How About Letting Investors Structure Their Own Markets?
On Friday, the House of Representatives will hold a hearing on Regulation NMS- a set of Securities and Exchange Commission's rules governing the way shares of companies are bought and sold. The hearing offers an opportunity for policymakers to consider whether it is time to free the NMS--"national market structure"-from the grip of regulators and put it into the more capable, nimble hands of the investors who actually use the markets.
Reg NMS was adopted by a sharply divided SEC in 2005 after a contentious battle fueled by a flurry of comment letters. A key feature of Reg NMS was to force the execution of orders, regardless of where they are placed, at the best price available in any trading venue. The SEC viewed the rule as an investor protection measure, but many investors did not share that sentiment. After all, investors care about more than price when they decide where to place an order. Confidentiality, certainty of execution, and speed matter too. As often happens, rejiggering the markets just a little was impossible, and the core NMS rule led to additional rules governing trading and markets.
As expected given the complexity of both Reg NMS and the markets it regulates, the new rules took effect through a lengthy, painful, and massively expensive implementation process. During the transition, the SEC whittled away at the rules' many rough edges through exemptions, extensions, and interpretations.
Even with this substantial post-adoption refining, Reg NMS has not produced the stronger marketplace that its advocates promised. Events such as the so-called Flash Crash of 2010 and similar market disruptions persist in the new marketplace. As a recent Wall Street Journal article explained, some people think that Reg NMS-rather than making the markets function better-may be causing or exacerbating problems in the financial markets. The rules added complexity and new vulnerabilities to the markets and may have impeded the private sector's ability to respond to problems as they arise.
Proprietary trading firms, hedge funds, newly flourishing exchanges, and dark pools have found ways to profit from the SEC's rules of the road, but how would a market unfettered by Regulation NMS have looked? Would it have better served investors and the companies that rely on them for funding? As Commissioner Cynthia Glassman remarked upon the rule's adoption, "The underlying rationale of the proposal is that it is better to rely on our staff's interpretation and oversight to manage competition. My rationale is that I would prefer competitive market forces to determine the outcome."
The preference for SEC-crafted competition reflects a deeper conviction that the agency is essential to the healthy and competitive functioning of the equity markets. As a result, the SEC is mired in the minutiae of market design-mediating among market venues and investors, crafting pricing plans, and blessing order types. This is too big a task for the SEC with its finite resources and necessarily limited knowledge of what is important to the wide variety of investors the agency is trying to protect.
An alternative approach would allow investors simply to vote with their trades-placing their orders in whichever trading venue they feel offers the best combination of price, speed, and execution quality. A market driven not by regulatory pushing and pulling, but by investor demand and competition for their business, has a remarkable ability to efficiently serve the ever-changing and heterogeneous needs of investors. There is nothing inherent about trading stocks that necessitates the current level of SEC engagement. Friday's hearing is an opportunity to challenge the presumption in favor of regulatory intervention in the stock markets. What has worked well in other arenas-allowing the demands of the customers to shape and reshape the marketplace-could work equally well in reforming U.S. equity markets. The SEC, freed from an intense participatory role in the markets, would then be able to concentrate its time and attention on broad oversight of the markets.
