Over the last few decades, how stocks are traded in the United States has been totally transformed. Gone are the dealers on NASDAQ and the specialists at the NYSE. Instead, a company’s stock can now be traded electronically on up to sixty competing venues where a computer matches incoming orders. A majority of quotes are now posted by high-frequency traders (HFTs), making them the market makers that are the preponderant source of liquidity in the new market.
This new stock market has spawned a bewildering number of controversies. From the quoting practices of HFTs, to the rise of so-called dark pools (off-exchange trading venues that keep quotes – but not transactions – secret), to the Flash Crash, and payment for order flow, this new stock market is no stranger to criticism. This criticism came to a boiling point with the public furor surrounding last year’s publication of Michael Lewis’s book Flash Boys: A Wall Street Revolt. In the months following, the U.S. Department of Justice, the FBI, the Securities and Exchange Commission (“SEC”), and the Commodity Futures Trading Commission all confirmed investigations into HFTs. Plaintiffs’ class action lawyers filed multiple civil lawsuits based on criticized market practices. The New York Attorney General brought a high-profile lawsuit against the major investment bank Barclays, devastating its dark pool’s market share, and Congressional hearings were held, followed by calls for SEC action. Just recently, accusations of manipulative “spoofing” by the trader Navinder Sarao in the market for stock-index futures has been front page news.
What is true and what is false in all this controversy? In an article forthcoming in the Duke Law Journal, Professor Merritt Fox, Professor Lawrence Glosten, and Gabriel Rauterberg argue that a simple, but powerful, conceptual framework can greatly illuminate analysis of the new stock market. Just as appreciating principal-agent problems is indispensable to understanding the interactions among the shareholders, managers, and creditors of a firm, so we seek to identify the key economic dynamics driving contemporary trading practices and structures in the equity market. The foundation of our framework is adverse selection. Some of the most important participants in equities trading are “market makers” – parties that provide liquidity to the market by regularly posting both bid (buy) and offer (sell) quotes against which others can trade. Markets makers face a serious problem, however. Stocks trade in an information-driven market. At least part of the time, some of the individuals trading in the market possess private information about the value of a stock that other traders and market makers do not. These “informed traders” will only buy from a market maker when it is willing to sell at an offer quote lower than what the informed trader’s private information suggests the shares are worth. And that trader will only sell to the market maker when it is willing to buy at a bid quote higher than what the trader’s private information suggests the shares are worth. Such trades are not a recipe for success from the market maker’s point of view. If the market maker could identify which orders are from informed traders, it could avoid the losses due to trading with them, but the market is anonymous and the orders of uninformed and informed traders are mixed together. Trying to minimize being adversely selected by informed traders is thus a fundamental task of market makers. Doing so is socially valuable because market makers that minimize their losses to informed traders will, in a competitive market, offer cheaper liquidity to all traders. Two other dynamics round out our framework. The new stock market, unlike the quasi-monopoly of thirty years ago, is an open, multi-venue system. This changes how market makers deal with adverse selection and gives rise to some of the new stock market’s most controversial practices. The existence of multiple venues also spawns new principal-agent problems, in which broker-dealers can exploit their clients in ways that give rise to yet other such controversial practices.
We illustrate the utility of this framework by analyzing eight of these controversial practices in the stock market: electronic front-running by HFTs (the centerpiece of Flash Boys); “slow market arbitrage”; the exploitation of mid-point orders in dark pools; the relationship between volatility and HFTs; dark pools and inferior execution of orders; dark pools ignoring client orders; maker-taker fees; and payment for order flow. Some of these nefarious sounding practices turn out to be just as socially injurious as critics allege. They are sometimes already illegal, and we propose reforms that could strengthen enforcement. In other cases, there are trade-offs among multiple social goals that equity markets serve, complicating the analysis. We identify where further empirical research could be helpful as well as moderate structural reforms. In still other cases, such as electronic front-running, our framework shows how a practice is profoundly more complicated that what first meets the eye. What seems like exploitation may simply be reasonable order cancellation techniques by market makers, who are seeking to minimize losses to informed traders, in order to provide cheaper liquidity.
Beyond these eight practices, we think our analytic framework takes a step forward in clarity and will be of use to observers of our complicated new stock market with all the issues that it raises.
The preceding post comes to us from Merritt B. Fox, the Michael E. Patterson Professor of Law and NASDAQ Professor for Law and Economics of Capital Markets at Columbia Law School, Lawrence R. Glosten, the S. Sloan Colt Professor of Banking and International Finance at Columbia Business School and Gabriel V. Rauterberg, Post-Doctoral Research Scholar in the Program in the Law & Economics of Capital Markets at Columbia Law School & Columbia Business School. The post is based on their recent article entitled “The New Stock Market: Sense and Nonsense”, which is available here.