The Worst Market Structure … Except All Others

To paraphrase (poorly) Winston Churchill, our equity markets are the worst form of market structure “except all the others that have been tried.” Our current market structure is competitive, fast, innovative and cheap — all to a fault. The problem is, each market participant has different demands and trading strategies, making it difficult to solve market structure challenges; helping one constituency tends to hurt another.

The market can be segmented into five major constituencies: issuers, investors (retail and institutional), brokers, liquidity providers (market makers, high-frequency traders and day traders), and market centers (exchanges, ATSs, ECNs, MTFs, SEFs and organized trade facilities). Each of these constituents has different demands and concerns. If regulations favor any constituent to the detriment of others, the market can be thrown out of balance, not only impacting trading volumes but also the allocation of capital to corporations, which translates to jobs.

A Retail Boom

Structurally, the market has never been better for retail investors. While the majority of retail orders is internalized by wholesalers, spreads are tight, transaction costs are low, technology is extensive and, for small orders, liquidity is abundant. Retail internalization typically is not a problem for retail investors; it is challenging for institutions and liquidity providers. Confidence is the problem for retail investors. Post-financial crisis and post-Flash Crash, the individual has little market confidence and even believes the game is rigged.

Institutional investors have more confidence, but they also have greater demands. They need liquidity, have a hard time trading blocks, and believe exchange flow is toxic because most desirable flow is internalized or traded in the dark. Since buy-side firms can’t trade blocks, they have an over-reliance on broker technology, algorithms and dark pools. This becomes a self-fulfilling prophecy: As blocks disappear, traders employ dark pools and algos, which reduces block executions and forces flow into algos and dark pools. Speed also is a disadvantage for the buy side, as market makers and liquidity providers leverage colocation, putting the buy-side trader micro- to milliseconds behind the fastest liquidity providers.

Brokers managing buy-side flow increasingly need to invest heavily in technology. The development of trading algorithms, dark pools, smart order routing and market connectivity isn’t cheap. In addition, competition is fierce and commissions are being driven downward. For brokers, reducing exchange payments puts money directly back in their pockets; negotiating the fragmented market environment, however, is problematic, as is supporting the various buy-side players with a wide array of tools and services.

The current market structure generally benefits liquidity providers — not because the SEC drafted beneficial regulation, but because the more modern liquidity providers crafted their business models based on the new rules. While the current structure benefits these players, competition, low volatility, decreasing order flow, and the growth in internalization and dark pools have reduced the flow with which this demographic interacts. Lower retail trading volumes also hurt internalizers, many of which are liquidity providers as well.

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