done?
Time for Action
Given the problems with the Flash Crash, Facebook and now Knight, have our market become too fragile? Has the technology surpassed our management capabilities? Have the regulators been left in the dust and investors on the sidelines?
Increasingly, I believe that, yes, our fragmented infrastructure needs to be simplified. No matter how technology proficient the firm, these systemic problems hurt investor confidence and trust.
[Check out exclusive photos of the Knight Capital trading floor, from Advanced Trading.]
While time fragmentation won't stop -- chips will certainly get faster, networks speedier and bandwidth wider -- we can manage venue and price fragmentation. For example, Congress recently passed the JOBS Act, tasking the SEC to examine widening the quote for less-liquid stocks, which hopefully would reduce price fragmentation at the lower end of the capitalization scale, where action is most needed to aid capital formation.
And while the NYSE RLP program will ferment price fragmentation, it may play a role in reducing venue fragmentation. The goal of the RLP is to attract retail liquidity to the NYSE by providing rebates to brokers that route retail market orders to the NYSE. While the NYSE would be ecstatic if retail brokers bypassed wholesalers, the most likely outcome will be that wholesalers will route their unmatched flow to the exchange for a credit, instead of obtaining either a low-cost or free execution via a dark pool. The end result, if successful, will be to reduce flow to dark pools and centralize flow back to the NYSE.
But unless the NYSE RLP is wildly successful, it probably will not be enough. Given the events of the past six months, the SEC should think hard about the market structure it has created, and do its utmost to rein it in. While the SEC can't stop computers from getting faster, there is no reason it can't reduce price and venue fragmentation, which should slow the market down, reduce message traffic and lower technology burdens.
Until we can safely manage complex and massive message streams in microseconds, fragmentation is making one of the greatest financial markets of all time about as stable as a McLaren with its RPMs buried in the red.