An Open Letter to Mary Jo White
Dear Mary Jo,
Congratulations on your nomination for SEC Chairman. As you may know, we at Themis Trading are, and have been, very critical of the current US equity market structure. We believe that a series of rule changes begun under the stewardship of one of your predecessors, Arthur Levitt, are largely responsible for turning deep, centralized, and diverse pools of liquidity into our current fragmented mess of a market, which includes thirteen stock exchanges and dozens of dark pools. These fragmented trading venues are shallow and non-diverse in their participation, have non-uniform matching rules, and in many cases are extremely non-transparent. And in times of market stress, this current fragmented system has an Achilles heel, which has been exposed in the May 6th Flash Crash, as well as in the countless mini-flash-crashes, botched IPOs, and algo-glitches.
Ironically, the SEC has been very aware of so many conflicts of interests and flaws in our modern market structure. It recognized many of these flaws back in the actual Reg NMS 2007 document, but chose to implement Reg NMS anyway. In 2009 it proposed banning “flash-style” orders, although it has never followed through. In that same year it proposed regulating dark pools, recognizing that publicly displayed market quotes are important for the price discovery process, although again it had never followed through.
Since May 6th 2010, the SEC has proposed some marginal patches for the exposed market structure flaws, including the removal of stub quotes and the addition of single stock circuit breakers, which are soon to be replaced by a limit up limit down safety mechanism. These actions, however, amount to little more than band aids on an infected wound. These actions do not address root plumbing issues and instabilities in our structure. They did not prevent the Knight algo disaster last August, and they will most likely not prevent the next flash crash. While our regulatory bodies are quite adept at holding roundtables, and “looking into” troublesome issues, they need to follow through in order to command respect from the investing public.
While markets are currently near historic highs, there exists a temptation to ignore problems as complex as market structure. However, we think it is precisely at this point in time that we need to fix our capital-raising system’s plumbing. We think that you have a great opportunity as the new Chairman to take a holistic approach to market reform. We hope you will seriously consider:
– Banning payment for order flow at all levels.
– Eliminating the maker-taker exchange pricing model.
– Mandating that exchanges route to each other when fragmented markets become “locked”.
– Simplifying/eliminating complex and unnecessary exchange and dark pool order types.
– Instituting dark pool regulation.
– Changing the SRO rulemaking process so as to include input from investors, and not just traders.
The time has come to recognize that the Frankenstein market that has been created, perhaps unintentionally, does not possess a sound foundation. While technology has been a crucial and cherished driver of good for investors, the SEC must make sure technology is leveraged in alignment with the goals of investors, and not traders – no matter how fast they are.
As you settle in, be prepared to be bombarded with self-interested industry participants and their lobbyists who want to sway your opinion. You are likely to hear from:
– Exchange executives. They will tell you technology has created a very cost effective and efficient market. They will say there is no need for reform and things are going smoothly despite some recent “glitches”. They will tell you not to throw out the baby with the bath water, and that all is needed is a kill switch here or there, and a lifting of a ban on locked and crossed markets. They will tell you it is a good thing for a buy order at 50 cents to exist alongside a sell order at the same price – and they not trade.
– High frequency trading firms. They will claim spreads have never been tighter and liquidity is abundant, and it is due to their activity. This is untrue. They will also tell you that the real problem is a financial media, and some old school brokers, who are scaring investors about the dangers of high frequency trading unnecessarily; the problems are simply message management.
– Lobbyists – Be prepared for this group to wave around their cherry-picked sponsored academic studies that claim high frequency trading has lowered costs for all. Make sure you ask them who funded the studies, as well as examine their assumptions.
To help you prepare for those meetings, we recommend that you gander at this robust collection of academic studies on market structure and high frequency trading.
And we also recommend you pick up the following books, one of which is co-authored by us:
– Crapshoot Investing (Jim McTague)
– Broken Markets (Sal Arnuk and Joe Saluzzi)
– Dark Pools (Scott Patterson)
– The Problem of HFT (Haim Bodek)
– The Payoff- Why Wall Street Always Wins (Jeff Connaughton)
We wish you great success in your new role. We are excited for the leadership of an SEC Chairman with a prosecutorial mindset.
Feel free to call on us any time. We would love to help you build a case for convincing investors to bring back their trust to the marketplace.
Your Friends at Themis Trading
Joseph Saluzzi (jsaluzzi-at-ThemisTrading.com) and Sal L. Arnuk (sarnuk-at-ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.