Recovering the Promise of the Orderly and Fair Stock Exchange

By Macey, Jonathan; Swensen, David | Journal of Corporation Law, Summer 2017 | Go to article overview

Recovering the Promise of the Orderly and Fair Stock Exchange


Macey, Jonathan, Swensen, David, Journal of Corporation Law


Paper Presented at the Journal of Corporation Law 2017 Symposium: What Happens in the Dark: An Exploration of Dark Pools and High Frequency Trading

I. Introduction.778

II. Historical Market Structure.779

III. Fragmentation in the Current Market Structure.780

A. The National Market System and the Trade Through Rule.782

B. Problems with the NBBO: It 's not the Best Bid or the Best Offer.784

C. Hide Not Slide and Complex Order Types.787

D. Payment for Order Flow.789

IV. A New Market Structure Proposal.790

V. Conclusion.791

I.Introduction

U.S. stock exchanges do not exist in the form they historically took and our equity markets are no longer orderly or fair. In the place of the traditional stock exchange, which was oriented around human beings and featured single-venue floor trading, an array of fully-automated trading platforms across multiple venues has arisen. Some of these have been formally designated as stock exchanges for legal purposes, while others operate as trading platforms. Almost all facilitate high frequency trading.

We believe that radical change is required to address the pathologies of inefficiency and unfairness that characterize the current structure of U.S. trading markets. Our proposal is to create multiple trading venues and then to allow trading in particular securities on only one of these venues. For the approximately 6,000 companies whose shares trade publicly in the United States, we propose licensing ten stock exchanges, each of which would provide a centralized-and exclusive-forum for trading approximately 600 stocks. Organizing our markets in this way would create exchanges that are large enough to benefit from scale, yet numerous enough to compete for listings.

Formerly, stock exchanges existed to provide "fair and orderly markets" for long-term investors.1 In this Article we will use the term "end-user" investor or "long-term investor" to connote investors who purchase and sell securities for investment purposes to take advantage of fundamental research into a company or to engage in portfolio management. In contrast, high frequency traders (HFTs) purchase and sell on the basis of unfair information or unfair advantages regarding what other traders intend to do in the future, and therefore subtract value from markets by extracting parasitic profits.

The obligation of exchanges to provide fair and orderly markets was part of a complex system of informal, non-contractual arrangements with the trading public that were sustained by the value of future relationships that served the collective interests of both exchanges and traders. This "relational contract"2 between exchanges and investors served the interests not only of traders, who benefitted from fair and equitable markets, but the exchanges as well, which benefitted from a natural monopoly in the provision of liquidity services.

After describing the structure of equity markets in the era of traditional stock exchanges in Part II, we identify some of the more acute problems with the current market structure in Part III of this Article. As explained in Part II, exchanges historically were run as not-for-profit utilities. Corporations would apply to list shares for trading and exchanges would list only those firms that met their standards and paid their listing fees. Listing firms got prestige, fair and orderly markets for their investors, and an efficient set of "off-therack" corporate governance rules.3

In Part III, we examine four of the symptoms of the disease affecting securities market structure. These are: (1) the Trade Through Rule, which prevents large sized orders from being executed and allows markets to lock as matching orders (orders where the bid price and sell price match) cannot be executed when they exist on different markets; (2) the socalled National Best Bid Best Offer, the implementation of which creates arbitrage opportunities for HFTs; (3) the complexity of order types as illustrated by the "Hide Not Slide" order type approved by the SEC and abused by both HFTs and major exchanges; and (4) payment for order flow, which pits brokers' duty of best execution against their private interest in obtaining additional trading revenues from directing orders to venues paying for order flow. …

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