The U.S. Securities and Exchange Commission has spent 15 years remaking the stock market into 11 competing exchanges and hundreds of computer-driven traders. In the process it has virtually eliminated the traditional market makers who bought and sold stocks when no one else would.
Now the SEC is concerned the revolution has gone too far, leaving markets vulnerable when selling starts to snowball.
Chairman Mary Schapiro called on the agency last week to examine whether the loss of “old specialist obligations” has hurt investors after measures such as trading stocks in penny increments cut the number of those firms on the New York Stock Exchange to 5 from 25 in 2000. With market making now dominated by hundreds of automated traders with few rules for when they must buy and sell, the SEC will consider ways to keep the biggest from abandoning the market at the first sign of trouble.
The debate over how to keep U.S. stock prices from plunging in times of stress gained urgency after the May 6 crash that erased $862 billion in equity value over 20 minutes. Lawmakers have asked if the high-frequency firms that have supplanted specialists and market makers with strategies that transact thousands of shares a second destabilized trading by stepping away when they were needed most.
‘He Got Canned’
“In the old days, the specialist obligation was quite stringent,” said Patrick Healy, a former trading executive at Bear Stearns Cos. who now runs Chevy Chase, Maryland-based Issuer Advisory Group LLC. “If he didn’t meet it, he got canned, and someone else traded the stock. In the move to electronic trading, NYSE and Nasdaq emphasized speed, more technology and less of a role for humans.”
John Heine, a spokesman for the SEC, declined to comment.
A joint report by the SEC and Commodity Futures Trading Commission said a “severe mismatch of liquidity” possibly worsened by the withdrawal of orders from electronic market makers may have contributed to the May 6 crash, in which the Dow Jones Industrial Average fell 9.2 percent before recovering. A follow-up to the May 18 study is expected this month.
“The players in our markets have changed but our regulations have not kept pace,” Senator Charles Schumer wrote in a letter to Schapiro last month. “High-frequency traders pulled out during the freefall, leaving a dearth of liquidity and exacerbating market volatility.” The New York Democrat urged the SEC to impose obligations on high-frequency trading firms and give them incentives to become market makers.
Vanguard Group Inc., the biggest U.S. manager of stock and bond mutual funds, told the SEC in April that regulatory changes and efficiencies produced by high-frequency firms reduced costs for long-term investors by about 0.5 percentage point over the last decade. It cited increased liquidity and shrinking spreads between the best bid and offer prices.
A mutual fund returning 9 percent annually whose entire stock holdings are sold and replaced within a year would see the gain cut to 8 percent without the savings, according to Valley Forge, Pennsylvania-based Vanguard, which oversees almost $1.4 trillion and offers more than 160 funds to U.S. investors.
Schapiro is trying to protect investors in a fragmented U.S. stock market fostered by the SEC while maintaining liquidity -- the ease with which investors can buy and sell shares -- on exchanges dominated by firms that profit from computerized trading. Chicago-based Getco LLC, the high-frequency firm founded in 1999, purchased rights in February to oversee NYSE trading in 350 stocks as a so-called designated market maker. A month earlier, 86-year-old LaBranche & Co., the largest specialist firm in 2008, exited the business, saying it would seek higher profits elsewhere.
Exchanges historically relied on specialists, or securities professionals who each made markets in designated stocks and provided prices for investors through their willingness to buy and sell shares. The business produced steady profits for the firms, which offered less to buy a stock than they charged to sell it.
All trading on the Nasdaq Stock Market went through competing market makers in the 1990s, while New York Stock Exchange specialists brought together buy and sell orders on the trading floor. Exchange operators Nasdaq OMX Group Inc. and NYSE Euronext are based in New York.
Specialists at the NYSE maintained “fair and orderly” markets by stepping in themselves when buyers and sellers weren’t available. Similar to market makers on the Nasdaq, they took risks in return for the ability to see supply and demand for stocks and profit from the difference between the bid and offer prices. Both businesses suffered when exchanges started pricing stocks in penny increments in 2001, squeezing profit out of the bid-ask spread.
The SEC is in the “early stages of thinking about whether obligations on market makers akin to what used to exist might make sense,” Schapiro told reporters on Sept. 7. The issue is “whether the firms that effectively act as market makers during normal times should have any obligation to support the market in reasonable ways in tough times,” she said during a speech in New York the same day.
As quoting and trading obligations on exchanges were weakened over the last 10 years and the profitability of market making shrank, firms engaged in automated trading assumed a bigger role. After abusive practices by Nasdaq market makers in the mid-1990s and NYSE specialists in the last decade, the SEC adopted rules to foster competition in trading companies listed by Nasdaq and NYSE.
Firms such as Getco and Knight Capital Group Inc. provide liquidity on electronic systems run by companies such as Kansas City-based Bats Global Markets and Direct Edge Holdings LLC in Jersey City, New Jersey, using computer-driven tactics that produce thousands of buy and sell orders a second. High-frequency trading firms, which employ strategies that provide and take liquidity from exchanges, make up more than 60 percent of U.S. trading volume, according to research firm Tabb Group LLC in New York.
“The playing field has leveled dramatically,” said Joe Ratterman, chief executive officer of exchange operator Bats, which accounts for 11 percent of U.S. stock trading. “It used to be easy for a specialist to work off a 6- or 12-cent spread, but when he had to offer a penny spread it became hard to make a fat living. A new breed of firms stepped in and learned to be efficient. Those firms replaced the ones that were less efficient.”
Getco, Knight of Jersey City, New Jersey, and New York-based Virtu Financial LLC urged the SEC in July to stiffen rules governing traders who place orders on exchanges for investors to execute against, mandating that market makers quote at the best price available at least 5 percent of the time. Such firms should also be required to post orders for a specified number of shares at staggered prices to improve liquidity and face limits on how wide spreads can be between their buy and sell requests, they said.
Reform of market-maker obligations may make equity trading more resilient, especially in times of “high volatility and price dislocation,” although no set of market-maker rules could have prevented May 6, they wrote. William O’Brien, the chief executive officer of exchange operator Direct Edge, said once a rout has started, no trader will obey a regulation that forces him out of business.
“If you burden any firm -- I don’t care how big or fast your computers are -- if you have to buy when everyone is selling until you’re bankrupt, even the biggest, fastest trading firm is not going to want to take on that obligation,” he said.
Market makers failed to stop the biggest plunges in the past. The Brady Commission report on the October 1987 crash found NYSE specialists and Nasdaq market makers performed erratically and didn’t stem the downward slide of prices. Many Nasdaq market makers didn’t answer their phones, ignoring customers, while overwhelmed NYSE specialists who had bought as sell orders flooded in later gave up or halted trading, according to the January 1988 report by the Presidential Task Force on Market Mechanisms, led by former New Jersey Republican Senator Nicholas Brady. He became the U.S. Treasury Secretary later that year.
Fifteen years ago, market makers had two functions, said Robert Colby, a partner at Davis Polk & Wardwell LLP in Washington who left the SEC in 2009 after 27 years. He helped write the rules that transformed equities trading over the last two decades.
“They provided liquidity to uninformed retail orders and they provided liquidity to traders more broadly through the market,” making money from the spread, he said. “What changed is with the narrowing of spreads in active securities, market makers were still willing to provide liquidity to retail customers, but they were less willing to stand at the best price for all comers.” They offer liquidity to discount brokers through “internalization mechanisms” that allow them to transact customer orders away from a trading venue, he said.
“Usually obligations go along with benefits” for market makers, Colby said. “The specialists’ obligations were watered down when the benefits of being a specialist were reduced.” The challenge for regulators who want to ensure more liquidity is available for investors is finding the right balance between new duties and market-making privileges, he said.
“How do you know if the benefit you’re giving is too great for what you’re getting?” Colby said. “That’s the difficult part.”
In October 2008, after the NYSE’s share of trading in companies it listed had fallen to about 24 percent from 79 percent in January 2005, the exchange overhauled its trading rules, stripping specialists of many of their traditional responsibilities and benefits and renaming them designated market makers. The traders no longer got a look at all orders from investors, which had helped them gauge supply and demand in their stocks. While they maintained heftier obligations than now exist on most other venues, they didn’t have to be the trader of last resort when the market turned volatile.
To counter rivals, NYSE also introduced a second tier that competes with the DMMs called supplemental liquidity providers. The nine firms, which include Goldman Sachs Group Inc., Barclays Plc, Getco, Knight and Virtu, don’t have all the trading duties and benefits DMMs receive today, though like the DMMs they get better pricing than is available to others.
Nasdaq, whose model depends on competition among many market makers in a given stock, gradually eroded the obligations of those firms as the spread between bid and ask prices decreased. In 2007, it eliminated the 20-year-old requirement that market makers provide quotes that are “reasonably related” to the prevailing price, telling the SEC it was mirroring rules on NYSE Arca, an exchange run by NYSE Euronext.
NYSE and Nasdaq are now beefing up the requirements for certain market makers, obliging them to quote at the best nationally available bid or offer 10 percent of the day. The firms have no obligations if the stocks they trade rise or plunge because of buy and sell imbalances. NYSE’s primary market makers have more onerous obligations in exchange for benefits other firms are denied.
Michael Lynch, head of Americas Execution Services at Bank of America Corp. in New York, said his firm “would support a tightening of market-making obligations -- specifically tighter two-sided quote requirements -- provided they are not anti-competitive and do not give incumbents an unfair advantage.” He oversees the specialist unit that serves as a DMM on the NYSE floor for the Charlotte, North Carolina-based firm.
“Turning away from letting markets competitively sort out who provides liquidity and under what rules, which has been the case for at least a decade, and heading towards a governmental policy at the federal level isn’t the best way to address the problems,” said Jamie Selway, managing director at Investment Technology Group Inc. in New York. “If you reduce competition, you increase the cost of trading.”