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Market Structure 101James J. Angel, Ph.D., CFA

Visiting Associate ProfessorThe Wharton School

University of Pennsylvaniaangeljam@wharton.upenn.edu

Mobile: (703) 851-8575Twitter: GUFinProf

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About me• Teach Capital Markets at Wharton

– 2012-2014– Professor at Georgetown University 1991- Present

• Industry experience:– PGandE, BARRA (later part of Morgan Stanley), NASD, Shanghai Stock Exchange

• Former Chair, Nasdaq Economic Advisory Board• Board member: Direct Edge Stock Exchanges (EDGX and EDGA)• 10 patents on financial technology• Education:

– B.S. Caltech (Engineering), – MBA Harvard, – Ph.D. Berkeley

• Warned SEC in writing five times before the “Flash Crash” that our markets were vulnerable to big glitches like the Flash Crash. – http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=a4f49d29-fe78-4ed9-a839-

3a6c09917298• Warned SEC in writing in 2004 that proposed NMS rules would result in an “enormous

implementation headaches”.– http://www.sec.gov/rules/proposed/s71004/jangel063004.pdf

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Market Structure 101

• How the stock market works today– High speed computerized market

– Usually better, faster, and cheaper than before, but it has different problems than before.

• What are people complaining about?– Market manipulation with fast computers

• Can the regulators catch the bad guys? – Not as well as they should

– Market fragility• Will we have more glitches like the Flash Crash? (Yes)

– Market fairness • Do high speed traders have an unfair advantage?

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How the stock market works

• It’s a lot like EBay:– Lots of different vendors (brokers and exchanges)

to choose from– When you want to buy:– You can put in your own bid (limit order) or accept

the “buy it now” price (market order)

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Who puts in the orders?

• Just like on eBay, many of the participants are dealers or “market makers”.– They provide immediacy or liquidity through their willingness

to buy when others want to sell and to sell when others want to buy.

– Like used car dealers, their business model is to provide convenience for investors who want to trade quickly• Buy at the trade-in price (the “bid” price)• Sell at the retail price (the “ask” price)• They have no desire to drive the car for the long-term• Competition between them makes it fast and cheap for long-term

investors to trade when they want to. • The “bid-ask spread” is a cost of trading.

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Typical order entry screen

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Brokerage Firm’s Job

• Your broker has a duty of “best execution” to do the best job of executing your order. They can choose from:

• 13 exchanges• 40+ broker-operated trading systems– So called “dark pools”• Don’t post quotes to public before trades• But all trades are public after they are executed.

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How exchanges work

• Buy orders (bids) and sell orders (asks) are sorted in the computer.

• “Market” buy orders are executed against the best-priced sell order (the ask).

• “Market” sell orders are executed against the best-priced buy order (the bid).

• All done by computer

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Example from BATS Exchange

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Issue: Market Complexity

• In 1975, Congress directed the SEC to create a National Market System (§11A) and they did– Competition between exchanges– Competition between exchanges and off-exchange – Ability of investors to trade with each other without an

intermediary.• This makes good sense, and other nations (EU,

Canada, Australia, Japan are following our lead.)– Competition is good– But for-profit entities do a better job competing

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Result

• No exchange dominates trading like the NYSE once did.

• Technology and competition have brought down trading costs.

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Competition or “fragmentation”

21.20%

10.10%

13.80%

8.90%

10.80%

35.20%

Where NYSE-listed stocks trade December 2012

NYSENYSE-ArcaNasdaqDirect EdgeBATSOther exchanges, dealers, and dark pools

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NASDAQ is similar

10.10%

27.40%

11.70%12.70%

38.10%

Where NASDAQ-listed stocks trade December 2012

NYSE-ArcaNasdaqDirect EdgeBATSOther exchanges, dealers, and dark pools

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Issue: Speed

• Many beneficial trading strategies are simple and low-tech, and easily copied.– Market making– Arbitrage

• Result: Intense competition and a race for speed.

• Race to be the first to capture good trades• If you lose the race, it doesn’t matter whether

you lose by a minute or a microsecond

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Result

• Arms race among some participants to be first.

• Participants pay $$$ to co-locate their computers in the exchange data centers.

• Expensive races to get data faster from one market center to another.

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Issue: Market fragility

• Fast computers can make fast mistakes. • The SEC was slow in understanding the

fragility of a complex interconnected market network. – Slowly putting in rules and gaining expertise.– There will be more glitches. • Some of them big.

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Issue: Market manipulation

• Are the super-fast players manipulating markets?

• Can the SEC catch the bad guys?• Flash crash demonstrated how poorly SEC

understood markets and their inability to understand market glitches.

• Their capability to diagnose market problems is improving at a glacial pace but is still primitive.

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Examples:

• Excessive order cancellations– Manipulation?– Or computer algorithms misfiring?

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Issue: Capital formation

• Are our public markets nurturing the smaller new companies that are the engines of our future economic growth?

• NO• Reasons:– Compliance costs– Litigation costs– Market structure

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The number of US-listed public companies has been shrinking

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What should Congress do?• 1. Push SEC to upgrade staff skills

– Congress should regularly ask SEC how many CPAs, CFAs, MBAs, FINRA license holders, engineers, and people with industry experience are on staff.

– Hire more people with market experience – More people with technical backgrounds– Professional certifications other than JD degrees

• 3. Fully fund SEC but monitor it closely– SEC cumulative budget since 1934: About $22 billion in current dollars

• Less than investor losses on 1 Enron or 1 Madoff!

– Agency is self-funded from user fees, so it is deficit neutral. • 3. Carefully consider reform of regulatory structures

– A properly functioning regulatory system will do a better job of protecting consumers and enhancing economic growth while preventing and containing future financial crises

– Dodd-Frank did not fully address the fragmentation of the regulatory system. – Move SEC to New York and Chicago