“Fragile” US equity market structure needs attention

US regulator the SEC supports circuit breakers

The recent market data glitch on US consolidated tape C, in which investors were unable to view Nasdaq-listed stocks, highlights the need for regulation on resilience, according to Frederic Ponzo, managing partner at capital markets consultancy GreySpark Partners.

Ponzo added that the Nasdaq data problem also illustrates the reliance of the US alternative  trading systems on prices formed at the primary exchanges, to the detriment of the market in the event of a technical problem.

“The problem here is twofold,” he said. “We are missing the regulation we need on market resilience, and secondly when the reference market goes down, the entire system of alternative marketplaces collapses because there is no alternative for price discovery.”

On 3 January, Nasdaq reported at 1342 EST that it was investigating a problem with the data feeds for its Universal Trading Platform. The outage lasted around 10 minutes, and affected users viewing consolidated tape C, which is a public utility provided by the DTCC using data collected from US exchanges including Nasdaq. Users that subscribed directly to Nasdaq’s specialist feed were not affected. Rival exchange Direct Edge halted all trading in Nasdaq-listed instruments for the duration of the outage.

The incident follows a spate of exchange outages and technology problems in the last year. Nasdaq attracted sharp criticism for a technology problem that turned its IPO of Facebook into a public debacle in June; rival US exchange BATS Global Markets likewise bungled its own IPO in March, leading to accusations that exchanges seemed no longer capable of performing basic market functions – and that they had squandered their resilience in an effort to make themselves attractive to lucrative high-frequency traders interested only in speed and low transaction costs.

Exchanges have been keen to provide low-latency trading systems for HFTs in recent years because they help to drive up trading volumes. HFTs typically make their profit from large numbers of very small transactions, including arbitraging tiny price differences between stocks listed on different venues that may exist for only a fraction of a second. Critics of HFT, including Tony Mackay, founder of Chi-X Europe, have argued that excessive focus on speed has harmed the integrity of equity markets as exchanges have stripped out much of the functionality on which longer-term institutional traders used to rely for the sake of greater speed. Some also contend that these changes make exchanges less reliable. A series of technical difficulties that accompanied the transfer of the London Stock Exchange and its Turquoise MTF onto the new MillenniumIT trading platform in 2010 and 2011 were widely cited as proof of the downside of excessive focus on speed at the expense of reliability.

However, according to Ponzo, the issue is not so much that exchange outages happen more often now than in the past, but that the fragmented structure of equity markets, in which tens of alternative trading systems, dark pools and broker crossing networks compete with each other for order flow, all relies on primary exchanges for price formation.

“When the system crashes, it hurts a lot more, because the entire marketplace is more fragile,” he said. “It’s also true that exchanges have focused on speed and cheapness over safety. There’s nothing in the rules for trading platforms about market resilience.”

Regulators in the US and Europe have been particularly concerned with market stability since the flash crash of 10 May 2010, in which $1 trillion was briefly wiped from the value of the US stock market. The crash was blamed on an erroneous order, which was then picked up by algorithms which fed off each other to create the crash.

In June 2012, the US Securities and Exchange Commission approved proposals to replace the US’ existing single stock circuit breaker safety net with a system in which the entire market can be temporarily suspended, to alleviate the effect of unusually large sudden price movements. However, some buy-side market participants have questioned the move, suggesting that to prevent price formation during a moment of market stress could stop the market from achieving equilibrium, and may even exacerbate volatility when the market reopens.