The Shifting Sands of Market Structure: Equity Trading in the Spotlight

Market Structure Overview and SEC Directives

• The US equity market consists of 11 active exchanges owned by four entities, 37 active ATSs (35 dark, 2 semi-dark), nine retail wholesalers, three single-dealer platforms, and two trade reporting facilities.
• SEC Chair Mary Jo White issued 13 directives to improve market structure, focusing on preventing instability, market fairness, high-frequency trading, transparency, conflict of interest, and supporting small companies.
• Panelists are divided on the efficacy of these directives; some view them as a positive move toward evidence-based policy, while others characterize them as "cosmetic facade changes" that fail to address core inefficiencies like the proliferation of 57 unique SEC-approved order types.
• A specific directive involves building stronger markets for smaller companies, currently being addressed through the TIC (Tick Size) pilot program and discussions around a potential US venture exchange model.

Tick Size Pilot (TIC) Controversy

• The Tick Size Pilot, mandated by Congress via the Duffy bill, proposes widening minimum price increments (ticks) for small-cap stocks, a move panelists largely view as a "bad solution to a bad problem" based on outdated 90s investment banking logic.
• Panelists, particularly from execution services, strongly oppose the "Trade-Out" provision within the pilot, which would force orders to trade on lit exchanges; they argue this reduces competition, impedes price improvement for off-exchange players, and effectively transfers wealth from investors to dealers.
• The SEC exempted retail orders from the Trade-Out provision, a move panelists acknowledge as correct, given that retail investors currently receive significant price improvement through competition among off-exchange market makers.
• Critics argue the pilot is a policy-based wealth transfer intended to force market makers to bundle research with trading, a premise rejected by modern market practitioners who do not believe wider ticks will generate increased IPO activity or research coverage.
• Winton's quantitative strategy team supports the pilot only on the condition that it includes a "date of death," viewing the temporary, empirical nature of the test as superior to permanent, "carte blanche" regulatory mandates.

On-Exchange vs. Off-Exchange and Dark Pool Regulation

• The US has approximately 43.3% of trading volume occurring off-exchange, compared to 5-8% in Canada, where regulatory structures limit dark trading to small institutional blocks or require a "trade-at" rule (unless price improving by half a spread).
• Panelists identify three primary drivers for high off-exchange volume in the US: access fees on exchanges (approx. 0.3 cents), the inability to trade in fractions of a penny due to the fixed 1-cent tick size, and the demand for anonymity.
• A "Trade-At" rule similar to Canada's is deemed unacceptable in the US by panelists, predicting it would result in a transfer of over $100 million annually in lost price improvement from retail to institutional investors.
• Dark pools are described as having smaller average execution sizes than exchanges, suggesting a proliferation of venues that do not add unique value to institutional trading or price discovery.
• Panelists note that 9.6% of US dark volume actually occurs on-exchange, blurring the regulatory distinction between lit and dark markets and highlighting the interconnectedness of liquidity across venues.

Execution Quality, Disclosure, and Data Costs

• Rule 605 and 606 have successfully improved transparency and execution quality for retail investors, but panelists highlight a significant data gap: there is no analogous standardized disclosure for institutional investors regarding order routing and execution quality.
• This lack of data prevents institutional investors from effectively evaluating venues, leading many to default to on-exchange execution (60% of volume) which may yield inferior results compared to diversified off-exchange liquidity.
• The cost of market data is identified as a "hidden tax," with exchange groups doubling revenues from data sales in recent years (e.g., NYSE's $253 million in 2014) as trading volumes shift off their platforms.
• Exchanges currently hold a monopoly on market data, allowing them to set prices arbitrarily; panelists advocate for regulatory caps and treating data fees similarly to utility rates.
• Canada prohibits payment for order flow (PFOF), whereas the US allows it, creating a regulatory arbitrage opportunity; the TSX is launching a new venue to help Canadian retail desks access similar economics without PFOF.

Industry Trends: ETFs, Capital Formation, and Research Funding

• The rapid shift of capital from active to passive funds (approx. $260 billion in vs. $80 billion out last year) poses a systemic risk to capital formation, as passive funds do not purchase IPOs or assist in secondary offerings.
• There is concern regarding the "passive concentration" where massive inflows into index funds cause price fluctuations unrelated to company fundamentals, particularly in small-cap stocks.
• Panelists anticipate the European MiFID II regulation, which will decouple research payments from trading commissions, will force US asset managers to "ring fence" research costs even if similar rules are not immediately adopted in the US.
• The conflict of interest in current US research funding involves asset managers using client money to pay for research that directly benefits the trading desk, a model panelists argue is unique to this industry and lacks standard pricing.

Future Regulatory Actions and Dates

• Panelists highlighted three critical dates for monitoring regulatory progress:
  • May 13: Deadline for the SEC to create a Market Structure Advisory Committee.
  • May 6: Expected announcement or updates regarding the Tick Size Pilot.
  • End of the Week: FINRA CEO Rick Ketchum's testimony before Congress regarding SRO rulemaking and potential card regulations.
• Upcoming discussions are expected to focus on adding "depth of book" data to the SIP (Securities Information Processor), a technical improvement previously deemed impossible but now targeted by new advisory committees.