Challenge The National Market System

Introduction

To evaluate the National Market System (NMS), I compare the NMS with futures markets, seeking to use the most retail-investor-friendly components of both, thus creating a third structure that meets retail investor needs better. The objective is to design a wholly new separate financial market structure – call it the Simple market structure.

Designing a completely new structure is not a flight of fancy. The financial futures markets are an alternative structure competing with the NMS now, introduced circa 1975. By comparing the NMS with futures, perhaps a third structure better for retail investors can be identified. This article borrows the most efficient properties of futures and securities markets to produce the competing Simple structure.

What is wrong with the NMS?

How would a better Simple market structure differ from the NMS, the SEC’s version of the ideal environment for retail investors? I certainly hope there is a way to do better than the NMS. After all, retail investors no longer use the NMS much at all; see here. We cannot do worse than that.

The NMS has been the victim of the takeover of exchange-based transactions by multiple exchanges surrounded by legions of colocated computers. The NMS serves computers more than 90% of the time. Less than 10% of retail orders reach NMS exchanges. Retail orders are now primarily filled in the OTC market, returning us to the market structure of the 18^th century, electronified. That 18th century structure was built by dealers for dealers. Today’s structure reflects the same market interests.

This article sets out the functions of a well-run financial market structure. It contrasts a structure designed from scratch with the NMS that the SEC intends to reform with duct tape and baling wire.

The summary of the SEC proposal is to be found in the Federal Register SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 240 and 242 [Release No. 34-96495; File No. S7-31-22].

“If a retail broker sends an order to a wholesaler, before trading with the order, the wholesaler has to put it up for public auction at a stock exchange or other “open competition trading center. The auction would last between 100 and 300 milliseconds. Anyone could bid to trade with the retail order, and whoever offers the best price wins. If nobody bids, or if the original wholesaler has the best price, then the original wholesaler can trade with the order.”

This proposed structure looks something like this, compared to the current market structure and the SEC’s proposal.

Not simple enough. Good luck identifying efficient and inefficient components of the structure. The alternative Simple market structure borrows the best aspects of the NMS and financial futures, intending to improve on both.

How to evaluate the alternatives.

Here’s a list of performance criteria, paraphrasing the International Organization of Securities Commissions (IOSCO). IOSCO has three underlying characteristics of securities regulation. These are.

1. Investor safety.
2. Market efficiency.
3. Market transparency.

Below I apply these three criteria to the two major components of an exchange market structure: clearing and transactions.

The structure’s components are clearing and transactions.

Clearing. Retail investors would benefit greatly from a reexamination of the securities clearing process. Some components of NMS clearing are valuable to retail investors yet could be far less expensively provided, but some of the most expensive components are of no interest to retail.

The responsibility for implementing clearing in the NMS resides in the securities market clearinghouse, the Depository Trust and Clearing Corporation (DTCC). Consistent with its status as an afterthought of major broker-dealers reacting to periodic crises such as the Financial Crisis of 1987, the DTCC is slow to change and over-concerned with stepping on the toes of broker-dealers providing clearing-related services.

Notably, the structure of clearing in futures markets has proven safer than the DTCC during major market crises. Authors of the post cited above, Donald Bernhardt and Marshall Eckblad of the Federal Reserve Bank of Chicago, compare the two clearing methods during the Financial Crisis of 1987.

“Stock trade transactions settled after three days, while options and futures market trades settled after one day. This cash settlement mismatch forced traders and investors to wait two days for stock trade proceeds to arrive in their accounts even though payments for options and futures trades were required after one day. The mismatched settlement protocols resulted in a virtual standstill in trading after the opening bell on October 20. The Fed’s injection of liquidity later that morning encouraged stock trading to resume.”

The quote identifies two issues that a new market structure could address to improve market safety. First, same-day settlement is safer. Second, a safer market structure would clear securities and their derivatives such as futures within a single structure that trades both in tandem.

If a clearing structure is integrated with the exchange transaction engine, the practice in financial futures markets, it becomes feasible to make clearing and transaction one activity, reducing the time to settlement to zero.

The futures market clearing process is more efficient and safer than the NMS. But financial futures trading falls short of meeting the most fundamental investor need. Financial futures do not transfer dividends and interest to buyers at the close.

Securities transactions. There are four activities inherent in securities transactions.

1. Recording of intraday price changes.
2. Transfer of intraday price changes.
3. Payment of dividend and interest income to investors.
4. Transfer of ownership.

The recording of intraday gains and losses is an essential aspect of both futures and securities trading and is the sole function of a securities exchange transaction engine. Both kinds of marketplace separate this function from clearing. Transfer of intraday price changes (or settlement at the market close) is part of the clearing process in both markets. There is no important difference between futures and securities trading in these first two exchange functions. Transfer of dividends and interest income is the key distinction.

The securities most efficient in income transfer are exchange-traded funds (ETFs). ETFs are a useful model for a better structural settlement component. ETFs reduce clearing costs by transferring income without transferring ownership. An efficient retail investors’ platform would omit transfer of ownership.

The SEC’s NMS plan. Why it won’t produce the ideal market structure.

Don’t blame the SEC for the broken NMS. The SEC has limited ability to make changes. They can’t manage the firms that operate in the NMS, but only constrain these firms’ behavior. In essence, any regulation limits behavior. What is needed is active innovation. An alternative to the NMS. A reform that remakes the financial market structure from the foundation to the rooftop will excite retail investors.

An alternative.

The alternative clearing and transaction features of the Simple market structure follow from the comparison of the NMS to financial futures.

1. Recording of intraday price changes. The Simple structure is no different from the other two.
2. Transfer of intraday price changes. The Simple structure mirrors the structure of a financial futures clearinghouse, eliminating the problems of the Financial Crisis of 1987.
3. & 4. Payment of dividend and interest income to investors. The Simple structure uses the practice of an ETF, transferring income without transferring ownership.

Even these basic changes are beyond the reach of the SEC. To make them happen, we need a market structure separate from both the NMS and from financial futures markets. Following the lead of the SEC, which has in recent years approved only privately held new SEC-approved exchanges, a new market structure should avoid the publicly-traded ownership model of the NMS and futures exchanges, adopting the more customer-friendly Vanguard ownership model.

The Vanguard model is customer ownership. This model attracts retail investors because they know that after Vanguard pays its electric bill, the profits that remain won’t go to an anonymous Wall Street entity but to investors themselves.

Over the years, I have advocated that retail investors go further, applying the Vanguard model to an all-inclusive firm that includes both an exchange and subsidiaries that provide the remaining functions of any financial market structure.

Reader comments have been lukewarm. For example, “I don’t care if the broker I use, Fidelity, makes phantom pennies from their trade routing and bundling as long as I get the limit order price I pick.” In other words, Payments for Order Flow (PFOF) are OK with this reader, even though she might do a little better if a replacement were found.

Implicit in these comments is a skeptical notion of the gains from a retail-investor-managed universal financial firm. To many investors, the whole SEC market reform brouhaha is about trading zero commissions for a better bid-ask spread – small potatoes.

This article looks at a simple market structure that includes the entire spectrum of market structure functions. Does a full-function retail investor-oriented firm do enough to excite retail investors? Here is the list of new market functions the Simple market would provide.

• A retail-friendly, safer internal clearing structure. Use the futures clearing mechanism. It is simpler, safer, and within the control of the Simple market.
• A captive broker-dealer that assures Simple market prices are inside the SEC’s National Best Bid and Offer (NBBO).
• A complete record of the costs and revenues resulting from customer transactions and inventory.
• Zero clearing fees.
• Same-day instant clearing.
• Two-way payment for order flow with the NMS.
• An exchange that Issues and makes markets in new securities that are more retail-friendly.

The idea would be to combine Vanguard’s fund management services with a captive broker-dealer, portfolio manager, and a combined securities exchange and futures exchange. The firm’s philosophy would be to perform functions that would benefit retail investors more efficiently and to dispense with high-cost functions retail does not need.

• A captive broker-dealer. One improvement over the NMS would be to put retail investors on both sides of Payment for Order Flow (PFOF). Also to assure that prices in the retail investor’s marketplace improve on the SEC’s best bid and offer.
• A portfolio manager. A captive portfolio manager would issue and list investments designed to meet the needs of retail investors.
• A retail investor’s combined futures and securities exchange. The combined exchange would solve a problem of futures traders – lack of control over the market for the deliverable instrument – and a problem of securities traders – securities that meet the needs of issuers instead of retail investors.

The Simple market structure would look like that of the graphic below,

As the graphic shows, the Simple structure is worthy of its name. This simplicity carries with it transparency. Moreover, there is no doubt that the structure where all investors meet in the same marketplace will maximize liquidity.

Conclusion.

The NMS is a failure. The SEC understands that and has proposed a reform of the market structure. What stands out in an examination of the SEC’s proposed market structure is that it adds complication – and thus, added resource cost – to the current NMS. Market participants will inevitably pay for the added cost. The Simple market would reduce resource costs, adding transparency and liquidity.