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Fortunately, our market infrastructure is robust and has been up to the burdens that the recent turmoil has placed upon them. I'm not so sure that the people implementing those trades have fared as well.
Therein might lie the rub. As we have made our markets faster and less personal, we've very likely fueled some of the forces that have destabilized trading. Has the pursuit of speed come with some hidden costs, both for the markets and for the traders who interact with them? Should we just set the whole system on autopilot and let it run?
Isn't there still a need for human interaction?
Think of the average buy-side trader's experience in recent years. He or she has been tasked with ever-greater responsibility and must now monitor and trade in upwards of 40 separate execution venues. Quotes flicker incessantly, trading velocity has accelerated, and meaningful bids or offers have significant market impact. Reliable point-of-sale information is increasingly difficult to obtain, and when traders call a bulge bracket sales desk for help in managing an order, the phone is often answered by an inexperienced junior trader. After all that, who wouldn't be tempted to "put it in the box?" The sense that traders are flying blind is almost palpable.
I'm not suggesting that life was better in the "good old days." It's clear that we have made great strides in improving the functionality and accessibility of our markets, and we've eliminated many conflicts of interest along the way. Unfortunately, new conflicts have arisen and our markets still need improvement. What I am suggesting is that the aftermath of the Panic of '08 is a good time to make an honest appraisal of the current state of U.S. cash equity markets. Change is in the air.
The most noticeable change is the movement of order flow away from the bulge bracket firms. With capital in short supply that's no surprise. Throw in a healthy dose of counterparty risk awareness, and the result is a resurgence of the unconflicted agency execution model. Some of that resurgence can certainly be traced to unease about the state of the bulge bracket balance sheets, but I don't think that's the whole story.
Overburdened buy-side traders are disenchanted with the impersonal nature of today's trading environment and the inescapable sense that "you're on your own." They seek access to liquidity and solutions that provide context to market activity. Agency brokers provide those services. Traders vote with their order flow, and agency brokers are seeing marked increases in trading volume.
Human interaction was greatly reduced by the passage of Reg NMS, which simultaneously lessened individual accountability for market maintenance. We will have to wait for empirical studies to confirm this, but most traders I speak to are convinced that trade-to-trade volatility has dramatically increased in all but the most liquid names. Perhaps that is the price we all pay for the elimination of the specialist system, but we must recognize that speed for the sake of speed incurs hidden costs.
Unquestionably, pre-Reg NMS markets were slow and cumbersome at times, but the idea of slowing down the market during periods of duress has a place in the modern marketplace. On several occasions recently, the NYSE has declared an extreme market volatility condition as permitted by Rule 48. That rule allows designated market makers to seek contra-side interest to offset large opening and closing imbalances. The NYSE's actions protected the market from free fall and the resultant dampening of volatility benefitted the investing public. Faster markets are not always better markets.
Where does that leave us? In a bit of a quandary, I suspect. When speaking not for attribution, some leading buy-side opinion makers acknowledge that recent market reforms may have been too aggressive. They also concede that the new regulations resulted in the loss of positive aspects of the old system. Many of those same buy-side leaders had been vocal proponents of reform.
Unfortunately, most of them are unwilling to publicly advocate revisiting recent rule changes, and our conversations always seem to end with a Humpty Dumpty anecdote or something about the impossibility of putting the genie back in the bottle.
That raises the essential question: Should we as an industry accept the new market structure as immutable and refuse to revisit recent hot-button issues, or should we try to tweak the model? Shouldn't we be willing to acknowledge that some reforms have been counterproductive? While I recognize that the passage of Reg NMS took years of effort on the part of many within the industry, I believe that it is incumbent on all of us to ensure that the effort wasn't a "one and done" deal. The markets are too important for us to accept any status quo. Even one that was so painstakingly arrived at as Reg NMS.
Count me as one who believes that there is still work to be done. Whether it is addressing concerns about payment for order flow, unequal customer access to trading technology or simply a restoration of some human aspects of the business, it is obvious that there is room for improvement. Some improvements will come in the form of innovative technology that reproduces important benefits of pre-Reg NMS markets, while other improvements may come in the modification of the new rules. It's clear that the activity of the last few months has exposed some serious structural flaws, and for the good of all, it's time to correct them.
By Bernard McSherry
McSherry is senior vice president of strategic initiatives at Cuttone & Company, where he is a member of the management committee involved with strategic planning and market strategy. He has served in a number of leadership positions within the Industry and has chaired several New York Stock Exchange committees, including the Equity Traders Advisory Committee. He was also a member of the Market Performance Committee and served as a New York Stock Exchange Governor for six terms. He is a past President of the Alliance of Floor Brokers, an industry trade group and is a member of both the Security Traders Association of New York (STANY) and the National Organization of Investment Professionals (NOIP).
McSherry began his career as an options trader, overseeing floor operations for Walsh, Greenwood and Company. He founded McSherry & Company in 1988, eventually growing it into one of the largest independent brokerage firms on the floor of the NYSE. In 2000, McSherry & Company was acquired by SunGard Global Execution Services. Mr. McSherry served as CEO of its New York and London-based Broker Dealers for two years following its acquisition. He then joined Prudential Equity Group and held the position of Head of Sales Trading and NYSE Operations before joining Cuttone & Company in 2007.
