Fragmentation of U.S. Equities Market Criticized in SEC Panels

Investors, traders and regulators underappreciate the harm caused by the fragmentation of trading across a dozen public markets with different rules and conventions, said Dave Cummings of Tradebot Systems Inc.

“The market is still very broken and I think the changes we’ve put in place don’t go far enough,” said Cummings, who’s chairman at Tradebot, an automated proprietary trading firm in Kansas City, Missouri. “When you introduce bad data because of ridiculous quotes, that ripples through the whole system and into other markets.” Tradebot accounts for 5 percent to 10 percent of daily equities volume, according to Cummings, who also founded Bats Global Markets, an exchange operator.

A report published by securities and futures regulators on May 18 found six potential causes of the May 6 plunge, which wiped out $862 billion of stock value in 20 minutes. One of the reasons was disparate trading rules on different markets. The Securities and Exchange Commission and Commodity Futures Trading Commission held their second meeting yesterday to discuss problems caused by the interplay of multiple venues.

SEC Chairman Mary Schapiro raised concerns at the meeting about differing trading conventions, including mechanisms that slow down trading on individual markets and a rule that allows venues to ignore prices on rival exchanges if they perceive problems with their executions or get slow responses to buy and sell requests.

“The U.S. equities market is so complex normally that when you add in a situation like May 6 the complexity turns into confusion,” said Matt Schrecengost, chief operating officer at Jump Trading LLC, a proprietary trading firm in Chicago. “The only responsible thing to do as a trader is to shut down.”

Accenture at a Penny

Jump stopped submitting bids and offers to exchanges on the afternoon of May 6. Other market makers and high-frequency trading firms also scaled back business when volatility surged that day and stocks such as Accenture Plc and Exelon Corp. traded as low as a 1 cent. Accenture closed at $38.24 yesterday, while Exelon fetched $39.75.

Schapiro asked whether the market could suffer if venues introduce their own versions of a mechanism that slows down trading in volatile stocks only on the New York Stock Exchange. NYSE’s program converts automated executions into human-overseen electronic auctions. Nasdaq OMX Group Inc. last month proposed its own measure that would pause trading when a stock rises or falls a set amount in 30 seconds.

Didn’t Exacerbate

NYSE’s program offers a “differentiated” service to companies listed on the exchange and didn’t exacerbate problems on May 6, said Joe Mecane, executive vice president and co-head of U.S. listing and cash execution at NYSE Euronext. “We’re mixing some competitive arguments with some market structure arguments.” He added that changes shouldn’t be introduced to alter the “competitive dynamics” among trading venues.

“There must be consistency regarding how the markets work, and how market participants conduct themselves, to prevent market turbulence from turning into market tragedy,” said William O’Brien, chief executive officer at Direct Edge Holdings LLC. One of the risks that can accompany innovation by markets is confusion, he added.

Brokers also deserve scrutiny for decisions about how they routed orders during a time of stress, Mecane said. Market orders, or requests to buy and sell shares at any level, sent into the marketplace on May 6 led to 21,800 trades more than 60 percent away from their price before the plunge being canceled hours later.


“We can put a lot of Band-Aids in place to prevent people from hurting themselves,” Mecane said. Still, he added, “someone had responsibility for those orders that caused the damage in the marketplace.”

The SEC is considering whether exchanges or brokers could install constraints that would put a limit on the price at which market orders execute. Mechanisms that do this exist on some equities and futures venues.

Stock exchanges recently introduced a new program of circuit breakers for stocks in the Standard & Poor’s 500 Index. Panelists suggested that such fixes, while necessary to address problems caused by the fragmentation of markets, could also cause more volatility or new frictions for traders.

O’Brien, whose firm is based in Jersey City, New Jersey, and Joe Ratterman, CEO of Bats Global Markets in Kansas City, said constraints that prevent trading in a declining stock from occurring below a certain level and executions when shares are rising from taking place above a price should eventually be introduced instead of trading halts. These steps could reduce volatility without preventing the shares from trading, they said.

200 ETFs

The circuit-breaker program will be expanded to at least 200 exchange-traded funds this summer, according to James Ross, a senior managing director at state Street Global Advisors, the second-biggest manager of ETFs.

CME Group Inc. Chief Executive Officer Craig Donohue yesterday raised concerns about that expansion to products such as the SPDR S&P 500 ETF Trust and SPDR Dow Jones Industrial Average ETF Trust. ETFs accounts for 70 percent of securities with trades on May 6 that were later canceled.

In the current interconnected market, trading halts in ETFs could cause a “de-linkage” between those prices, futures based on the security and the value of the underlying index, Donohue said. “Our customers would not like that result,” he said.

The idea of halting broad-based ETFs should be discussed “collectively” by executives in equities and futures markets and index calculators, Donohue said. CME created a joint venture with Dow Jones & Co., which operates 130,000 stock indexes including the benchmark Dow Jones Industrial Average. The exchange’s E-mini S&P 500 futures is the Merc’s biggest equity index contract, trading more than 2.2 million contracts daily last year.

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