Small investors focus of trading shake-up

Five years of adverse headlines about dark pools, flash crashes and high-frequency trading has hardly encouraged retail investors jumping on board the long-running US equity bull market.

However, the main US regulator of equities has not forgotten small investors and is looking at whether share trading requires a fresh approach.

On Wednesday, sixteen of the US equity markets' most experienced traders, executives and academics meet in Washington under the Securities Exchange Commission's first Equity Market Structure Advisory Committee.

This meeting will not focus on any of the attention-grabbing incidents such as the 2010 flash crash, the rogue algorithm at Knight Capital and numerous technology outages but an arcane part of the market's plumbing.

The SEC thoroughly revamped the US equity market in 2007 via a piece of market legislation, known as Regulation National Market Structure. This heralded greater competition by encouraging more trading venues, linked together by high-powered computerised systems, a change that has attracted hefty criticism.

Now the SEC and the industry are looking at potential remedies, in particular, the little known Rule 611, which makes sure investors receive the most competitive price for buying or selling shares in a company, across numerous trading venues.

"Rule 611 is the linchpin of Reg NMS and modern market structure in the US," says David Lauer, a former high-frequency trading software programmer and now president of Kor Group, a market structure consultancy.

"It's a piece of a much larger puzzle that includes off-exchange trading and market fragmentation and complexity. You cannot address them in isolation," said Mr Lauer, who is presenting at the meeting.

The SEC says Rule 611 has significantly reduced trading costs for investors by making sure the prices they see on a trading screen are legitimate. But behind those flickering publicly disseminated quotes, is a very complex world of sophisticated order types.

Electronic trading has greatly reduced the average size of share trades, making it harder to buy or sell large parcels.

To get around that, and in response to some customers' requests, exchanges have also brought out a series of even more exotic order types.

The profusion of so many different types that are spread across some 50 trading venues for US equities has introduced a great deal of technological complexity.

The FIA Principal Traders Group, a US trade association for high speed traders, in white paper in January, has called on regulators to eliminate the rule and restore investor confidence by simplifying the market and making it more transparent.

"The SEC has never gone back and evaluated these rules; was RegNMS a success?" says Chris Concannon, chief executive of BATS Global Markets, the country's second-largest stock exchange, who favours scaling back Rule 611.

"Before we agree new regulations, should we find out ?if these rules were effective?"

Eliminating the rule may also hinder some of its objectives. For its meeting, the SEC has flagged market concerns that institutional investors may be being disadvantaged by Rule 611, as it forced fund managers trading large blocks of shares to access small-sized quotations.

That would signal their intentions to high-frequency traders, critics argued. In a memo circulated ahead of the meeting, the SEC makes clear that critique was "based on misunderstanding".

Eric Noll, chief executive of Convergex, a broker and also on the panel, cautions that "we have to look carefully at the secondary effects".

Mr Noll is in favour of modifying the rule rather than eliminating it, arguing the aim should be to pull more trading back towards public exchanges from private networks, which currently account for 35 per cent of daily US equity transactions.

However, picking apart a single rule from the complex web of interlinking rules that govern other behaviours in the market is a difficult job, others warn. Besides eliminating Rule 611, the FIA PTG wants to eliminate Rule 610, which bans the market from offering an identical bid and offer price.

Mr Lauer points out that changing one rule in isolation will not settle the debate over trading. "When you look at the criticism of Rule 611, it is that it drives fragmentation, complexity and off-exchange trading, but it is not the only thing doing that," he says.

Some worry the committee will be little more than a talking shop. The industry has long grown used to trips to Washington for meetings with good intentions but which ultimately produce little.

At the Sifma conference, Jamil Nazarali, senior managing director and head of execution services at Citadel Securities, said it would accelerate the SEC's ability to understand the industry's view on many issues.

"If you look at the composition of the committee, there are a lot of diverse backgrounds. You can expect a lot of informed and spirited discussion. What you can't expect is agreement on virtually anything."

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