By HAL S. SCOTT and JOHN GULLIVER
Originally published by the Wall Street Journal on August 16, 2015
The NYSE’s three-hour closure in July sent a signal that more data competition is needed among exchanges.
The three-hour shutdown of the New York Stock Exchange last month made headlines world-wide. Despite the brief calamity, investors emerged largely unharmed, because the technical glitch was with the NYSE’s trading platform. The outcome would have been very different had the problem been with the exchange’s consolidated public market data feed—the live feed that lets traders and investors see public bid and ask prices, the price and time of the last trade, and other crucial information.
Any future problem with the public market data feed of the NYSE or Nasdaq exchange would cause trading NYSE stocks with $19 trillion in value or Nasdaq stocks with $6.8 trillion in value to come to a halt for an indefinite period. This would shake investor confidence in this country’s public market, and might even affect the attractiveness of U.S. capital markets to private U.S. companies and foreign issuers. There is a way to stop such a shutdown from happening, but it will take a change in regulatory policy. Here’s the background.
Following the identification of hardware problems on its trading platform on the afternoon of July 8, the NYSE announced that it would suspend trading. Brokers and market makers promptly diverted investor orders to the 11 other exchanges and nearly 40 dark pools that were ready and eager to execute those trades. The orders were filled, and harm to investors was averted.
Without such competition among trading venues, a NYSE shutdown would have been far more consequential. As recently as 2005, the big board dominated trading in its own stocks and accounted for 80% of all daily trades in the U.S. stock market. Today the NYSE accounts for 20% of all trades. Other trading venues had the capacity to absorb the additional order flow.
The increased competition is due to a Securities and Exchange Commission rule called Regulation NMS, for national market system, which went into effect in 2007 and allowed orders to be directed to the exchange that quotes the best price. This rule also dramatically reduced transaction costs for investors, as trading venues vigorously competed for market share. Despite concerns that today’s marketplace is too fragmented, the NYSE shutdown demonstrated that this increased competition can be good for investors.
On the other hand, in the summer of 2013 Nasdaq experienced a technical glitch with its market data feed, commonly called an SIP (for Securities Information Processor). The SEC prohibits brokers and trading venues from executing an investor’s order unless they have access to aggregate market data, so Nasdaq halted trading in all Nasdaq stocks across all trading venues. Investors were unable to enter or exit their positions for three hours. The markets were paralyzed.
So why couldn’t brokers and trading venues simply shift to alternative consolidated market data feeds? While individual trading venues, including exchanges, can supply their own faster data feeds, Reg NMS effectively prohibits competing consolidated data feeds for the stocks traded on Nasdaq and the NYSE because the SEC wanted a “single source that is highly reliable and comprehensive.” Obviously this has not occurred.
Although the SEC recently implemented minimum technology standards for the SIPs, these systems aren’t infallible. Moreover, the lack of competition means that each SIP is incentivized to meet only these minimum standards. If competition among SIPs were permitted, then surely they would compete over resiliency.
On an average trading day approximately $279 billion in U.S. stocks are traded. Until we permit SIP competition, then trading in all Nasdaq or NYSE stocks would once again come to a halt if the Nasdaq or NYSE encountered problems with its SIP.
The lack of SIP competition also has important consequences for transaction costs. Brokers and trading venues are effectively required to purchase access to the SIPs, but their revenues aren’t publicly disclosed and there is no competitive pressure to lower the cost of access to each exchange’s SIP.
There is another, related problem. Nasdaq and some other trading venues use only private data feeds to determine whether investor orders are executed at the best prices while the NYSE and still other venues use only the Nasdaq or NYSE SIP. Because the SIP is substantially slower than private data feeds, the best price at one exchange isn’t necessarily the best price at another.
The result is that investors cannot be sure that orders are executed at the best prices. While a trading venue can consolidate these faster private data feeds for its own use, the SEC prohibits the sale of this consolidated private data to others, as part of its single SIP policy.
Investors emerged from the July NYSE shutdown virtually unscathed, thanks in large part to SEC rules that encourage competition among trading venues. The SEC would be wise to adopt a similarly competition-friendly approach to addressing the risks posed by single SIPs.
Mr. Scott is professor of international financial systems at Harvard Law School and director of the Committee on Capital Markets Regulation, where Mr. Gulliver is the research director.