By the time I left the Securities and Exchange Commission as the head of the Trading and Markets Division in March of last year, I had grown deeply dissatisfied with the structure of the equity markets. They seemed too complicated, too hard for participants to decipher and too riddled with conflicts of interest. I heard similar concerns from many buy-side firms — it was too difficult to do trades in size and too easy for their orders to be sniffed out by high frequency trading firms. Given the events of the past year (including regulatory fines and lawsuits), now is the time for those same buy-side firms to use their clout so that the markets better serve their interests.
These issues matter to buy-side investors not just because of explicit costs but, more important, because of those that are hidden. For example, when orders are sent to markets based on incentives that work against institutional investors, opportunities to get better prices than the published bids and offers are lost.
There has been a lot more discussion about these core problems, especially since the publication of Michael Lewis’s Flash Boys last year. That book led to debate in the industry and by the public, but there is still no consensus on what changes are needed. SEC chair Mary Jo White — my former boss — has proposed some sensible reforms, including steps to improve oversight of HFT firms and requirements that brokers increase disclosure to their buy-side clients so they can better understand how their orders are being handled.
These changes would be positive. But I have learned — both inside and outside the government — that you can’t expect regulators to fix every problem, and too often major regulatory change can create new problems or opportunities for abuse. Regulators are usually put in the position of fighting the latest war, and often the problems have morphed by the time new rules are implemented. Forward-leaning change has to come from the private sector.
And that means institutional investors have to be a big part of the solution. Specifically, the clients — the owners of the orders — have to drive change. For many, that involves exercising closer supervision over how their orders are handled or being more directive about routing decisions. That’s not only good business, it is called for by the changing legal and regulatory landscape. Although the application of fiduciary duties to order-routing decisions is evolving, it is fair to assume that the bar is also being raised in this regard.
For one thing, there is a much higher public profile to questions about how different venues do or don’t serve investor interests — how transparent they are, the types of firms that trade in each of them, whether they pay rebates to attract orders or try to control how HFT firms trade on their platforms. As a result, various stakeholders — regulators, clients and beneficiaries — are looking at decisions related to equity market trades through a sharper lens.
Also, the legal standards as applied in this area will take account of the importance of these factors. For example, a New York state court recently determined that a decision about where to execute a trade is an “investment decision” for purposes of state law jurisdiction because of the importance of that decision to the outcome of the trade.
What does that mean in practice for oversight by advisers and pension plans? At a minimum, all clients can benefit from asking focused questions of their brokers — and demanding clear answers — about conflicts, choice of venue and actual experience, and doing so on a recurring basis. How many of the orders are sent to the broker’s affiliated platform? What data can be provided on those trades compared with trades on other venues in the same names at the same times? How, if at all, do individual markets seek to limit or respond to the impact of high frequency trading?
Many clients can and do benefit from exercising more direction over where their orders are sent. There are various options that can make a difference. IEX is a marketplace that provides one new model that is simpler, designed to avoid conflicts and create a level playing field for investors; there are others in existence or being considered that can also provide a meaningful benefit.
The key message is that the buy-side community has the right, and the ability, to use its influence to make sure that markets serve its interests, not the other way around. And when that influence is used by many firms at the same time, the result can be truly transformative.