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Current Perspectives on Modern Equity Markets

Copyright November 2010 Knight Capital Group, Inc.

All rights reserved. No part of this book may be reproduced in any form

whatsoever, by photography or xerography, or by any other means, by

broadcast or transmission, by translation into any kind of language, nor

by recording electronically or otherwise, without permission in writing

from Knight Capital Group, Inc.

ISBN: 978-0-578-06874-9

Design and Production: Mighty Media, Inc.

Editor: Sue Freese

Printed in the United States of America

CLS & Associates

1850 M Street, NW, Suite 800

Washington, DC 20036

To obtain a copy of this book, please contact Margaret E. Wyrwas at

Knight Capital Group, Inc., [email protected].


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Contents

preface by Thomas M. Joyce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

chapter 1 Historical Perspective on Equity Markets: How We

Got Here, by James J. Angel . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

chapter 2 Overview of the U.S. Equity Markets Today, by Jamil

Nazarali . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

chapter 3 Imagine an Investor: Washingtons Historical Role inShaping the Industry through Regulation and

Legislation, by Arthur Levitt . . . . . . . . . . . . . . . . . . . . . . . . . . .21

chapter 4 The Retail Investor and the Reinvention of Equity

Market Trading, by Fred Tomczyk . . . . . . . . . . . . . . . . . . . . . 27

chapter 5 Liquidity and Volatility, by Lawrence E. Harris . . . . . . . . . . 37

chapter 6 Speed and Equity Trading, by Chester S. Spatt. . . . . . . . . . 47

chapter 7 Man versus Machine: The Regulatory Changes That

Led to the Modern Market, by Daniel Mathisson . . . . . . . 53

chapter 8 The Uproar over Flash: A Flash in the Pan,

by Gary Katz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

chapter 9 Market Structure Reforms: A View from the Buy-Side,

by Paul Schott Stevens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

chapter 10 The Importance of Financial Policy Makers Making

Informed Decisions, by Jennifer E. Bethel and

Erik R. Sirri . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

chapter 11 New Realities in the Era of Global Markets,

by Duncan L. Niederauer . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

chapter 12 Where Do We Go from Here? The Utopian

Marketplace, by Brett F. Mock and John C. Giesea . . . . . .117

index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126


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v

Preface

Thomas M. Joyce

chairman & chief executive officer,

knight capital group, inc.

Competition, technology, and innovation have dramatically changed the

way investors of every shape and size interact today. At Knight Capital

Group, we welcome the opportunity to engage in a dialogue about ourrapidly changing equity markets.

We are in the midst of a market transformation. Markets are more

efficient and more liquid than ever before, enabling investors to swiftly

access significant amounts of information and to rapidly execute their

transactions at remarkably low cost. But transformation is not, by nature,

smooth, and with change comes the responsibility of regulators and

policy makers to appropriately monitor its impact on the industry.

At Knight Capital Group, we believe appropriate rules and regula-

tions are needed to help maintain a level playing field for all market

participants. And as technology changes how we conduct business,

the rules that govern our markets need to continue to strike a smart

balance between appropriate regulation and the preservation of a viable

marketplace for competition and innovation. Open, transparent, vibrant

markets provide everyone with the freedom and power to reach financial

independence.

In fact, what interests Knight Capital Group most about this new way

of trading is its potential to continue to improve execution quality for

the average retail investor. A variety of trading platforms have already

benefited investors by enhancing the capital formation process, but they

have also made the equity markets more democratic and transparent

by providing all market participants with unfettered access to the best

trading technologies. Indeed, there has never been a better time to be an

investorlarge or small.


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vi p r e f a c e

In an attempt to better understand these profound developments,

Knight Capital Group invited industry experts to contribute their obser-

vations, insights, and recommendations and participate in a broader

discussion. Our goal in creating this book was to provide a body of work

that outlines how U.S. markets were shaped, how they currently work,

and where they may go in the future.

The words and ideas expressed in each chapter are those of its author

alone, and as such, you will find that ideas across chapters are some-

times at odds. Even so, we strongly embrace this platform and put forth

all the ideas for thought and discussion. We thank all of the authors andtheir affiliated organizations for contributing to this important project.

November 2010


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1

chapter

(

Historical Perspective

on Equity MarketsHow We Got Here

by James J. Angel , Ph.D., CFA

associate professor of finance, mcdonough

school of business, georgetown university

To understand todays and tomorrows equity markets, we need to

understand how the markets arrived at their present state. Doing so

involves understanding why equities are different from other financial

products and what technological, economic, and regulatory develop-

ments helped form the markets. This chapter provides a brief overview

of these topics.

Why Equity Markets Are Different

from Other Financial Markets

Equity markets are fundamentally different from other markets. In partic-

ular, equity markets tend to be highly structured and organized around

exchanges, while most marketseven most financial marketsare not.

Most goods and services trade quite nicely in decentralized, over-the-

counter markets. For example, we would not think of hiring a broker


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2 h i s t o r i c a l p e r s p e c t i v e o n e q u i t y m a r k e t s

to send an order for paper clips to the New York Paper Clip Exchange.

Instead, we would just call our local office supply store. Even most finan-

cial products trade without heavily structured and regulated exchanges.

Currencies, bonds, loans, and many derivative markets thrive without

centralized exchanges.

This difference between equity markets and other markets is driven

by information. It is relatively easy to price most goods and services and

even most financial products. The price of paper clips does not fluctuate

much, and it is pretty easy for customers to know if they got a good

price. Bonds are similar. If we know the term structure of interest ratesand current yield spreads, we can price most bonds. Knowing the spot

price of an asset and an estimate of volatility leads to accurate pricing

of most derivatives.

Equities are another story. No one really knows what an equity secu-

rity is worth. While owning a high-grade bond results in a nearly certain

cash flow, the cash flow accruing to an equity holder is highly uncer-

tain. Even identifying the correct discount rate to use is a matter of great

controversy and debate. Most pricing models for equities are highly

sensitive to the assumptions used. Small changes in assumptions can

lead to large changes in the estimated value. Indeed, Fischer Blackone

of the architects of the famous Black-Scholes option-pricing formula

felt that markets got prices within a factor of two at least 90% of

the time.1

Furthermore, while there is little private or inside information about

government bonds and currencies, there is a good deal of private infor-

mation about the value of the more than 10,000 equities that trade in

the United States and the more than 30,000 equities that trade world-

wide. When investors trade, they reveal some of their private informa-

tion about the value of a stock. This makes information about recent

trades and information about trading interest extremely valuable.

1 Fischer Black, Noise, Journal of Finance 41, no. 3 (July 1986): 533.


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c u r r e n t p e r s p e c t i v e s o n m o d e r n e q u i t y m a r k e t s 3

Naturally, traders and investors do not want to give away this valuable

information for free. Keeping it confidential gives them an advantage

over other market participants. However, traders do need good market

information to make sound trading decisions. As traders often note, they

want other investors to reveal confidential information while they want

to reveal none of their own. This leads to a so-called prisoners dilemma

of trading,2 in which each investor is better off revealing no information,

even though all investors would be better off if each revealed a little.

Organized equity exchanges arose as a solution to this prisoners

dilemma. Organized exchanges and trading platforms require the disclo-sure of at least some information as part of the price of access to the

exchange. Participants agree in advance to follow the exchange rules,

even though they may prefer not to disclose particular information about

their own trading activity. Some of that information is known only within

the trading system. For example, on the old floor of the New York Stock

Exchange (NYSE), brokers sometimes revealed partial information to

other brokers to find the other side of the trade. In modern dark pools,

the information is revealed only to the pool operator, who attempts to

match trading interest.

Assuring proper settlement and reducing counterparty risk are other

reasons for the existence of organized exchanges, especially derivative

exchanges. Having the buyer and seller agree on the terms of the trade

does not necessarily guarantee that it will be consummated according

to those terms. Exchanges quickly learned that they had to limit their

membership to honest participants with adequate financial resources

who would live up to their trading commitments.

2 The prisoners dilemma is a famous problem from game theory. In it, the police hold two

prisoners and interrogate them separately. The police offer each prisoner the choice

of whether to cooperate, with a penalty based on what the prisoner decides. In each

case, the prisoner receives a less severe penalty by cooperating, even though both pris-oners are better off if neither cooperates with the police. See Anatol Rapoport and A. M.

Chammah, Prisoners Dilemma (Ann Arbor: University of Michigan Press, 1965).


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The Network IS the Market

Another important point is that the equity markets involve a lot more

than a single exchange or trading platform. They comprise an entire

network of market participants. This complex network is comprised of a

wide range of institutions, including the following:

Regulated exchanges for equities, options, futures, and other

derivatives

Alternative trading systems

Clearance and settlement organizations

Financial intermediaries that trade for their own accounts, suchas dealers

Financial intermediaries that provide access to the market

Information intermediaries, which provide data ranging from

trade and quote feeds to advanced analytics and fundamental

research

Technology intermediaries, which provide communications and

technology infrastructure, such as data centers

Financial institutions, which operate the payment system

Lending institutions

Media companies, which produce and disseminate content

Regulators charged with maintaining fair and orderly markets

Registrars and transfer agents

Proxy solicitation firms

Regulatory institutions

Investors and traders

Along the lines of Sun Microsystems popular slogan The network IS the

computer, all market participants should remember that The network

IS the market. Focusing on only one part of the network can lead to

major misunderstandings of market behavior.


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Evolution of the U.S. Equity Market Network

Financial transactions have occurred almost since the beginning of civili-

zation.3 They started with the lending of money and the forming of busi-

ness partnerships. However, modern equity trading began in Amsterdam

around 1610 with shares of the Dutch East India Company (Vereenigde

Oost-Indische Compagnie).

Equity securities represent transferable ownership interests in corpo-

rations. Dividing business organizations into small, affordable pieces

made it possible for entrepreneurs to raise capital from multiple sources.

At the same time, having limited liability allowed investors to diversifytheir investments without fear of buying into a black hole of liability that

would devour their wealth.4 This lack of liability also made it easier to

transfer shares to new buyers.

Secondary markets in the securities of joint stock companies quickly

arose as these companies began to multiply. Merchants and traders

bought and sold securities just like other commodities, and specializa-

tion gradually developed. When the traders in these instruments realized

that their markets functioned better when organized, stock exchanges

began to spring up, first in Europe and then in the United States. The

Philadelphia Stock Exchange was founded in 1790, and the NYSE origi-

nated out of the famous Buttonwood Agreement of 1792. In that agree-

ment, a group of 24 brokers agreed to give preference to each other and

to fix minimum commissions; this system of fixed commissions would

last until 1975.

In the late-nineteenth and early twentieth centuries, stock exchanges

arose in the United States not only in large cities, such as New York

and Philadelphia, but also in smaller cities, such as Cleveland, Ohio;

Wheeling, West Virginia; and Beaumont, Texas. Given the limitations

3 Ernst Juerg Weber, A Short History of Derivative Security Markets (Social Science

Research Network, June 2008), http://ssrn.com/abstract=1141689 (accessed July 15,

2010).

4 In extremely rare cases, it is possible for courts to pierce the corporate veil and makeshareholders liable for the debts of the corporation. See Robert B. Thompson, Piercing

the Corporate Veil: An Empirical Study, Cornell Law Review76 (1991): 10361074.


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on communication in those days, these exchanges handled mainly local

securities for local investors. For example, the Beaumont Board of Trade

handled the stocks of local oil companies following the Spindletop gusher

in 1901.

Technology and regulation have shaped the U.S. financial markets, and

the U.S. markets have always been leaders in the adoption of information

technology. For instance, the invention of the telegraph and stock ticker

in the nineteenth century made it possible to transmit price information

and orders quickly and over large distances. Indeed, it was the skillful use

of the stock ticker to disseminate prices that led to the NYSE graduallybecoming the dominant stock exchange in the United States.

Financial markets display a large amount of network econom-

ics.5 Network markets are those in which the usefulness of a product

increases with the number of users. For example, one telephone by itself,

without a telephone network, is fairly useless. That telephone becomes

very useful, however, when connected to a network of other telephone

users. When two mutually exclusive networks compete, the larger

network usually wins, because its larger user base gives it an advantage

over the smaller network. Competition over technology standards (e.g.,

VHS versus Betamax, Blu-Ray versus DVD-HD, etc.) exemplifies this

type of network effect.

In the past, when communication between markets was difficult, each

market represented its own network of buyers and sellers. Since buyers

want the market with the most sellers and sellers want the market with

the most buyers, having a larger market network wasand still isa

huge advantage. Or, as traders put it, liquidity attracts liquidity. This

network effect also contributed to the NYSE emerging as the dominant

stock exchange in the United States.

The stock market crash of 1929 heralded the beginning of the Great

Depression. President Franklin Roosevelts New Deal policies included

federal regulation of the securities markets, which had previously been

5 Nicholas Economides, Network Economics with Application to Finance, Financial

Markets, Institutions, and Instruments 2, no. 5 (December 1993): 8997.


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regulated at the state level. A series of laws were passed to regulate

financial markets, beginning with the Securities Act of 1933 and the

Securities Exchange Act of 1934. In addition to creating the Securities

and Exchange Commission (SEC), the 1934 act also regulated national

securities exchanges and required exchange-listed stocks to disclose

information.6 The act also established national securities exchanges as

self-regulatory organizations (SROs) responsible for enforcing not only

their own rules but also national securities laws. The SRO model was a

compromise that allowed the industry to police itself (with SEC over-

sight), while sparing taxpayers the direct cost of enforcement. Gradu-ally, however, the SEC became the primary rule setter for the U.S. equity

market network.

At first, the Securities Exchange Act of 1934 ignored the unlisted

markets. Faced with the regulatory burdens of the new regulatory regime,

many smaller stock exchanges closed down, and many issuers preferred

the less-regulated over-the-counter market. This oversight was corrected

by the Maloney Act amendments of 1938, which required broker-dealers

who were not members of a national securities exchange to join one. This

led to the designation of the National Association of Securities Dealers

(NASD) as the SRO of the over-the-counter market.

Years later, the rise of computer technology fundamentally changed

the economics of markets. In 1970, Instinet launched the first electronic

alternative trading system (ATS), providing computerized matching of

customer limit orders. In 1971, NASD launched NASDAQ as a system to

broadcast dealer quotes.

A major watershed occurred in 1975 with the elimination of fixed

commissions on the NYSE. The result was much greater competition

among brokers, along with lower brokerage commissions. The same year,

Congress passed the so-called National Market System amendments to

the Securities Exchange Act, which directed the SEC to facilitate estab-

6 Other important U.S. laws include the Commodity Exchange Act of 1936, the Trust Inden-ture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act

of 1940. These laws have been amended many times over the years.


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lishment of a competitive and efficient national market system. The 1975

amendments also increased the regulation of exchanges as securities

information processors (SIPs) and required advance approval of SRO rule

filings, thus increasing the role of the SEC as the primary determinant of

U.S. market network rules.

Additional technological developments continued to change the face

of stock trading. In 1976, the Cincinnati Stock Exchange became the first

fully electronic stock exchange. Toronto launched its electronic CATS

system in 1977.7

A major scandal erupted in 1994, when NASDAQ dealers were accusedof colluding to maintain wide bid/ask spreads.8 The SEC responded in

1996 by imposing the order-handling rules.9 These rules required dealers

to reflect customer limit orders in their quotes. Furthermore, quotes from

other electronic communications networks (ECNs), such as Instinet,

were added to the consolidated quote montage. These changes made

it possible for customers to bypass dealers and trade directly with each

other, which resulted in a narrowing of NASDAQ bid/ask spreads. The

changes also led to an explosion in the number of ECNs.

Following political pressure, the minimum price variation, or tick size,

fell from one-eighth of a dollar to one-sixteenth in 1997 and then to one-

hundredth (i.e., one cent) in 2001.10 Bid/ask spreads fell dramatically as

a result.

Also during the 1990s, many exchanges around the world adopted

fully automatic trading systems, closed their trading floors, and converted

from membership organizations into publicly traded joint stock compa-

7 Donald E. Weeden, Weeden & Co.: The New York Stock Exchange and the Struggle over

a National Securities Market (Greenwich, CT: Author, 2002), and Ian Domowitz, The

Mechanics of Automated Trade Execution Systems, Journal of Financial Intermediation 1,

no. 2 (1990): 167194.

8 William G. Christie and Paul H. Schultz, Why Do NASDAQ Market Makers Avoid Odd-

Eighth Quotes? Journal of Finance 49, no. 5 (Dec. 1994): 18131840.

9 SEC Release No. 34-37619A, Order Execution Obligations (Sept. 6, 1996).

10 SEC Release No. 34-42360, Order Directing the Exchanges and the National Associationof Securities Dealers, Inc. to Submit a Decimalization Implementation Plan Pursuant to

Section 11A(a)(3)(B) of the Securities Exchange Act of 1934 (Jan. 28, 2000).


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nies. American exchanges were slow to follow this trend, however. The

NASD spun off NASDAQ in 2000, as it gradually evolved from a system

that displayed decentralized dealer quotes into a centralized limit order-

matching engine. The NYSE demutualized in 2006 through its acquisi-

tion of the electronic Archipelago Exchange.

In 2005, the SEC promulgated Regulation NMS (National Market

System), which required stock exchanges to honor the quotes of other

exchanges but only if they were accessible for automatic execution.11

This forced the NYSE to automate its executions. At the same time, it

lessened the network advantage that the NYSE had enjoyed, as it madeit much easier for other markets to compete with the exchange. The

NYSEs market share in its listed stocks fell from 79.1 percent in 2005 to

25.1 percent in 2009.12

Much like U.S. markets, global markets have also consolidated and

deconsolidated. Both NYSE Euronext and NASDAQ OMX are now

global exchange operators, and cross-border competition in Europe is

eroding the market shares of once dominant local exchanges. Moreover,

liquidity is increasingly provided by so-called high-frequency computer-

ized traders, rather than flesh-and-blood humans. The flash crash of

May 6, 2010, resulted in the implementation of stock-by-stock circuit

breakers, which were previously missing from the U.S. markets.

Equity markets have evolved a lot in recent years, and they will

continue to do so with developments in the technology and regulation

of financial markets. Specifically, changes in financial and information

technology will make new forms of trading possible, and regulators will

struggle to understand and catch up with the changes.

11 SEC Release No. 34-51808, Regulation NMS (June 9, 2005).

12 SEC Release No. 34-61358, Concept Release on Equity Market Structure (Jan. 14,

2010).


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11

Overview of the

U.S. Equity Markets Todayby Jamil Nazarali

senior managing director,

head of the electronic trading group

for knight capital group

For better or for worse, the U.S. equities markets and the U.S. economy

are inextricably linked. While the ups and downs of the market may seem

random, the stock market is actually quite a good forecaster of economic

activity six to nine months in advance. Investors focus on future earn-

ings, determining whether they are confident they can make a return on

the money they invest today.

This predictive capability, driven by the collective wisdom of millions

of market participants, is why the S&P 500 is included in the Conference

Boards Leading Economic Index and why the Federal Reserve considers

the performance of this index when setting the United States monetary

policy. Policy makers are joined by analysts, the media, and the public

in their daily watch of closing prices. All of the nightly news broadcasts

include a segment on the equities markets for a reason: because it

provides insight into where the country is headed.

This collective wisdom can become a virtuous feedback loop or a

negative spiral. If everyone expects the economy to do well and starts to

chapter

)


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12 o v e r v i e w o f t h e u . s . e q u i t y m a r k e t s t o d a y

invest, this by itself can create demand by corporations to hire people,

who in turn will spend more to create more demand for more products,

and on and on. But the opposite effect can also happen. A look back

at the performance of the stock market and economy in the months

following the Lehman Brothers collapse in 2008 reveals that corpo-

rate payrolls were shedding jobs at a rate not seen in decades. Market

psychology can become self-fulfilling prophecy, it seems.

Individual investors have taken on an increasingly significant role in

this feedback loop as their participation in the market has skyrocketed

over the last three decades. From 1980 to 2009, the number of house-holds that owned mutual funds (which in turn invest in equities and other

assets) grew from 4.6 million to 50.4 million, an average annual increase

of 8.6 percent.1 From 1989 to 2007, the median value of stock invest-

ments among those households participating in the market increased

from $9,000 to $35,000.2 Much of that growth came from increased

participation in retirement plans such as IRAs and employer-sponsored

defined contribution plans such as 401(k) accounts. The total amount

of assets in these plans was $8.6 trillion in the first quarter of 2010, up

from $700 billion in 1985.3

Its been a rough couple of years for investors. At the time of this

writingthe close of July 2010U.S. investor confidence remains signif-

icantly lower than it was in the aftermath of the 9/11 terrorist attacks,

with almost half believing that U.S. economic conditions are getting

worse.4 Ponzi schemes, big bank failures, sovereign debt, and other crises

1 Investment Company Institute, 2009 Investment Company Institute Fact Book: A Review of

Trends and Activity in the Investment Company Industry, 49th ed. (2009), http://www.ici.

org/pdf/2009_factbook.pdf.

2 Federal Reserve Board, Survey of Consumer Finances: 2007, http://www.federalreserve.

gov/pubs/oss/oss2/scfindex.html (accessed August 2010).

3 Investment Company Institute, The U.S. Retirement Market, First Quarter 2010, Research

Fundamentals, http://www.ici.org/pdf/fm-v19n3-q1.pdf (accessed August 2010).

4 Rasmussen Consumer Index, Rasmussen Reports, http://www.rasmussenreports.com/public_content/business/indexes/rasmussen_consumer_index/rasmussen_consumer_

index (accessed August 23, 2010).


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have piled on the fear and made investors reticent to invest surplus cash,

let alone remove it from under the mattress.

The U.S. equity markets have been unfairly caught up in the tumult.

Through it all, the stock market has continued to serve its vital role in

the U.S. economy: to allow for the efficient allocation of capital to start

new ventures and help companies grow and to allow for individuals to

pursue their dreams.

The Primary Market and theCapital Formation Process

In its essence, an equity market is a public facility in which parties can

come together to trade stock, or shares of a company, at published prices.

An equity market can be a physical location for trading, such as the New

York Stock Exchange (NYSE), or it can be a virtual world where trading is

conducted electronically. NASDAQ, Direct Edge, and BATS all fit this bill.

Within this framework, there are two types of equity markets, both

critical to the health of the U.S. economy all the way down to the finan-

cial well-being of individuals. To appreciate the whole, it will be helpful

for us to focus on a specific interaction.

First, theres the interaction of the growing company and the equity

markets through whats called the primary market. Since the beginning of

the NYSE in 1792, the U.S. equities markets have evolved into a complex

matrix of investors, brokers, dealers, exchanges, and alternative venues.

Companies use the equity markets to raise capital, which is then used

to grow their businesses, pay their debts, or simply provide their owners

with a means to reduce their stakes by creating a market for their compa-

nies shares.

For example, Starbucks started selling coffee in its first store in 1971.

Armed with the belief that consumers would seek and pay for an Italian

coffeehouse experience, the company began opening locations outside

its hometown of Seattle in 1987. As a private company, Starbucks had

limited access to capital, and so it turned to the public equity marketswith an initial public offering in 1992.


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Going public on the NASDAQ changed Starbucks forever, allowing

the company to open 16,000-plus locations in more than 50 countries.

One might even say that this event changed our coffee-drinking habits

forever. But its not an exaggeration to say that company access to the

primary market has changed the world and continues to do so.

Take, for example, the effort to reduce reliance on oil and otherwise

go green. Wind farms, bio fuels, and other alternatives all require capital

to pursue and build out ideas. How about the race to cure diseases such

as cancer? Pharmaceutical companies, medical device manufacturers,

and other innovators need equity to help fund their research. And thelist goes on. Guaranteed, we wouldnt be Googling on our iPhones for the

nearest Starbucks location if these companies hadnt been able to seek

equity investors in the public market.

Companies do have the option of private investment. Venture capital

(VC) firms may help fund a start-up, but its their confidence in the U.S.

equities market that allows them to raise money. VCs and their clients

want their money back eventuallywith a healthy returnand they seek

it through a public stock offering. Theres also debt, but the fixed income

markets cant compete in terms of cost and transparency with equi-

ties. One of the primary benefits of raising equity versus debt is that a

company doesnt need to make interest and principal payments, freeing

funds for use in other corporate activities.

While the U.S. equity markets are strong, we can find plenty of exam-

ples of the opposite. The effort to build a much-needed power plant to

meet the needs of an exploding population in India or China, for example,

is hindered by the lack of a deep, liquid market, forcing the intervention

of the government or a foreign investor. Theres little ability to build infra-

structure without burdening the general population or opening the door

to outside political influence.

Further, theres growing recognition that industries such as utilities and

airlines can be more efficient and competitive as publicly owned compa-

nies than as state-owned enterprises. Weve seen increasing denation-

alization in countries such as the United Kingdom and Russia. Here athome, U.S. citizens have recently become acquainted with governments


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influence on business and, for the most part, expressed extreme discom-

fort with Uncle Sams ownership in banks and auto manufacturers.

The Thriving Secondary Market and the Investor

Once a company goes public, its shares can be traded in the secondary

market, or aftermarket. Just as the health of the equity markets impacts

innovation, job formation, and the like, its also the key to individual

wealth formation.

Enter the investor. Lets say his name is John. One of Johns dreams isto save money for his daughters college education. To get a little extra

out of his savings, John seeks a way to make his money go farther. He

looks to the equity markets to buy shares of companies like Starbucks,

taking the chance that he will make a profit on his investment when he

goes to sell his shares down the road. John is joined in the marketplace

by other individuals and institutions such as mutual funds, hedge funds,

pension plans, and insurance companies. The path of a typical trade is

illustrated in Figure 2.1.

Figure 2.1.

Typical trade execution path in U.S. equity market

Institutions

Retail

H[jW_b?dl[ijeh

H[jW_b%


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For investors big and small to wade into the U.S. equities markets,

they have to know that they can access their investments quickly, easily,

and cheaply. John may need cash in the short term if he loses his job, or

he may be close to retirement and want to change his allocations and

manage risk.

Again, individual investorsalready spooked by gloomy newshave

become even further on edge because of recent events, including the

May 6, 2010, flash crash. Theyre questioning whether the U.S. equi-

ties markets are working as they should. Theyve pulled back from direct

investment in the markets as well as from mutual funds and other invest-ments through institutions.

The vitality of the markets should not be in doubt. In the U.S. stock

market, the liquidity is readily available for John to get in and out as

he desires, as smoothly as possible, as his situationhis lifechanges.

Even in the depths of the recent crisis, during the fall of 2008, the U.S.

equities markets never stopped working. Investors may not have liked

the value of their investments on the computer screen, but if they were

willing to sell at that price, they could always have found a buyer.

Liquidity and the Role of the Market Maker

Today, the market has never been more liquid. The number of shares

available at the national best bid/offer (NBBO), as well as within a 6-cent

range of the NBBO, has trended steadily upward over time.5 John there-

fore has a high probability of selling 1,000 shares at or near the price he

sees on the screen. Technology, regulatory changes, and competition have

created this depthwith interconnectivity between various exchanges

and pools of liquidityand made it possible for market participants to

electronically make markets and post quotes away from the old exchange

floors. In fact, it is the market maker who plays a critical role in making

sure the U.S. equities markets continue to work as well as they do.

5 Equity Trading in the 21st Century, Knight Capital Group, February 23, 2010, http://

www.knight.com/newsroom/researchAndCommentary.asp.


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When John is ready to sell out of one of his more volatile tech hold-

ings for a utility or another typically safer stock as he nears retirement,

another individual buyer at the same price, size, and moment in time

isnt necessarily ready to take the other side. Rather, when John presses

the button to buy stock through his online broker, that broker will most

likely route the order to a third party. In days past, that third party was

an exchange like the NYSE or NASDAQ. However, regulatory changes,

technology, and competitive dynamics fueled competition and the rise of

alternative sources of liquidity, including the market maker, where most

brokers now route their orders for execution.One of the reasons the U.S. equities markets are so efficient is that

when a market maker receives a customer order, it can cross it with

other customer orders. For example, if the market maker receives a

market order from a customer at Merrill Lynch to buy 100 shares of IBM

and theres another order to sell the same stock at the same price from

Scottrade within the market makers books, the orders will cross and the

trade will be executed at subsecond speed. If the market maker doesnt

have an opposing customer order for that buyer of 100 shares of IBM, it

can fill the order by selling IBM shares from its own account, otherwise

known as internalization. In this case, the investor gets the price at the

NBBOthe best publicly available price at the time of the tradeor even

better. So in addition to speed, market makers can provide investors with

the opportunity of price improvement.

Sometimes, the market maker decidesbased on market condi-

tions, its current inventory, and/or its view of the marketto route a

customer order to another venue for execution. Traditionally, the NYSE

and NASDAQ were the primary recipients of U.S. equity orders for most

U.S. equities. However, in 2005, Regulation NMS changed the competi-

tive landscape. Now, the best quote is protected no matter where it was

posted. Newer exchanges, such as Direct Edge, ECN, and BATS, can

compete with the old guard by posting a better bid and ask.

As the market has evolved during the last few years, more choices than

ever have become available in which retail trades can be executed outsidethe primary listing exchange, including dark pools, electronic communi-


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cents per share in 2010, while as recently as 2004, commissions were

closer to 5 cents per shareover a 40 percent decrease8helping asset

managers offer lower-fee products. Even better for the little guy, the U.S.

equity markets represent one of the few marketplaces in which an indi-

vidual can make a trade more cheaply than a big customer. John might

trade 1,000 shares for $10 through his online broker, while a mutual

fund will pay a commission per share. When you multiply the savings

times the 10-plus-billion shares that trade every day, that means tens of

millions of dollars are staying in the pockets of investors.

These are explicit fees. There are also implicit fees in the form of spreads.In fact, these have also come down over time, because of both competi-

tion and decimalization (after which stocks were quoted in penny incre-

ments versus fractions). So, in the U.S. equities markets, spreads are often

a penny, and investors can buy and sell instantaneously. On a $20 stock,

1 cent is 0.05 of 1 percent. Imagine for a moment that the housing market

worked the same way. That would mean you could instantly sell your

$300,000 house to an intermediary who would hold onto it until finding

a buyer for the mere price of $150. This low trading cost means that for

stock investors, its a lot easier to rebalance their portfolios for risk and

access cash when they need it. Its also a lot easier and quicker, generally,

for the value of the holdings to increase and ultimately cover these costs.

Both explicit and implicit trading costs are important, no matter how

small they are or become, because its very hard to beat the overall

market. This is actually a good thing. Millions of buyers and sellers are

in the market every day, analyzing millions of pieces of information. And

in the United States, investors large and small have access to the same

information, leading to an incredibly efficient system. Sometimes, its

hard to reconcile that efficiency with wild price movements. Could the

value of a company change so much in so little time? Maybe yes, maybe

8 Greenwich Associates, U.S. Equity Trading Business Falling Short of Expectations

in 2010, June 2010, http://www.greenwich.com/Greenwich0.5/CMA/campaign_

messages/campaign_docs/naeif-10-GLG.GR.pdf; and Brokerage Commissions andInstitutional Trading Patterns, Review of Financial Studies, 22 (December 2009), http://

www.terry.uga.edu/profiles/pub_docs/rf5175%20commissions.pdf.


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no. Either way, theres a collective genius, which makes it difficult for

active managers to outperform indices. And ultimately, this means that

the prices we all see on the screenwhether through a professional

Bloomberg terminal or an online account accessed from a laptop in the

living roomare fair. (All of this makes a case for investing in ETFs and

index funds, but thats another topic entirely.)

The U.S. equity markets are the envy of the world and the basis for

Americans wealth creation and innovation over the last 100 years. The

liquidity is unparalleled, and the fairness, efficiency, and cost unmatched.

Recent events must be put in context. Certainly, changes to the market-place over the last 10 yearsprimarily technology drivenneed to be

reviewed and addressed, but carefully. Not in a vacuum, not as a knee-jerk

reaction, but as a thoughtful, data-driven effort to protect this treasure.


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21

Imagine an Investor

Washingtons Historical Rolein Shaping the Industry through

Regulation and Legislation

by Arthur Levitt

former chairman of the securit ies and

exchange commiss ion (19932001)

During my time at the Securities and Exchange Commission (SEC),

discussions of market structure always seemed to begin with the mantra

of the National Market System (NMS). Congress urged the SEC to expe-

dite the development of a system of multiple, competing markets linked

through technology. The core goals of that system included (1) efficient

execution of transactions; (2) competition among exchanges and other

market centers; (3) transparency of market data; (4) the brokers duty ofbest execution; and (5) the opportunity for the interaction of customer

orders without the participation of dealers.

The clarity of the NMS mantra somehow became obscured once the

discussion turned to what the framework actually required. The SEC and

its staff were faced with difficult and fundamental trade-offs among the

core goals that were daunting in both complexity and detail. These trade-

offs are the key to understanding how the SEC approaches the regulation

chapter

*


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22 i m a g i n e a n i n v e s t o r

of trading and markets in the face of intensive and conflicting political

pressures. For me, the essential guideline for reconciling often competing

NMS objectives is simply to recognize that the point of market structure

is to make markets work for investors.

Market Competition versus Order Interaction

Perhaps the most difficult market regulation trade-off resulted when

Congress rejected the approach of a single central market and opted

instead for a system of multiple competing markets. In doing so,Congress essentially traded off the optimal order interaction and pricing

efficiency of a single market to achieve the dynamism of competing

markets. This trade-off means that the most aggressive bidder for a

stock may be separated from the most aggressive seller because the

sellers order is in another market. On the other hand, having multiple

competing markets tends to ensure that markets will drive each other to

innovate, at least in theory.

Some parties, of course, strenuously opposed the trade-off from the

beginning. Early on, members of the New York Stock Exchange (NYSE)

argued that prices suffer when buyers and sellers are scattered across

multiple exchanges, rather than forced into a central meeting place

preferably, the NYSE floor. Ultimately, Congress was persuaded that the

costs associated with a monopolistic utility were not worth the pricing

efficiency of a single central market.

The same tension between goals of order interaction and market

competition continued into the late 1990s in the debate over NYSE rule

390, which prohibited NYSE members from dealing in listed securi-

ties away from an exchange. While the NYSE and other proponents of

centralized markets argued that the rule prevented the fragmentation of

trading interest, most saw the rule as providing an anticompetitive use

of market power. In the end, the SEC struck a balance in favor of market

center competition and sided with opponents of the rule. It may be that

rule 390, at the time it was abandoned by the NYSE, was of limited prac-tical significance, in that most market participants had found ways to


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effectively avoid it. Regardless, the NYSE abandoned the rule only when

the threat of SEC rule-making became clear and the symbolism of its

demise was important. In any event, the decade that has passed since

then has seen intense competition among markets.

In particular, the NYSE and NASDAQ have become global, publicly

held technology companies, fueled by their acquisitions of former elec-

tronic upstart competitors. More recently, these exchanges have been

joined by electronic exchanges such as BATS and Direct Edge. Trading

volume has dispersed among these venues, with no individual venue

accounting for more than 20 percent. Significantly, more than 30 nondis-played venues or dark pools now operate, executing approximately 8

percent of marketwide volume in the NMS (according to SEC statistics).

Investors today have a wide-ranging choice of execution venues and

enjoy faster, cheaper, more reliable executions than ever before. In addi-

tion to expanding choice and reducing costs for investors, this competi-

tion has woven a level of resiliency into the U.S. market structure that

simply was not there a decade ago. It seems clear to me that promoting

competing markets has helped deliver greater dispersion and redun-

dancy to the market infrastructure, and in doing so, it has significantly

enhanced U.S. financial markets security.

Even so, recent SEC pronouncements make it clear that the commis-

sion is now sharply focused on the potential effects of the dispersion

of liquidity across multiple trading venues on the ability of orders to

interact with one another. The troublesome tension between a system

of multiple competing, ever-innovating markets and an acceptable level

of interaction between buyers and sellers across markets shows no sign

of relenting.

Transparency versus Market Competition

The goal of market data transparency also forces difficult trade-offs with

market center competition. On one level, the data produced and the

types of orders offered by an exchange are at the core of the exchangesproduct and competitive edge. On another level, the key components


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of that data necessarily belong to the public quote stream. Not surpris-

ingly, exchanges sometimes see commercial advantage in practices by

which they limit distribution of certain data to its members. The goal of

competition among exchanges arguably favors allowing the exchange to

tailor its product to its customers and to compete as it sees fit. The goal

of market transparency, however, calls for protecting the integrity of the

public quote stream by prohibiting the selective dissemination of core

quote and price data.

This trade-off that is sometimes required between market center

competition and transparency underlies the recent SEC proposal to banflash orders. A flash order occurs when an exchange exposes an order

privately to its members before routing it to another exchange offering

a better price, thus giving members an opportunity to interact with the

order. In essence, flash orders create a private marketone limited to the

members of the exchange and cordoned off from the stream of public

quotes. In this respect, flash orders strike me as a perilous departure

from the transparency that has become one of the hallmarks of the U.S.

market system. I believe the SEC was correct in ultimately proposing to

ban them.

Yet I also understand why the SEC was slow to take this action. It

is hard to deny that flash orders were the product of intense market

center competition. They were part of the hunt for the big, fast, lucrative

customers known as high-frequency traders. In addition, it seems clear

that offering flash orders directly affected the battle for market share

among the NYSE, NASDAQ, BATS, and Direct Edge, with those venues

that offered flash orders gaining at the expense of those that did not.

Although the SEC may have been reluctant to step into the middle of

this interplay of competitive forces, the promotion and protection of the

public quote stream required it to do precisely that.

An analogous intervention in market center competition took place in

1996 with the adoption of the limit order display rule. This rule mandated

for the first time that brokers display in the public quote those customer

orders priced better than the quote. Overnight, previously hidden inves-tors orders became visible to the marketplace, and investors began to


32/138


compete with dealers on more equal footing. This change immediately

and substantially improved prices for all investors, saving them billions

of dollars within a few years of the rules approval.

In a sense, though, the rule represented an intervention into the inter-

play of competitive forces that was shaping trading venues. Specifically,

the rule prevented commercially successful private trading venues, such

as Instinet, from distributing their order information to their customers

according to their business models. The SEC was entirely correct, in my

opinion, in viewing these private venues as creating a two-tiered market

that disadvantaged the public and in taking action to curb them. More-over, it is hard, in retrospect, to see the limit order display rule, along with

Regulation ATS, as anything but an unequivocal success. Nonetheless,

the transparency and pricing gains made for investors involved a trade-

off: The long-standing policy of allowing the interplay of competitive

forces between trading venues to run its course gave way to a practical

and necessary intervention.

We have, in other words, NMS policy goals that at times complement

one another and at other times require trade-offs, as discussed earlier.

How should regulators approach the hard questions when the policy

framework sends conflicting signals? Two points bear emphasis.

Start by Imagining an Investor

The tried-and-true advice given to homeowners designing a kitchen is

Start by imagining a bag of groceries. The point of this exercise, of

course, is to focus on exactly how homeowners will use the kitchen and

thus anticipate how to make it perform its intended purposes better.

The same type of advice should be given to regulators about market

structure. They should begin not by considering the pursuit of theoretical

policy goals but by imagining investors placing orders, looking at screens,

reviewing statements, and asking questions. Imagine, for example, having

to explain to investors in straightforward terms why certain pockets of

liquidity should be beyond their or their brokers reach. Something tells


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me that flash orders might have been nipped in the bud had this image

been conjured up.

More concretely, imagine an investor, as the limit order display rule

was being considered, entering an aggressive order and watching it set

the markets best price. The exercise would have revealed a lot about

how the rule would boost confidence in the pricing mechanism of the

market.

Distinguish Competition fromCommercial Advantage

Notwithstanding the exceptions already discussed, I believe that the

markets have been served well by the NMS frameworks general prefer-

ence for letting the free interplay of competition among markets shape

market structure. It is hard to imagine either NASDAQ or the NYSE deliv-

ering the speed, reliability, and fee schedules they do today without the

competitive heat applied by the electronic upstarts that they now own or,

for that matter, by BATS and Direct Edge. Virtually every niche, business

model, and commercial advantage can be framed by advocates as the

very embodiment of market center competition.

The key, in my view, is to distinguish between market participants who

successfully occupy a commercial niche or operate an efficient business

model and participants who truly have the potential to drive their compet-

itors, their vendors, and others they touch to new levels of liquidity, reli-

ability, and efficiency. As a regulator, I would lose relatively little sleep

about the impact of otherwise worthy proposals on the first category, but

I would tread cautiously where the latter group was affected.


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27

The Retail Investor

and the Reinvention ofEquity Market Trading

by Fred Tomczy k

president and ceo of td ameritrade

Introduction: The New World of InvestingThe United States stock markets have evolved dramatically in the last

decade. In 2003, an average retail trade execution took more than 10

seconds; today, the average is less than 1 second. In the last 30 years,

online brokers and the tools they use have greatly enhanced operational

efficiencies and lowered costs for the average retail investor.

This chapter identifies three primary trend groups that have signifi-

cantly advanced the trading practices of the individual investor and set

the path for the evolution of the stock market: secular trends; increased

retirement and investing options; and demand in the market.

Technological advances and innovations in trading have been the key

driver in the evolution of todays trading practices. The high-speed trans-

mission of data, including increased data capacity capabilities and direct

connections to electronic markets, has made trading readily accessible

to individual investors. In addition, the growth of Internet use by the

mass affluent populationincluding baby boomers, Generation Xers,

chapter

+


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28 t h e r e t a i l i n v e s t o r a n d e q u i t y m a r k e t t r a d i n g

and millennialshas increased the comfort and experience levels that

individual investors have in conducting financial matters online, thereby

driving the need for improved online trading capabilities.

Next to Social Security, defined contribution plans have become

the most important element of most citizens retirement security,

and retirement and investing options have become a quickly growing

market. In 2006, the Pension Reform Act, which includes incentives for

self-directed retirement accounts, spawned an increasingly competitive

retirement fund market that includes 401(k) funds, IRAs and Roth IRAs,

and 529 and college savings plans. Individual investors regular access toand monitoring of these portfolios has further expanded.

Technology and increased generational use of the Internet, along with

growth in retirement and investing options, has led to the third evolu-

tionary driver: market demand. Despite the recent economic downturn,

investor confidence and trust in the U.S. equity markets remains high,

and easily accessible trading options have driven down fees.

Before the Securities and Exchange Commission (SEC) abolished fixed

brokerage commissions in 1975, access to the markets was reserved for

institutions and wealthy individuals. Discount brokers such as TD Ameri-

trade changed this.

At TD Ameritrade, we serve individual investors by offering access to

financial services at a lower price. When the firm was founded in 1975, it

was one of the first to offer negotiated commissions to individual inves-

tors following passage of the Securities Acts Amendments of 1975. Over

the next three decades, our discount brokers pioneered technological

changessuch as touch-tone telephone trading and Internet investing

to make market access by individual investors more accessible, afford-

able, and transparent. To understand just how quickly the industry has

changed from these advances, consider that it was just over 20 years

ago that the first touch-tone trade was executed. The first Internet trade

was executed just 6 years later.

Today, the individual investor enjoys access to information, choice,

transparency, price improvement, lower cost/barriers to entry, superiorpricing, lightning-fast trade fulfillment, and ample liquidity. Market data


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can now be streamed in real-time directly to the investors computer.

All of these innovations have contributed to the decreases in pricing

over the past 30 years, and TD Ameritrade continues to lead the way in

keeping trading affordable. At no other point in the history of the markets

has the average individual investor been closer to the institutional trader,

in terms of pricing.

There is no question that providing tools such as news, charts, graphs,

and real-time quotations that feature the depths of various markets and

create an environment in which investors can flourish has been and will

continue to be beneficial for individual investors. It is imperative that theinterests of average retail investors be recognized, especially during these

times of economic stress. In todays economy, making sound investments

and financial decisions is more important than ever for individuals.

During the last 18 months, the very foundation of the U.S. economy

has been shaken to its core. The S&P 500 lost $8 trillion of market value

from the October 2007 peak to the March 2009 low, and the nations

unemployment rate has soared. The financial services sector has under-

gone monumental changes, as a number of companies that once had

household names have consolidated, been constricted in size and scope,

or simply gone out of business. Most distressingly, high-profile cases of

investor fraud have rocked the trust of the American people.

The cumulative effect of these events is that Americans have lost

confidence in the nations financial markets and the companies that serve

them. The silver lining, however, is that out of crisis comes opportunity.

Now is the time to start restoring investor trust and rebuilding investor

confidence. Doing so is critical to both the viability of our industry and

the long-term stability and growth of our nation.

In many ways, the discount broker has traditionally led the way for

the individual investor and will continue in that role. That role began with

the introduction of SEC rules such as rule 605, which requires that all

market centers display statistics on how well they fulfill orders, and rule

606, which requires broker-dealers such as TD Ameritrade to disclose

information regarding which market centers and exchanges receivedthose orders. As this information became available, brokers such as


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TD Ameritrade took a stand for the individual investor and sought to

compete against the array of stock exchanges in the market. The evolu-

tion of transparency in order fulfillment paved the way for the massive

technological arms race underway, all the while providing benefits to

individual investors through reduced commissions, quicker trade fulfill-

ment, and readily available real-time stock quotations.

Who Is the Average Individual Investor?

United States retail investors are a powerful force, made up of roughly91 million individuals. About half of all American households invest in

equities. As of June 2008, retail investors directly owned equities valued

at about $4.9 trillion, according to the Federal Reserve. In fact, individual

investors in the United States own the single largest pool of equity capital

in the world.

The growth in ownership of mutual funds over the last 30 years has

played a major role in U.S. equity ownership. An estimated 92 million

individuals, or 52.5 million households, own mutual funds. These individ-

uals are part of the larger U.S. mutual fund industry that had $9.6 trillion

in assets at the end of 2008. Individual owners of mutual funds invest

with a variety of long-term financial goals, but the majority of them are

saving for retirement. Fifty-two percent also hold mutual funds to reduce

taxable income, and 45 percent are saving for emergencies.

Saving and investing have become critically important to the average

individual investor. And because of this, expectations for quality and

accessibility continue to grow. For years, TD Ameritrade has focused

on understanding individual investors needs and creating a system that

provides them access to liquidity in a secure manner. Investors want to

know that the financial system wont suddenly seize up and shut down,

as it did during the Great Depression. At the same time, many individuals

want the opportunity to invest in the growth of the economy and are

willing to take a risk to achieve that returnprovided they have access

to clear information that helps them understand the nature and extent


38/138


of the risk. Put simply, investors want to know the deck isnt stacked

against them.

It is these factors that shape how individual investors trade. The vast

majority of investors purchase stocks for the long-term, because they

seek capital appreciation as they save for everything from their chil-

drens college education to their own retirement. Investors range from

the completely self-directed (do-it-myself) individual, who may trade

periodically, to the individual who works with an independent Registered

Investment Advisor (RIA). This type of individual might use, for example,

TD Ameritrades platform.As the information barriers have fallenmaking available to indi-

vidual investors pertinent news, real-time quotations, and simple access

to the marketso have individual investors continued to take control of

their finances. More and more, individual investors are taking matters

into their own hands or seeking the advice of independent RIAs to reach

their goals.

Mutual fund owners purchase and sell mutual funds directly through

full-service brokers, independent financial planners, employer-sponsored

retirement plans, and fund companies. In todays market environment,

retail investors increasingly access the public market through discount

brokers. In return, todays individual investors are only asking for afford-

ability, stability, access to a transparent and level playing field, choice

between platforms, and educational materials. These are the only major

demands from the average individual investor who is paying a fee for

discount online trades or full commission service. Figure 4.1 depicts retail

trading by investors today versus in the recent past.

Retail investors can help counteract price volatility that results during

periods of market stress or from trading by high-turnover institutional

investors. The increasing competition in online trading options, including

the increase in individual investors holding stocks for the long-term,

continues to balance the equity market even as technology advances.


39/138


Protecting the Investors InterestsMarket evolution is natural in a highly competitive environment, particu-

larly given the added influence of rapid technological innovation. The

facilitation of a National Market System (NMS), as called for by the

Securities Acts Amendments of 1975, has provided a framework for this

evolution. As such, regulation has been an integral part of the develop-

ment of the NMS, with the SEC refining rules and continually increasing

transparencyfor example, requiring quote displays and requiring

market centers to publish information related to how well they perform

on trade fulfillment. Moreover, the process has improved dramatically

and with ever-increasing speed, so that today, trades are rarely executed

at inferior prices.

Even so, regulations and policies should be sensitive to the retail inves-

tors interests. In the current market, rules and regulations can provide

additional investor protection, but they can also reduce market efficiency

at a great cost to investors. Finding the right balance is challenging andmust preserve optimization of trading for the retail investor.

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Retail trading by investors today versus 1990s2000s


40/138


Promoting strategies that advance efficiency and reduce investors

costs in the markets is important if we are going to continue to level the

playing field for individual investors. TD Ameritrade recognizes the need

to advocate for market structures that create transparency, promote

competition, and reduce trading costs for individual investors.

In this vein, as technology continues to advance rapidly, it is all the

more important for the SEC to complete a comprehensive review of the

NMS to ensure that individual investors are not adversely impacted. At

the same time, because regulation has the potential to produce unin-

tended consequences, it is critically important that rule-making be basedon empirical data and reasoned analysis

The fierce discussion going on about marketplace issues shows us

that there is a high level of competition in the equity markets, which is

good. At the end of the day, the beneficiary of this competition should

always be the retail investor.

Case Study: Flash Orders and Flash TradingA good deal of discussion has focused on the fact that some of the

new tools available for trading may pose harm to retail investors and

the market in general. For example, a flash orderallows participants in

a given market center the opportunity to improve the current bid or

offer on a security, so that the order does not have to be routed away

to another market center, thus incurring additional time and execution

costs. It is estimated that flash trading accounts for less than 2 percent

of all market activity.

There are three key arguments against flash orders and flash trading:

Flash orders remove or limit transparency in the markets, which

could lead to longer execution times or higher costs for trades

placed by retail investors.

Flash trading creates a two-tiered market.

Flash trading is the equivalent of front-running.

In fact, few data have been offered to support these claims. Theperception that flash trading is unfair and predatory has become a reality,


41/138


although an unexamined one. Flash trading is actually a symptom of the

current two-tiered market structure. The SECs goal of ensuring that flash

trading is not used to further two-tiered access is something TD Ameri-

trade supports as part of a comprehensive solution in this area.

The reality is that anyone who has access to NASDAQs TotalView,

which is offered by discount brokers such as TD Ameritrade, or BATS

BOLT has access to flash orders and flash trading. This means that retail

investors have access to them as well.

Flash orders for equities have been in place for years. During that

time, the incidence of price improvementor a trade receiving a betterprice than what was originally orderedand trade execution speed have

both improved substantially.

The data show that flash orders help increase efficiency in the routing

of trade orders and actually lead to more competitive prices for retail

investors. Flash trading saves costs and creates liquidity in the market,

benefitting retail investors. In addition, flash trading allows users to

lower transaction costs and obtain better prices in both the equity and

option markets. Thus, the benefits of flash trading to retail investors are

significant.

Since the advent of flash tradingfirst in the options markets and

later in the equities marketsretail investors have enjoyed improved

retail trade execution speeds. In 2003, an average retail trade execution

took more than 10 seconds; today, the average is less than 1 second.

Also in 2003, 85 percent of listed transactions took place on the

NYSE, and 16.7 percent of TD Ameritrade clients received price improve-

ment on their trades. Today, 85 percent of listed transactions occur away

from the NYSE, and price improvement for TD Ameritrade clients has

soared to 80 percent. TD Ameritrade monitors these items daily, for

every trade made with or without a flash order. We take our obligation to

deliver the best possible prices for our clients orders in the market very

seriously, so we examine the results daily for slippage, price improve-

ment, and price disimprovement.

Based on our experience, the allegations that flash trading is erodingmarket quality are unfounded. Flash trading is just the latest in a long


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line of tools that TD Ameritrade has used to continue to encourage

exchanges to compete with one another and to continue to foster price

competition, of which the ultimate beneficiary is the individual investor.

Moreover, flash trading is not the cause or equivalent of front-running.

Today, all exchanges use sophisticated electronic monitoring technology

to identify front-running, trading ahead, and other illegal activities. TD

Ameritrade does this for every trade, every day, and places more trades

than anyone else in the world (more than 300 K per day). In addition,

for each order placed today, an audit trail is submitted to the regulatory

bodies responsible for investigating red flags and spotting and appre-hending violators. Trading ahead of orders is illegal, and if it is occurring,

it should be reported to these regulatory bodies.

Conclusion

Never before has the individual investor been better equipped to compete

with the institutional investor in the marketplace. Likewise, never before

has the individual investor been able to engage in the market system

and meet investors from the Street on a level playing field. We need to

continue to foster the benefits of individual investors in todays markets,

as these investors are the cornerstone of the U.S. financial market

system. Let the rules in our markets continue to foster competition and

innovation for the benefit of individual investors.

Authors Note: TD Ameritrades comment letter on flash trading goes into detail about

the firms policy, stating that market structure decisions should be grounded in empirical

evidence. That letter can be downloaded from this link: http://www.sec.gov/comments/

s7-21-09/s72109-88.pdf.


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Appendix

Figure 4.2

Individual U.S. investors equity holdings:

19902008 (in billions of dollars)

Source: Federal Reserve, Flow of Funds Accounts of the

United States, June 2008.

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38 l i q u i d i t y a n d v o l a t i l i t y

People have mixed feelings about volatility. In general, they accept

the need for prices to change as fundamental values change. However,

excessive volatility in the absence of news generally indicates that

markets have failed to properly value assets or to provide liquidity at

reasonable prices to impatient traders.

This chapter identifies the origins of liquidity and volatility and

describes the relationship between them.

1 LiquidityLiquiditythe ability to tradeis the successful outcome of bilateral

searches, in which buyers look for sellers and sellers look for buyers.

Bilateral searches differ in two important respects from unilateral

searches. First, you may search actively or passively. Active searchers try

to find matches. Passive searchers wait for others to find them. Second,

you cannot always return to the best match that you identified during

your search. You may discover that your best match is no longer avail-

able when you want to return to it.

The search strategies that traders use to find liquidity vary by their

trading objective. Impatient traders generally search actively. Patient

traders usually wait for impatient traders to find them. Since impatient

traders initiate trades, we say that they demand liquidity. Patient traders

supplyliquidity.

Patient traders often display their interest in trading to help active

traders find them. They submit limit orders, quote markets, post indica-

tions, or advise their brokers.

Passive traders make markets when they are willing to buy at bid prices

or sell at ask prices. Active traders take markets when they initiate trades.

Large traders generally avoid showing that they want to trade,

because they fear that front-runners will trade ahead of them or that

liquidity suppliers will retreat from them. Large traders therefore either

actively take markets, or they trade in dark pools, where they can hide

their orders from all traders except those willing to trade with them.


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Exchanges and brokers help traders solve their search problems by

matching buyers to sellers. Traders use them because other traders

dothus, the expression Liquidity attracts liquidity. Exchanges and

brokers often provide facilities or services that allow them to match

hidden orders.

The costs of finding liquidity vary substantially across stocks and

often through time for a given stock. Trading is easiest when many

buyers and sellers are simultaneously interested in trading. Widely held

stocks therefore usually trade in very liquid markets. Stocks in the news

also trade in very liquid markets.

1 . 1 L i q u i d i t y D i m e n s i o n s

Liquidity means different things to different people, in large part because

they often focus on different dimensions of liquidity. The most important

dimensions are the following:

Immediacy: how quickly trades of a given size can be arranged at

a given cost. Traders generally use market orders and marketable

limit orders to demand immediate trades.

Width: the cost of doing a trade of a given size. For small trades,

traders usually identify width with the bid/ask spread. Width also

includes brokerage commissions. It is the cost per unit traded.

Depth: the size of a trade that can be arranged at a given cost.

Depth is measured in the number of shares available for purchase

or sale at a given price.

Resiliency: how quickly prices revert to former levels after they

change in response to large order flow imbalances initiated by

uninformed traders.

Many traders also measure liquidity by trading volumes, since volumes

indicate the extent to which buyers have found sellers.


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1 . 2 L i q u i d i t y S u p p l i e r s

Traders offer liquidity to exploit profit opportunities that liquidity-

demanding traders create when they try to tradethe liquidity suppliers

hope to profit by buying at low prices and selling at high prices.

Whether the suppliers trading is profitable depends on how prices

change after their orders execute. If they trade with well-informed

traders, they tend to be on the wrong side of the trade, and they lose

when prices change.

Liquidity-offering traders may be market makers, arbitrageurs, block

dealers, buy-side institutions, or individual investors. Although these

traders compete with one other, they all specialize in the niches in which

they are best suited to offer liquidity. Their respective advantages depend

on the information they have about fundamental values and the traders

with whom they trade:

Market makers offer liquidity when they fill marketable orders. They

generally have little information about fundamental values or their

clients. To avoid losing to well-informed traders, they avoid trading

large sizes, and they try to sell quickly after they buy and buyquickly after they sell. They effectively match buyers and sellers

who arrive at the same market at different times.

Arbitrageurs trade when the prices of two or more securities whose

values depend on the same valuation factors are inconsistent with

each other. They buy the lower-valued security and sell the higher-

valued security. The securities may be the same stock traded in

different markets; closely related securities, such as an options

contract and the underlying stock; or two stocks in related indus-tries. Arbitrageurs effectively match buyers and sellers who arrive

in different markets at the same time.

Block dealers offer liquidity when they trade with their large

customers. They generally know their clients well and avoid trading

large sizes with traders whom they believe are better informed

than they are.

Buy-side institutions and individual investors offer liquidity when they

submit standing-limit orders with the hope of obtaining better


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prices for the trades they intend to make. They also offer liquidity

when they use market orders to trade in response to requests for

liquidity that others make. Although market orders demand imme-

diacy, they also may provide depth to other traders. Order type

therefore is not always a reliable indicator of whether traders are

offering or taking liquidity.

Well-informed traders who know the most about fundamental

values are the ultimate suppliers of liquidity. They trade when

less-informed traders move prices as they demand liquidity. Well-

informed traders recognize the resulting profit opportunities andrespond by trading the other side. They make prices resilient.

Traders do not need to display their orders to offer liquidity. For example,

a trader who submits a hidden order to an electronic trading system

offers liquidity that other traders can discover by submitting suitably

priced orders. Likewise, a trader who will trade only if asked by a broker

also offers liquidity. In both cases, the traders allow others to trade but

show their offers under very limited circumstances.

2 Volatility

Traders and regulators recognize two types of volatility. Fundamental

volatilityis due to unanticipated changes in stock values, whereas transi-

tory volatilityis due to trading by uninformed traders.

Traders must distinguish between the two types to accurately predict

future volatility, the profitability of dealing strategies, and transaction

costs. Market regulators must distinguish between them because,

although they can do little to reduce fundamental volatility, they often

can reduce transitory volatility by improving market structures.

2 . 1 F u n d a m e n t a l V o l at i l i t y

Since free market economies use prices to allocate resources, prices

must reflect fundamental values. Values change when the fundamentalfactors that determine them change unexpectedly. Prices therefore


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should change when traders learn about these changes. Such price

changes contribute to fundamental volatility.

When unexpected changes in fundamental values quickly become

common knowledge, prices may change without any trading. In contrast,

when few people know about such

modern equity markets

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