How the SEC should reform market structure

  1. Stop giving broker-dealers (and by extension, market makers) special trading advantages over institutional and retail investors.  There is no reason why broker-dealers should be able to price in sub-penny increments while investors cannot.  It’s bullshit.
  2. Tighten spreads.  Historically, this has been the biggest reason why trading costs have gone down for investors.  However, the SEC should be careful not to make spreads too narrow to preempt the “shaving” trading strategy.  Shaving is basically a strategy where you bid one penny more (on 100 shares) to stand in front of the line.  It currently exists as market makers can jump in front of any order by bidding an additional penny on 100 shares (e.g. sub-penny front running).
  3. Ban retail brokerages from taking kickbacks via payment for order flow.  Doing this would force retail brokerages to raise their rates to compensate for lost revenue from selling out their customers.  It may put an end to the “free” trades offered by some brokers.  This move might have bad optics politically but it would be the right thing to do.  This move would devastate the order internalization industry, which would have no reason to exist.
  4. Ban exchanges from giving special trading advantages to market makers.  (This stuff gets really complicated because there are so many trading advantages and because many of them are subtle.)  Of course the market makers would claim that they provide “liquidity” and are performing a valuable service for the markets.  They will claim that they need incentives to provide liquidity.

While the steps above won’t get rid of all the market abuses, they would dramatically reduce trading costs for investors.

The chance of this happening is almost zero.  The SEC gave special trading advantages to broker-dealers.  It played a role in creating the sub-penny front running game.  Currently, the SEC seems like it wants to confuse and mislead the investing public.  You can read their Twitter feed and the articles on their website (e.g. “research” that totally misses the point and this speech where a staff member pretends that complexity is a good thing).

In the past, I would blindly assume that regulators are the “good guys”.  Nowadays, I am disappointed in myself for being naive.  The reality is that the human beings who work at the SEC sometimes do the right thing and sometimes do not.

One thought on “How the SEC should reform market structure

  1. In terms of regulatory capture, the large financial industry players seem to have tamed the SEC years ago.

    Harry Markopolos’s book “No One Would Listen” makes the SEC come across even worse. Then again, explaining to multiple people in multiple offices of a regulatory agency that you’ve uncovered the biggest Ponzi scheme of all time, and being ignored over and over again seems to indicate that the SEC earned its reputation.

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