The New Stock Market, by Merrit B. Fox, Lawrence R. Glosten, & Gabriel V. Rauterberg (introduction)

THE NEW STOCK MARKET

Law, Economics, and Policy

Merritt B. Fox, Lawrence R. Glosten & Gabriel V. Rauterberg

Introduction

Financial trading markets can seem deeply puzzling. Central features conspicuously depart from how most markets work. This makes their study particularly interesting, but it also means there are many ways in which an unwary observer may stumble. For instance, voluntary trade is typically thought to leave both parties better off, but trade in financial markets also has a distinctively zero-sum aspect. Whereas many market transactions involve the consumption of goods that provide personal utility, transactions in financial markets involve the pursuit of claims on future cash flows and control rights.

Financial trading markets are also distinguished by their great social importance, particularly the market for corporate equities, which is the primary subject of this book. The U.S. stock market’s total valuation is about $25 trillion—almost double the total assets held by the commercial banking system.1 The stock market is the principal vehicle for the direct and indirect investment of public savings, representing roughly half of the value of the dollars saved. Its functioning is critical to the process by which changes of control in major companies take place. Famously, prices in the stock market incorporate enormous amounts of information and serve as important guides to decision making throughout the economy. For all these reasons, the stock market remains a potent national symbol of trade and commerce.

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This book aims to provide an accessible yet sophisticated overview of the institutions, social functions, and economics of the secondary trading market for corporate equities. This is done with the principal ambition of understanding and improving the regulation of this market. Moreover, doing so at this particular moment presents a distinct opportunity. Driven by technology, the trading of equities occurs in a fundamentally new environment relative to just twenty years ago. As a result, the market for equities has evolved in unexpected and complex ways. The trading of any given stock is spread over dozens of different venues, rather than being largely concentrated on or within a single exchange. There are entirely new kinds of participants, such as high-frequency traders, and new institutions, such as dark pools. Our understanding of the market now also benefits from the rapidly evolving theoretical and empirical work of microstructure economics, a field dedicated to understanding the nature of trade in financial markets, which dates back only slightly more than thirty years.

Our methodology combines legal analysis and institutional description with various strands of economics—not only microstructure economics, but also financial economics more generally and the theory of the firm. What results is a functionalist explanation of how the stock market works. This approach has advantages from both a positive and normative point of view.

It allows an integrated, understandable vision of the workings of the market and of the extraordinarily complex regulatory web to which it is subject, which involves federal statutory law and administrative rulemaking, state legislation, and self-regulatory rules. It also provides a basis for policy-based critiques of regulation that relate to the most basic values at stake in these markets.

In sum, we approach understanding the equity market from a distinctive perspective. Microstructure economics focuses on the differences in what market participants know. The central claim of this book is that this informational perspective significantly illuminates both the existing regulatory structure of our equity trading markets and how we can improve it. Crucially, some traders (the “informed”) possess information and analyses about a company’s future that provide them with a more accurate view of the value of its shares than is possessed by the rest of the market (the “uninformed”). Informed traders trade in order to make speculative profits based on their informational advantages.

Uninformed traders trade for other reasons, such as seeking a place to put their savings or later selling their shares in order to finance consumption.

In choosing to focus on the institutions, economics, and regulation of one particular financial trading market—the market for equities—this book follows the lead of the financial economics literature. For a variety of reasons, including the social importance of the market for equities and the availability of data

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for empirical work, microstructure has overwhelmingly emphasized the equity market. At the same time, however, this book will seek to develop a theoretical framework with rich insights for other trading markets, including debt, options, commodities, and over-the-counter derivatives. Although those insights will typically be implicit, we will explicitly turn to them briefly in the conclusion.

Before turning to the contents of this book, a note on its intended audience may be helpful. This book has two audiences in mind, and thus its ambitions are sometimes in tension. On the one hand, it aims to provide newcomers to the study of trading markets—whether regulators; industry professionals; interested laypersons; or law, economics, or business students—with an accessible overview of the major issues in these markets. On the other hand, it aims to generate novel critical insights into a range of policy issues that even the seasoned scholar of these markets should find of interest. Thus, early chapters have an introductory character that the second audience may wish to skip.

Part I of this book begins by addressing the foundations necessary for understanding the equity trading market. This encompasses the institutions, mechanics, and regulatory architecture of this market; the functions it serves for society; and the economic dynamics that underlie how it operates. We begin in chapter 1 by discussing the institutions and regulation of the stock market. The central institutions of today’s stock market are the trading venues themselves: the twelve stock exchanges, which account for 60 percent of trading volume; the approximately thirty active alternative trading systems; and the other forms of off-exchange trade, such as internalization, a means by which a broker-dealer transacts directly against order flow sent to it by brokers. We also introduce the federal regulatory scheme governing the structure of the stock market: principally, Regulation National Market System (NMS).

In chapter 2, we ask why equity trading markets exist, and we try to answer that question, defining the principal functions served by these markets for society. These functions include facilitating trade by investors, lowering companies’ cost of capital, allocating risk, and aggregating information in prices to guide decision making in the broader economy. These functions establish the normative yardstick for assessing the performance and regulation of the equity market. This chapter also explains the emphasis in financial economics on liquidity and price accuracy as the two primary quantitative proxies for the ultimate social functions served by trading markets.

Chapter 3 explores the economics of equity trading. It presents some central results of market microstructure economics in a form accessible to nonspecialists. Its principal models formally analyze trading behavior and liquidity. They reveal that equities trading is a strategic interaction driven by differences in what

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traders know. The attempt by other market participants to mitigate the adverse selection arising from the trades of informed traders is the central economic dynamic of trading in the stock market.

The remainder of the book—parts II, III, and IV—generally adopts a normative approach, evaluating the practices of major participants in today’s equity markets and the structures in which they interact. We canvass a range of popular and academic criticisms and consider their merits, attempting to demonstrate the usefulness of the microstructure perspective by applying it to these major issues in contemporary securities law.

Part II of the book, chapter 4, concerns the regulation of market structure.

We begin with high-frequency traders (HFTs) and how they operate within today’s world of multiple trading venues, each venue operating as an electronic limit order book. HFTs are a major source of liquidity in the modern stock market, posting a significant portion of the bid and offer quotes that result in trades. These quotes constitute the prices at which other traders can transact. HFTs revise their quotes at rapid speeds and high volume, employ private data feeds from exchanges, and are shrouded in secrecy. In the market, they occupy dual roles as liquidity providers and arbitrageurs. As a result of all this, they are enormously controversial. This chapter introduces the market-making role of HFTs and assesses four HFT practices that have been the subject of vigorous criticism, explaining why some of these criticisms reflect deep misunderstandings of the role of HFTs, while others appropriately target socially undesirable behaviors.

Part III of the book, consisting of chapters 5, 6, 7, and 8, addresses the regulation of traders. In chapter 5, we step back to offer a broader welfare perspective on informed trading. Trading on nonpublic or “private” information drives the stock market. Hedge funds, equity analysts, and active traders of all types, including corporate and institutional insiders, seek an informational “edge” from which to profit. Through trade, “private” information leads to more informative stock prices, which has real economic benefits. However, informed trade also leads to losses by liquidity suppliers, making trade costlier and less efficient.

There is thus a fundamental trade-off in how private information affects the two principal functions served by the stock market: price accuracy and liquidity.

Chapter 5 develops a general theory of the regulation of trading on private information, arguing that any given type of informed trade should be assessed based on how it affects the stock market’s basic social functions. Specifically, we argue that the time horizon of private information—the latency before it would otherwise be revealed—determines both the trading strategies traders must employ and the social value of trade. To demonstrate the utility of our framework, we

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apply it in chapter 6 to recent controversies involving informed traders, as well as to a welter of legal rules under the Securities Exchange Act of 1934 that affect the extent of certain types of informed trade. These include the insider trading prohibitions of Section 10(b) and Rule 10b-5, the issuer mandatory disclosure regime, Section 16(b), Reg. NMS, and Reg. FD. Chapter 7 analyzes manipulative trading. Traders may try to influence prices in ways that permit them to buy low and sell high when there has been no change in the economic fundamentals of the securities involved. Whether such manipulative trading activity is either profitable or common is highly controversial. This chapter provides a roadmap of different forms of manipulative trading, carefully separating the relevant economics of each type in order to assess its social impact. It considers the meaning of manipulation in terms of both market microstructure and securities law.

Chapter 8 discusses short selling. Short selling involves an arrangement by which a trader acquires shares from a third party under an obligation to return shares of the same stock to the third party at a later date. The trader sells the acquired shares immediately. If the stock’s price declines by the time the shares have to be returned, the trader can acquire them for less than the proceeds received from the earlier sale and will profit accordingly. Top officials of firms subject to heavy short selling often complain that the practice is socially harmful, as do many media critics and politicians. In this largely descriptive chapter, we examine the criticisms in light of current short sale regulation and survey recent empirical evidence on the types of short selling that prevail in the market.

The last portion of this book—chapters 9, 10, 11, and 12—concerns the regulation of broker-dealers. In chapter 9, we take a tour of one of the more confusing features of trading market regulation: broker-dealer status and the duties that accompany it. Federal law currently imposes one regulatory status, that of a “broker-dealer,” on any individual or institution that performs any of the following roles: 1) serving as a broker, which executes transactions on behalf of customers; 2) serving as a dealer, which facilitates order execution by trading with others as principal for its own account; and 3) operating a trading venue that is not a stock exchange.

In chapter 10, we turn to dark pools: off-exchange trading venues that promise to keep secret the existence of the orders sent to them and that can discriminate in terms of which parties they allow to trade. About 15 percent of equity transaction volume now occurs within dark pools. In chapter 10, we look at a few major criticisms of alleged practices of dark pools. For instance, some critics contend that large investment banks, which are both important

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providers of brokerage services and operators of most of the largest dark pools, sometimes route their brokerage customers’ orders to the banks’ own dark pools. They do so even when the orders will receive inferior execution there and even when the customers submitting the orders expressly direct that they be sent elsewhere.

Chapters 11 and 12 concern payments received by brokers from third parties in connection with the brokers’ handling of customer orders. Chapter 11 relates to the controversial practice by most exchanges of making payments to brokers for sending the exchanges certain kinds of offers and charging brokers fees for sending other kinds: so-called “maker-taker” and “taker-maker” arrangements.

Maker-taker exchanges offer rebates for limit orders that post a new offer or bid (i.e., “make liquidity”) that is eventually transacted against. Marketable orders— orders that arrive on the exchange and transact immediately against a standing limit order—pay a fee because they “take liquidity.” Taker-maker exchanges offer the reverse arrangement. Critics argue that these payments create incentives for brokers to direct customer orders to the venue paying the highest rebate, rather than the one that delivers best execution. Empirical evidence suggests that this may in fact be a widespread problem. In chapter 11, we assess the merits of this criticism from a legal and economic perspective and provide suggestions for regulatory reform.

In chapter 12, the focus turns to payment for order flow. When a brokerdealer receives orders from its customers, it in theory could transact against those orders directly itself, rather than directing them to an exchange or other trading venue. Doing so would be particularly attractive to a large broker-dealer with a steady stream of retail orders, which are typically uninformed and thus will have roughly the same number of buy and sell orders coming in nearly simultaneously. For technical legal reasons, the broker-dealer essentially outsources this activity, selling its customers’ order flow to another broker-dealer that is instead the one being the counterparty to the buy and sell orders sent to it. This practice is known as internalization and payments made by the internalizing broker-dealer to the broker-dealer supplying the customer order flow is known as payment for order flow. Critics argue that payment for order flow is a kind of bribe that generates an agency problem, inducing a broker to sell order flow for payments (that it does not pass on to customers) rather than providing customers with best execution of their orders. In chapter 12, we likewise evaluate the merits of this criticism and provide suggestions for reform.

In the conclusion, we briefly reflect upon the informational paradigm, which possesses remarkable explanatory power in equity markets, and on the differences between equities and other major trading markets, such as the debt

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and derivative markets. Our general claim here is that trading markets are generally information markets, and that their economic dynamics and social functions are critically shaped by what kinds of informational asymmetries are (or are not) present. The determinants of the cost of liquidity and the role of private information will vary depending on these asymmetries. If regulation fails to carefully attend to these features, it can misfire and do more harm than good, but when it is carefully crafted, regulation can play an essential role in optimizing market structure.

“In immensely readable fashion, The New Stock Market connects the fundamentals of market structure to new (and old) challenges: insider trading, market manipulation, high-frequency trading. A profoundly important look at how our stock markets have changed and the regulatory first principles necessary to keep them orderly and equitable as these changes continue.”

DONALD LANGEVOORT, Georgetown University

“Integrating the perspectives of information economics and the law for understanding markets for trading equity, this book will be of considerable interest to students of markets and the law, as well as securities lawyers, investment bankers, analysts, economists, and regulators.”

CHESTER SPATT, Carnegie Mellon Tepper School of Business and MIT Golub Center for Finance and Policy

Praise for

THE NEW STOCK MARKET “The New Stock Market achieves a difficult balance: it is accessible yet sophisticated.

The mysterious new terms of market microstructure—‘high-frequency trader,’ ‘dark pool,’ ‘maker-taker’ rebates, and ‘internalization’—are all fluently explained, and this serves as a prelude to the authors’ careful weighing of the policy choices.

Few books in this area have been this lucid and this rigorous at the same time.”

JOHN C. COFFEE, Columbia University

“Equity capital markets are going through unprecedented change: new technology, new players, new venues, and new trading strategies. How can regulators respond to these developments without impeding market efficiency?

These are the issues that Fox, Glosten, and Rauterberg analyze in their outstanding book, providing vital—and novel—insights and recommendations that should be welcomed by both regulators and investors. Highly recommended.”

EDWARD F. GREENE, Cleary Gottlieb Steen & Hamilton

COLU M B I A U NI V E R S ITY PR ES S / N EW YORK cup.columbia.edu Printed in the U.S.A.