NMS II: The SEC wants to change the way you trade stocks; Here’s why it won’t work


AAlthough most trading these days is electronic, different asset classes still trade in very different ways.

There are different types of market models

At either end of the spectrum, there are two different ways to facilitate liquidity:

  • Dealer markets: When customers interact as known counterparties with an intermediary, usually a bank. Features of these markets include: two-way trading and personalized pricing from quote requests, transactions often required by ISDA and with credit exposure.
  • Foreign exchange markets: A centralized marketplace that allows all customers to meet in a single, cohesive market, generally anonymously. Features of these markets include: a global market with the best published prices from continuous quotes and public trade reports, streamlined and cleared settlement across all sites.

Chart 1: Foreign exchange markets and brokerage markets are structured differently

Source: Nasdaq Economic Research

How each market works is very different for investors. Most stock markets offer transparent and continuous valuation and price discovery. This includes actionable prices and guaranteed liquidity. There are also advantages to being a single anonymous marketplace, as one participant’s signal is obscured by noise from everyone else.

In contrast, dealer markets are characterized by “requests for quotes” and indications of interest. There is often no tape (or recording of other peoples’ trades) and rarely a pre-trade quote. So it is difficult to know if you have received a good price, no matter how good your trader is.

Few markets operate at both ends of the spectrum. Futures exchanges are probably the closest to pure forex markets, with one location per contract and centralized settlement and clearing. While credit and swap markets are generally the closest to brokerage markets, with ISDA arrangements and often with non-cleared, non-fungible exposures.

Stock markets are primarily trading markets

Stock markets around the world are almost all closer to stock markets.

The structure of the forex market has many advantages for investors. They generally treat all investors more equally. They are more transparent to everyone with a price record, making it harder to give small investors bad fills and easier for investors to assess their portfolios and plan their next trades.

The listing exchanges themselves also provide a layer of supervision and quality control to tickers that are listed. Combined, these features tend to make them safer and more accessible for small investors. This is why the US $ 10 trillion equity mutual fund industry is generally limited to purchasing shares of listed companies, while regulators limit the ownership of private equity to qualified investors.

Capital seeking to invest in US equities also lowers the cost of capital for companies despite structural advantages that make private equity increasingly attractive.

Despite this, the US stock markets exhibit some aspects of dealer markets. There is a robust “floor” market for retail and block trades, as well as client prioritization and two-way transactions which account for over 40% of over-the-counter transactions.

But the current rules still require that these over-the-counter fillings not be worse than the enlightened prices of the exchanges, and the SIP allows investors to accurately prove it after the fact. That’s why it’s important that informed quotes are as inclusive and competitive as possible.

While the SEC’s mission is to protect investors, their new NMS II proposals (see also here and here) subtly push stocks further down the spectrum into brokerage markets. Adding to fragmentation and intermediation, allowing trades and possibly devaluing informed quote (intentionally or not) could make the quote itself less useful.

Today’s litany of markets is far from “equal” to the way that characterizes the forex markets. Contentious quotes are already liquidity of last resort, affected only if bilateral relations are not already filling orders. As this segmentation increases, the provision of quotes becomes less attractive and spreads widen. Much like global warming, there is a tipping point where investors acting individually end up hurting each other as a group.

Graph 2: Where are the different markets on the spectrum?

Foreign exchange markets vs dealer markets

Source: Nasdaq Economic Research

It is difficult to quantify the costs of less transparent bilateral markets without data

Academics and practitioners, benefiting from the wealth of public data from forex markets, have massively over-analyzed the frictions and economics of stock markets. This has resulted in pilot projects and proposals designed to target the last little distortion of the priority or toxicity of queues. Ironically, what most of the results show is that when markets are fragmented (by discounts, places or levels or speed), investors often lose, although usually only a fraction of a. penny per transaction.

In contrast, little research on bonds indicates that they are much more expensive to trade, although there is little data to prove how good or bad the executions were.

A study, carried out by Professor Larry Harris, examined the fillings of retail investors buying corporate bonds. This study found that trades (worse executions than those transmitted on trades available in an electronic marketplace) occurred 43% of the time and earned dealers over $ 500 million per year. This was before the additional $ 700 million that dealers added to prices in their own margins.

Given the much lower liquidity of corporate bonds than stocks, a similar lack of informed and protected competitive pricing in stocks would cost investors between $ 5 billion and $ 12 billion per year.

Chart 3: Non-Quoted Data Costs for Investors Worse and No Way to Find Out

Source: Nasdaq Economic Research

Trading corporate bonds via

The problem with less transparent markets is that it took a professor with access to private data to calculate this. Investors in many brokerage markets do not have reliable prices to measure their executions (and sometimes their portfolios).

In contrast, the leading study of U.S. stock market transactions, which is adjusted for geographic latency, estimated that the actual costs associated with latency arbitrage are $ 11 million per year.

Chart 4: Trading costs increase as market transparency and liquidity decrease

Stocks, bonds graph

Source: Nasdaq Economic Research

The problem is not limited to bonds. A long list of regulations fines over the past decade, show that the brokerage and over-the-counter markets, from Libor peg to FX and gold close, are more difficult for investors to control best execution, especially when the prices themselves are not available. And of course dark pools were not spared.

Surprisingly, the value of fines imposed on the broker market overshadows the estimated costs of less transparency in the stock market (above), which in turn overshadows the “A few hundred million”Dollars that the new NMS II rules seem designed to save. It puts the cost of stock market data into perspective!

COVID tested

Continuous trading-oriented markets also have other advantages. In stressed environments, they bring all traders together in a single market with equal and exploitable quotes. This is especially important if some parties want to blur quotes or reduce risk. It also simplifies the search for price and liquidity.

The recent massive sale of COVID-19 is a great test case. All reports point towards bind markets seizing again (as they did in 2009). Although spreads widened, the volatility of bond indices stagnated, indicating a lack of liquidity and price formation in the physical market. It was later revealed that companies used around $ 300 billion in loan facilities just as asset managers saw it. record bond fund outflows totaling $ 218 billion in two weeks.

In fact, although bond ETFs traded at a discount to their bond market indices in March, these dislocations coincided with Treasury market yields hitting around 10 times above normal. Since T-bills are a “risk-free” asset, this highlights the failure of the underlying market more than the ETF market. Meanwhile, the continuous exchange-driven stock market has become a source of price discovery and liquidity for investors. This is supported by the fact that bond ETFs sold out even though they registered moderate net inflows.

Chart 5: ETFs ‘dislocations’ from bond market spreads indicate that the underlying market was not pricing prices effectively

BND dislocation

The cost of a worse price discovery is underestimated

As the stock markets face free retail commissions and a declining institutional commission portfolio, it’s easy to see US data prices as a friction to reduce.

But as this analysis shows, knowing the best market prices could quite easily be worth the cost.

Other countries have made efforts to keep stock markets more open and more equal. Canada has trading rules to stop profiting from others’ public quotes, while Europe has dark pool caps that limit trading in dark pools to 8% of total trade.

Over the longer term, moving US markets from a “single protected NBBO” to dealer markets may not result in better prices for all investors. History shows that the opposite is likely. Especially once investors don’t know what the best prices are.


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