The most important recommendation in the report of the Flash Crash Advisory Board that I wrote about several days ago is that the SEC consider implementing a “Trade-at” rule in place of the current no trade-through rule. Trade-at would require a firm receiving an order to direct that order to the market offering the best quote for execution, whereas under no-trade-through, the firm could internalize the order and execute it by matching the best price currently displayed at any execution venue. Trade-at would largely cripple “dark pools” and internalization (although the Board disclaims any desire to hamper the operation of pools that facilitate block transactions)–what in the old days were referred to as “third markets.”
As I wrote in my original post, trade-at is a red herring when it comes to preventing Flash Crashes. It’s primary effect will be to alter the way securities markets work in normal times, rather than exceptional ones.
The objection to internalization is that it is a form of “cream skimming” that free rides on price discovery in public markets. This reduces liquidity in the public markets, widening spreads, reducing depth, and reducing the informativeness of prices.
Free riding is an externality that would lead to a less efficient outcome if you believe that the public market is competitive. Many of the criticisms of internalization* and recommendations that it be eliminated, or at least constrained via regulation, implicitly assume that the public markets are perfectly competitive.
This is crucial, because if these markets are not perfectly competitive, free riding can actually improve efficiency. When you have a departure from the first best (due to market power, for instance), what would be a market failure in a first best world can actually improve things. For example, usually market power is bad. Pollution is bad. But if there are no taxes or other restrictions on pollution, it can actually be better for a polluting industry to be monopolized rather than competitive. A competitive industry pollutes too much, but a monopolized industry restricts output, and therefore reduces pollution. Market power markups serve the same function as a tax on pollution. In this instance, two bads are better than one.
So when evaluating the desirability of internalization and dark markets generally, it is imperative to examine the nature of competition in public markets. If public markets exercise market power, the existence of an externality (cream skimming) is insufficient to justify eliminating it.
Sadly, this is a point virtually absent from academic analysis of the issue, and seldom raised in public policy debates either. But some people get it:
Kevin Foley, chief executive of Aqua, a block crossing platform, said: “A ‘trade at’ rule is hugely anti-competitive. We haven’t seen the SEC do something [like that] in ages.”
And the prize goes to a Russian guy (and who says I’m always slagging on Russia?):
Dmitri Galinov, head of liquidity strategy in Credit Suisse’s Advanced Execution Services unit, said that a “trade at” rule would have to be paired with reform in the SEC’s regulation of exchange fees, which are higher than fees charged by dark pools and other non-exchange venues.
Exactly right, Dmitri. As I showed in my 2002 JLEO piece, and an earlier working paper titled “Third Markets and the Second Best,” cream skimming, internalization, block markets, payment for order flow, etc., can improve welfare when exchanges exercise market power. And as I’ve also shown in my research, (a) network effects and coordination costs give exchanges market power, and (b) there is empirical evidence that exchanges do in fact exercise market power. Off-exchange trading venues–dark markets in the current parlance, third markets in the old–are a source of competition. The ability to free ride off prices in the public markets reduces the costs that these competitors incur–that is, it makes them more effective competitors and reduces exchange market power.
Indeed, there is a report in the FT that provides an excellent illustration of how exchanges exercise market power by charging supercompetitive fees: “Anger as Exchanges Raise Closing Auction Fees.” Once upon a time exchanges exercised market power and generated rents for their members by limiting the number of members: now they do it by charging supercompetitive fees.
The wars over securities market structure drag on. The criticism of dark pools and internalization is nothing new. If you believe that public exchanges don’t exercise market power, then you won’t like dark pools and internalization. If you believe that exchanges do exercise market power, the case isn’t obvious, and you have a strong basis to conclude that free riding is the lesser of two evils. I’m of the belief that exchanges do exercise market power, and as a result I am highly skeptical of regulations intended to clamp down on internalization and dark pools.
Too often, however, this crucial issue of competition has been overlooked. Discussing the pros and cons of internalization without coming to grips with exchange market power is to ignore the crucial issue. It’s good to see that at least some are making the point.
* Kind of ironic that internalization creates an externality!