Update: Writing About Equity Market Structure at MarketWatch

Image credit, Eric Hunsader, Nanex LLC, via the WSJ.

Update:  I wrote on February 3 about the absence of the CFTC for discussions at the SEC on equity markets structure.

The SEC Equity Market Structure Advisory Committee’s members include industry insiders, academics, exchanges and trading firms. The CFTC is not represented on the committee nor has it attended as an observer or a presenter. One committee member, Gary Stone from Bloomberg Tradebook LLC, mentioned the conspicuous absence of coordination between the equity and futures markets. “We did not really talk about the coordination between the futures market and the ETF market,” said Stone. “ETPs are not equities but equities-like and their sister in the arbitrage mechanism has to be tightly coupled.”

Stacey Cunningham, COO of the New York Stock Exchange and a presenter on the Aug. 24 issue, responded that, perhaps, the SEC/CFTC joint committee that studied the flash crash could support that coordination process. She dismissed the idea that it was the exchange’s role to do so.

When I joined MarketWatch in mid-May, I agreed to cover all financial regulation and legislation from a transparency perspective. That’s a broad mandate. ( I joke that there are at least ten people at the Wall Street Journal covering the same beats in New York and Washington.)

The task is made easier because, with few exceptions, I am not supposed to do straight up breaking news. The enforcement orders from the SEC alone could keep three people busy if you had to write up a quick summary every time something even slightly big happens, and that doesn’t include rule proposals, open meetings, hearings, and issuer actions such as de-listings, comment letters and other Corp Fin activities. Add in coverage of CFTC, Fed, the Senate and House hearings on these subjects and specific market news about companies when it crosses over into this territory and you’ve got a bundle of short, medium and long story possibilities every day.

My job, however, is to do second-day analysis of the story finding my own unique angle based on my interests, aptitudes and, of course now, MarketWatch reader interests.

One area I am now covering that is quite a stretch for me is market structure, specifically the equity markets. Reforming equity markets is a big ongoing issue, especially after the Flash Crash. So far there have been two different official explanations for the market disruption that occurred on May 6, 2010 and many other unofficial ones. As a result, five years later and a little more than one year after Michael Lewis published the book “Flash Boys”, the SEC initiated an Equity Market Structure Advisory Committee to explore and develop policy recommendations for fixing what appears to be broken. The regulator has held two meetings of this group and my first story on the subject was a long “enterprise” piece on that group’s inauspicious inaugural meeting last may.

SEC’s panel still at a loss over how to fix ‘broken market’ published on June 30, 2015.

Almost five years to the day since the so-called flash crash, the SEC and key market players were finally gathered to discuss, and inevitably debate, the causes and responses to a significant decrease in investor and regulator confidence in the markets. It’s been a long road getting to this point.

The severe equities market disruption known as the flash crash happened on May 6, 2010 when the Dow Jones Industrial Average plummeted more than 1,000 points in just seconds. It recovered almost as quickly. What was frightening to participants and observers was the near total evaporation and then return of liquidity to the markets in barely a half-hour span. Five years later regulators and the general public still question what really happened, and what can be done to prevent it from happening again.

I wrote another story on the issue not long after when the New York Stock Exchange experienced a three hour outage as a result of some software changes that were not fully tested before going into production.

Former senator: Market regulators need ‘black box’ to investigate outages published July 8, 2015

To one former senator, the outage at the New York Stock Exchange demonstrates the Securities and Exchange Commission is too dependent on exchanges for vital information.

Former Senator Ted Kaufman of Delaware, a member of the SEC’s Equity Market Structure Committee and a long-time supporter of reforms to market structure, is worried.

“When these outages occur, the regulators are dependent on the exchanges and other platforms, the regulated parties, to tell them what happened,” he said.

There’s an inherent conflict since the major exchanges are now public companies. The NYSE is held by Intercontinental Exchange ICE, -0.26% and the Nasdaq is a unit of Nasdaq OMX NDAQ, -1.44%  . The major “bulge bracket” banks that internalize many transactions, such as Goldman Sachs GS, -0.98%  , Barclays BCS, -0.92%  , and J.P. Morgan Chase JPM, -0.84%  , also are publicly traded.

“There’s an incentive for a public company to downplay or even obscure the true cause of an outage,” Kaufman said.

Senator Kaufman left the Senate after finishing Joe Biden’s term after he joined President Obama as Vice President. One senator still on the job and fairly well-versed in these issues and likes to talk about them is Senator Mark Warner.

Senator says he’ll press SEC to fix stock market problems published September 15, 2015

A key U.S. senator on Tuesday said it’s up to the Securities and Exchange Commission to follow up with advice after penalizing so-called dark pools over issues including disclosure.

Sen. Mark Warner, a Virginia Democrat, made the comments during the launch of a new report on dark pools from Healthy Markets, a non-profit coalition focused on investor protection in the equity markets…

Warner also spoke about lingering issues such as the consolidated audit trail initiative.

The consolidated audit trail would provide a complete database for monitoring, analysis and enforcement of equity markets rules.

Five years after the flash crash, there is little progress on the consolidated audit trail initiative, Warner remarked. “There’s nothing expedited about the consolidated audit trail. Building it is a challenge. ”

Warner says he’s never heard anyone say the consolidated audit trail was a bad idea. However, when pressed by a question from MarketWatch, Warner admitted that since CAT was initiated to produce more data for regulatory enforcement, some industry leaders charged with accomplishing it may be “slow rolling” it.

In October, before the SEC’s second planned meetup of the Equity Markets Structure Advisory Committee, industry and other critics complained about who was and wasn’t in the group.

SEC getting flack for participants in key stock-market reform group published October 23, 2015.

It is an issue that lingers and the tension shows no sign of abating.

The hero of Michael Lewis’ “Flash Boys” book is Brad Katsuyama, CEO of IEX, a dark pool known officially as an “alternative trading system” that wants to be an exchange like the New York Stock Exchange, Nasdaq, and BATS. The application to be an exchange filed by IEX with the SEC initiated a highly contentious, controversial and often confusing debate that continues. IEX recently gave the SEC three more months to consider its request.

As always I tried to find an angle I could write well and that would not be covered extensively, and probably better, by others. My question was: Why does IEX even want to become an exchange?

The real challenge facing ‘Flash Boys’ hero is the IEX business model published November 24, 2015

The established stock exchanges are battling IEX Group over the issue of an electronic “speed bump” — but the real battle the upstart faces is its own, unique business model.

IEX is known outside of trading circles because author Michael Lewis assigned the firm, and its Chief Executive Officer Brad Katsuyama, the role of hero in his book “Flash Boys: A Wall Street Revolt.” Lewis claimed IEX would create a stock exchange with an electronic speed bump to save the “rigged” market from high-speed traders. The IEX on Tuesday filed another defense of its plans to run a stock exchange.

More established exchanges such as BATS Global Markets, Nasdaq Inc NDAQ, -1.44%  , Intercontinental Exchange Inc’s ICE, -0.26%  New York Stock Exchange unit collect substantial fees from catering to high-speed traders, overtaking transactions fees which have been hurt by lower volumes.

NYSE non-transaction fee revenue for the second quarter of 2015 was 40% of net revenues, growing 15% from the prior year, according to its earning call transcript. Within non-transaction revenues, data services revenue grew 19% to a record $187 million. At Nasdaq the figure is even higher. Only 25% of revenues come from transaction sources, according to a Barclays analyst report.

IEX doesn’t plan to sell market data and it does not plan to collect fees from high-speed firms to put their servers closer to the firms “matching engine” to gain an advantage in trading ahead of everyone else.

Probably the most vocal critic of the IEX exchange proposal is Citadel.

Citadel makes third appeal to SEC over IEX application to become exchange published December 8, 2015.

Citadel is taking no chances that the SEC will get its message about IEX Group’s application to become a national securities exchange. The privately-owned, Chicago-based high-speed-trading firm, institutional asset manager and market maker sent its third missive to the SEC on Monday, and it’s not the only interested firm signalling serious concerns via a flurry of activity that threatens to continue until IEX submits the revised application they all say is necessary.

Citadel has apparently not met with or spoken on the phone with Securities and Exchange Commission Chairwoman Mary Jo White or the other commissioners or staff, according to notices posted so far by the SEC, relying instead on three strongly worded comment letters to make its points.

One of the more vocal supporters of the IEX application is Eric Hunsader, founder and CEO of Nanex, LLC, a research firm. He does not see what all the fuss is about. In his comment letter to the SEC, he says that the question of legality and fairness of the IEX “speed bump” has already been answered–by the SEC.

The so-called controversy generated by entrenched exchanges, internalizers and high frequency traders over the IEX “speed bump” has already been discussed, addressed, and settled—by the SEC no less.

From page 16 of Reg NMS:

The Reproposing Release touched on this issue in the specific context of assessing the effect of the Order Protection Rule on the interests of professional traders in conducting extremely short-term trading strategies that can depend on millisecond differences in order response time from markets. Noting that any protection against trade-throughs could interfere to some extent with such short-term trading strategies, the release framed the Commission’s policy choice as follows: “Should the overall efficiency of the NMS defer to the needs of professional traders, many of whom rarely intend to hold a position overnight? Or should the NMS serve the needs of longer-term investors, both large and small, that will benefit substantially from intermarket price protection?”

The Reproposing Release emphasized that the NMS must meet the needs of longer-term investors, noting that any other outcome would be contrary to the Exchange Act and its objectives of promoting fair and efficient markets that serve the public interest.

Those two paragraphs completely invalidate the negative comments surrounding the IEX 350 microsecond (%of a millisecond) “speed bump”.

(Hunsader also says that one SEC comment letter writer, Adam Nunes at Hudson River, in trying to defend the criticism of IEX effectively admits to “spoofing”, an illegal trading technique high on the SEC’s enforcement list. We shall see…)

Most incriminating comment letter ever posted to the SEC? (those #HFT are so smart /s) pic.twitter.com/2VGT3Vikpd

— Eric Scott Hunsader (@nanexllc) December 18, 2015

While all this is going on, the BATS Exchange is readying for its second try at becoming a public company. The first time was not a charm.

BATS IPO underwritten by its top clients, filing shows published December 18, 2015.

BATS Global Markets Inc. is getting a lot of help for its second IPO attempt from its friends. Those friends—thirteen affiliates of its customers that are also its principal investors— generate revenue as key customers and also provide mission critical services such as clearing and routing brokers. Some of them are also underwriting its offering.

One investor and customer is more special than all the others. That firm provided 11% of BATS’ total transaction fee revenue for the nine months ended September 30, 2015 and during 2014 and 2013.

That special customer is not identified by name in the filing…

This admission of the potential for a “material adverse effect” on its business if any of these top customers who are also investors take their business somewhere else will drive future BATS disclosures.

The firm will have to disclose more if, instead, any one customer goes over 10% of total revenue. Although BATS only provides figures for the proportion of transaction fees attributable to this one unnamed customer—11%—that volume is equivalent to approximately 8% of total revenue. That’s because transaction fee revenues accounted for 72.7% of total revenues for the nine months ending Sept. 30.

The SEC’s Regulation S-K requires disclosure of the customer’s name if revenues to that customer equal 10% or more of the company’s total revenues and losing that customer would have a material adverse effect. An SEC staff legal bulletin, No. 1, makes it very clear that companies are prohibited from requesting confidential treatment for this tidbit, regardless of how the company or customer may feel about that. Names of other customers may be included, as long as that’s not misleading and contracts with a major customer might be material and also required to be disclosed.

“Disclosure of the existence of 10% or more customer exposure is required by Generally Accepted Accounting Principles – but not the name. They could always do more than required, however,” said Jack Ciesielski, publisher of The Analyst’s Accounting Observer.