Free-market capitalism will ultimately lead any marketplace to its ideal state. Over the past half-decade this principle has driven my hypothesis that regulators should not try to stymie trading strategy and technology innovation, but should instead follow a principles-based approach (see the CFTC c. 2007) that prevents fraud while still allowing competition to carry on unencumbered. I know not everyone agrees. And I know the premise is idealist and comes with caveats. But the fact remains that privately-run companies in competitive markets yield the most robust solutions.
The equity market failure on August 22 proves that the markets need fewer regulations, not more. In simple terms, the Securities Information Processor (SIP) failed. Most institutional traders rely on private direct and consolidated feeds to make crucial trading decisions because they don’t trust the speed and accuracy of this data feed, yet its failure still caused a three-hour market outage. Government regulations essentially mandated the existence of the SIP, which generates revenue for the exchanges, but is lightly used by the exchange’s clients. So why have it at all? I’m not sure.
To be fair, exchanges, market data providers and institutional traders do have some use cases for the SIP. Exchanges must use the SIP to route out orders when another venue has a better price per Regulation NMS (a major reason why the failure caused a market shutdown). Market data providers creating and distributing a consolidated feed use the SIP feed as an input, and trading firms often look to the SIP for markets from which they do not consume a direct feed. Nevertheless, remove the regulatory requirement and all of the above would quickly move on to more effective solutions.
Recently we have had numerous conversations with financial technology providers convinced they can—or, in some cases, already do—provide technology to the market that is cheaper, faster and more accurate than the SIP. It’s virtually impossible to debate those claims given that nearly every major equities trader on the street already uses one of those technology solutions. So what would happen if the SEC took away the consolidated tape requirement ushered in by Regulation NMS? Nothing bad. The SIP would either be privatized and run by one or more independent providers or done away with all together as the market looked to off-the-shelf solutions for cheaper and more efficient solutions.
Europe’s unsuccessful attempt to create a consolidated tape for equities markets serves as another case in point against a mandated consolidated tape. Europe certainly has some unique issues—numerous currencies, regulators and languages to name a few. Pan-European trading, however, has been carrying on quite efficiently for years, with firms like Chi-X and BATS allowing price discovery across multiple listings in a single place. So, again, why mandate something into existence that the market has already solved for?
[Interest Rate Swaps: Electronic Trading and the New Regulatory Reality]
The issue of fairness for retail investors often comes up. Big institutions can buy up sophisticated technology to aggregate quotes, but what about the little guy? First, “fair” is not a useful concept to consider in a market driven by capitalistic principles. Everyone should play by the same rules, but if someone has more resources, then rules should allow that person or organization to be as successful as it can be. Second, plenty of firms take the aforementioned sophisticated technology and package it up for the retail investor. I certainly don’t have a ticker plant in my basement, but I’m sure the fund manager for my 401k has access to one.
It’s difficult to consider the need for more or less regulation these days without talking a little about Dodd-Frank. Market participants in the United States are now actively implementing the Act’s massive reporting requirements for swaps trading, and it’s hard to argue against the efficacy of that initiative. That said, conversations with market participants reveal that the technology underlying the new reporting infrastructure isn’t a new, sophisticated system that has taken into account lessons learned from past years. It is instead an updated version of existing trade capture technology enhanced to handle every flavor of swap trade. Regulators gave the market the opportunity to build this infrastructure from scratch, but it doesn’t sound as if anyone has taken full advantage of this once-in-a-career opportunity.
The bottom line: Financial technology companies have a huge opportunity at their feet. Parts of the existing equity market infrastructure are broken and much of the new swaps infrastructure has yet to be implemented. Private financial technology firms have the solutions and incentives to keep the United States at the pinnacle of the global capital markets. We just have to let them.
Kevin McPartland is the head of the Greenwich Associates new market
structure and technology advisory service. He helps the Firm’s clients navigate market structure changes driven by regulation, technology and behavior shifts.