STA Report Calls for Modification of U.S. Market Structure

30 April 2008

The Security Traders Association (STA), the leading advocacy and education organization for professional equity traders in the U.S., today issued a special report. The report details the key drivers of current market structure in the U.S. and recommends incremental actions to improve the markets, assure continued market quality, and sustain U.S. competitiveness. The STA offers this report to establish a dialogue on issues of concern with industry participants and policymakers.

The report finds that U.S. equity market structure has evolved considerably and that the evolution is due primarily to changes in exchange structure, regulation, and technological advancements. One consequence of this evolution is the volatility the U.S. equity markets are now experiencing. These changes and their consequences are having a significant impact on the securities industry and investors.

Among the key findings of the report are:

• The U.S. equity markets are currently experiencing volatility not seen recently. Underlying changes in market structure over the last decade have contributed to the current market volatility. Specifically, the increase in funds seeking short-term performance; the growth in the use of derivative products; new technologies; the pervasive use of algorithmic trading and quantitative models; and the reduction in the role of specialists and market makers have all contributed to volatility. Current volatility is not unprecedented, the speed with which markets move today is.

• In 2005, the Securities and Exchange Commission adopted Regulation NMS (Reg NMS), the most significant change in U.S. market structure since the Congress called for the creation of a National Market System in 1975. Regulation NMS included a market-wide Order Protection Rule (OPR – Rule 611), and a realignment of the fee structure for market data. The implementation of the OPR imposed significant technological and other cost burdens on the industry. Whether this complex rule has been a net benefit to investors is open to debate, especially in light of the some 17 exemptions currently authorized by the SEC.

• Further, given the tangible costs in technology and intangible costs to the industry for compliance with Reg NMS, the STA recommends that in the future rules should specifically consider the costs and benefits on technological demands and capacity.

• Simultaneous to the implementation of Reg NMS U.S. equity exchanges migrated from member-owned entities to shareholder-owned for-profit concerns. This competitive model has allowed exchanges to better position themselves to markets remain competitive globally. From the trading community’s viewpoint, for-profit exchanges raise a number of issues that need to be addressed. In particular, investors require a coordinated and timely opening of stocks. The report also suggests that there be clear and comprehensive policies and procedures for clearly erroneous trades and for trading halts.

• For exchanges and investors, the opening process is a unique time of the trading day where intense price discovery occurs. The exchanges have begun to compete with each other to open stocks at the start of the day. While this competition has had valuable benefits, it has also created some investor confusion. Due to the importance of the open to the efficient functioning of the markets, the STA has had initial contact with exchange executives and will convene a meeting with all interested market participants with the goal of coming to agreement on an appropriate and coordinated opening process that is in the best interests of investors.

• Exchanges have transformed from membership-owned entities to shareholder-owned for-profit exchanges, enabling them to raise the capital needed to better position themselves for international expansion, competition, and investments in new technologies. This change in structure has created pressure to increase revenues by raising fees, such as market data fees. Concerns among market participants about the costs of trading on exchanges have led to a proliferation of alternative liquidity pools, sometimes referred to as “dark” pools do not publicly display their liquidity. Many broker/dealers have invested millions of dollars in technology to enable them to internalize or match orders within their own systems before attempting to execute those orders on exchanges. The increased volumes trading on alternative liquidity pools should be monitored to prevent any negative effects on robust price discovery.

• Pursuant to SEC rules, the exchanges collect, consolidate and distribute stock quote and trade information. This consolidated market data has been essential to the transparency in the U.S. securities markets and for facilitating best execution of investor orders. Exchanges assess market data fees, which are intended to compensate the exchanges for consolidating the data and for distributing the consolidated data. The growth in trading volumes has enlarged the pool of revenues charged for market data. Because most exchanges are now for-profit enterprises concerns of the ownership, pricing and distribution of market data fees have been heightened. Market data fees have important implications for the structure of the markets, as well as for all market participants. Therefore, STA recommends that the Commission undertake a comprehensive review of market data fees.

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