Technology and Regulation: How Are They Driving Our Markets?

132 Pages·2009·0.59 MB·English

by  Ian Domowitz (auth.)

Technology and Regulation
For other title published in this series, go to
www.springer.com/series/7133
Zicklin School of Business Financial
Markets Series
Robert A. Schwartz, Editor
Baruch College/CUNY
Zicklin School of Business
New York, NY, USA
Other Books in the Series:
Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette:
The New NASDAQ Marketplace
Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette:
Electronic vs. Floor Based Trading
Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette:
Coping with Institutional Order Flow
Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette:
A Trading Desk View of Market Quality
Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette:
Call Auction Trading: New Answers to Old Questions
Schwartz, Robert A., and Colaninno, Antoinette:
Regulation of U.S. Equity Markets
Schwartz, Robert A., Byrne, John A., Colaninno, Antoinette:
Competition in a Consolidating Environment
Robert A. Schwartz John Aidan Byrne
•
Antoinette Colaninno
Editors
Technology and Regulation
How Are They Driving Our Markets?
Editors
Robert A. Schwartz John Aidan Byrne
Zicklin School of Business 169 Chestnut Terrace
Baruch College, CUNY Rockaway, NJ
One Bernard Baruch Way, B10-225 USA
New York, NY 10010
[email protected]
Antoinette Colaninno
Zicklin School of Business
Baruch College, CUNY
One Bernard Baruch Way, B10-225
New York, NY 10010
[email protected]
ISBN 978-1-4419-0479-9 e-ISBN 978-1-4419-0480-5
DOI 10.1007/978-1-4419-0480-5
Springer Dordrecht Heidelberg London New York
Library of Congress Control Number: 2009926068
© Springer Science+Business Media, LLC 2009
All rights reserved. This work may not be translated or copied in whole or in part without the written
permission of the publisher (Springer Science+Business Media, LLC, 233 Spring Street, New York,
NY 10013, USA), except for brief excerpts in connection with reviews or scholarly analysis. Use in
connection with any form of information storage and retrieval, electronic adaptation, computer software,
or by similar or dissimilar methodology now known or hereafter developed is forbidden.
The use in this publication of trade names, trademarks, service marks, and similar terms, even if they are
not identified as such, is not to be taken as an expression of opinion as to whether or not they are subject
to proprietary rights.
Printed on acid-free paper
Springer is part of Springer Science+Business Media (www.springer.com)
Contents
1 Opening Address ........................................................................................ 1
Ian Domowitz
2 The Impact of Electronic Trading Technology ........................................ 11
Richard Holowczak, Leslie Boni, Kevin Callahan,
Alfred Eskandar, James Leman, Robert McCooey, and Joseph Wald
3 Dialog with Erik Sirri ................................................................................ 25
Erik Sirri and Bob Pisani
4 Regulatory Initiatives: Implications for Competition
and Efficiency ............................................................................................. 35
Frank Hatheway, Leonard Amoruso, Douglas Atkin, Daniel Gray,
Richard Ketchum, Douglas Shulman, and Robert Wood
5 What the Buy-Side Needs .......................................................................... 47
Joseph Gawronski, Paul Davis, Fred Federspiel, Robert Gauvain,
Oscar Onyema, and Daniel Shaffer
6 Market Quality, The Big Picture .............................................................. 65
Nic Stuchfield, James Angel, William Harts, David Krell,
Andreas Preuss, James Ross, and Larry Tabb
7 Dialog with John Thain ............................................................................. 75
John Thain and Robert Schwartz
8 Divergent Expectations .............................................................................. 85
Paul Davis, Michael Pagano, and Robert Schwartz
Participant Biographies ................................................................................... 101
Index .................................................................................................................. 115
v
“This page left intentionally blank.”
Preface
This book is an augmented account of Technology and Regulation: How Are They
Driving Our Markets?, a conference hosted by the Zicklin School of Business at
Baruch College on May 1, 2007. The text includes the edited transcript of the full
conference: four panels and the major presentations of three distinguished industry
leaders – Ian Domowitz, Managing Director, ITG, Inc.; Erik Sirri, Director of the
Division of Market Regulation, US Securities and Exchange Commission; and John
Thain, who was CEO of NYSE Euronext at the time of the conference. The book
also includes a related paper by Paul Davis, Mike Pagano, and myself: “Divergent
Expectations,” Journal of Portfolio Management, Fall 2007.
My co-editors and I have worked diligently to make this book, like all the other
popular books in the series, more than an historical record. John Byrne, Antoinette
Colaninno and I have edited the manuscript heavily for clarity and unity of ideas.
New material is included from interviews after the conference with many of the
speakers. Our intention has been to round out the panel discussions with more
details, while being careful not to sacrifice the essential nature of the original dia-
logue. We worked closely with the panelists throughout the editing process to
ensure that we did not put words in their mouths. Indeed, all of the panelists
approved the final draft. We thank them for their assistance. We are also most grate-
ful to our sponsors who made this conference possible (see page xi). Their funding
and endorsement of our program are deeply appreciated.
Technology and Regulation was the tenth conference in our annual Zicklin
School of Business Financial Markets Series. Each year our theme has been some-
what different from the last. But the fascinating thing is that many of the same
underlying issues persist each year if you dig down deep enough. The debates sim-
ply do not end. I applaud this complex and dynamic industry for providing an
interminable array of issues!
Our first panel, under the leadership of my colleague Professor Rich Holowczak,
focused on technology while the second, under Nasdaq’s Chief Economist, Frank
Hatheway, turned to regulatory initiatives. In the third, moderator Joe Gawronski,
COO of Rosenblatt Securities, called our attention to, “What the Buyside Needs.”
Joes’s panelists were from the buyside and the sellside, which shows that it is not
only the buyside that has opinions about what the buy-side needs. In the final panel,
Nic Stuchfield, who at the time of the conference was Director of Corporate
vii
viii Preface
Development at the London Stock Exchange, brought us to the big picture. We
heard views from both sides of the Atlantic that included insightful perspectives
from both the equity and derivative markets.
I started the day off by presenting some of my own thoughts about the theme of
this conference. As we know, three forces drive our markets: technology, regulation
and competition. Competition, however, is not an external (exogenous) force simi-
lar to technology and regulation. Competition is a product of technology and regu-
latory developments. Also, our 2006 conference, Competition in a Consolidating
Environment, focused on competition. So, our 2007 event concentrated on the other
two forces, technology and regulation.
Technology and regulation were examined as collective as well as separate mat-
ters throughout much of the conference. The interaction between them is of great
interest as is clearly evident in the conference subtitle, “How Are They Driving our
Markets?” For instance, lately, dark liquidity pools have grown tremendously,
attracting much attention. What is the reason for this growth? Is it technology or
regulation, or both? The answer, undoubtedly, is both, but just how is it all playing
out? On another level, recent regulatory initiatives, such as the trade-through rule,
could not be implemented without technology. Reciprocally, at least some of the
technology innovations may not have been introduced without a regulatory push by
Washington. Technology advances occur on several fronts. Firstly, there is the
power, speed and capacity with which computers transmit and process information.
Secondly, computers have the ability to tie together disparate information sets, dif-
ferent marketplaces for the same product (e.g., stock), and different products (e.g.,
stocks and options). Finally, computers have been used to change the very structure
of a market. NASDAQ’s introduction of its opening and closing crosses is an excel-
lent example. The NYSE’s Hybrid Market is another. One might also note the novel
application of computer technology by two newer entrants, LiquidNet and Pipeline.
And then there is the International Securities Exchange, an automated marketplace
within which market makers play an integral role.
It pays to keep in mind, however, that technology is itself neutral. Whether its
impacts are desirable or not depends on just how technology is being used. To be
sure, computationally fast computers are great. But what are the market quality
implications of lightening-fast order handling that gives importance to microsec-
onds? And what about lightening-fast trading that has resulted in algos being used
along with “on-the-spot” human decisions?
Regulation will continue to have a tremendous impact on our industry. Back in
1997, just one decade before the 2007 conference, the Order Handling Rules come
on board. Today, in the US markets, we also have Reg NMS and the trade-through
rule. The trade-through rule will have a major impact on the operations of our mar-
kets. In Europe, market structure regulation is also taking center stage in the form
of MiFID, the Markets in Financial Instruments Directive. As we all know, each
major regulatory initiative on market structure, starting with the Securities Acts
Amendments of 1975, has generated substantial debate. I, along with many others,
have been sympathetic to the regulatory goal of making our markets fairer and more
efficient. But, based on my own view of the enormous complexity of the economic
Preface ix
issues involved, I have taken a more free-market stance toward the evolution of
market structure. Nevertheless, I will note one way in which the interaction between
technology and regulation can be very beneficial. Life may simply be too cushy for
a market center that faces only weak competition. A market center with monopoly
powers may be too slow to adopt new technology that would increase market effi-
ciency. Consequently, regulation can shakes things up. The Order Handling Rules
are an excellent example. The trade-through regulation in Reg NMS is another.
Even the very threat of regulatory intervention can have positive consequences.
Ernie Bloch and I pointed this out in a 1978 Journal of Portfolio Management paper
that we co-authored.1 At the time, the New York Stock Exchange had an order con-
solidation rule, NYSE Rule 390. In brief, the rule required NYSE member firms to
bring customer orders in exchange-listed stocks to the exchange for execution.
While the requirement was viewed by many as an unjustified monopolistic con-
straint on competition, others in the industry adamantly defended it. In light of this,
Ernie and I wrote, “Because of the expressed fears of industry, the SEC has been
able to use the threat of removing 390 as a club to get the industry to move itself in
the direction of an NMS (National Market System).”
Following major regulatory interventions such as those which we have seen, new
entrants can emerge and, as they do, the marketplace subsequently fragments. Then,
as time passes, the pieces get put back together again. In the process, a market center
may have re-engineered itself. Re-engineering has, in fact, occurred throughout
Europe, starting with London’s Big Bang in 1986. In the US, NASDAQ has reengi-
neered itself, and the NYSE has now completed that mission too. The 1997 Order
Handling Rules ushered in a period of intense competition in the US, followed by a
period of re-consolidation. Why the re-consolidation? Because markets exhibit huge
economies to scale, they convey enormous network externalities.
Let us hope that, after re-consolidation, some old problems will have been
solved. But will the new regulations have “unintended consequences”? Will new
problems appear? Will these lead to new calls for further market structure regula-
tion that will be followed by further rounds of fragmentation, intense competition,
and then re-consolidation once again? Three to five years hence, will our markets
be more efficient than they are today? Will we see yet lower transaction costs and
a level of intra-day volatility that is better contained? These are among the ques-
tions that were considered at Baruch on May 1, 2007. As one might expect, the
debates were lively. We hope that the excitement is conveyed in this book.
Robert A. Schwartz
1 Ernest Bloch and Robert A. Schwartz, ‘The Great Debate over NYSE Rule 390,’ Journal of
Portfolio Management, Fall 1978, pp. 5–8.