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This chapter is from the book

How Did HFT Become So Big?

After the SEC implemented Reg ATS and decimals, spreads narrowed drastically: from quarters, to eighths, to sixteenths, to 3 cents and lower. The average amount of money a short-term trader could make per trade dwindled sharply, and automated trading firms in Darwinian fashion made up for that with sheer volume of trades. Their growing volumes were on all of Wall Street’s radar. Brokerage firms, new electronic venues, and the major stock exchanges all took notice.

In the new millennium, when the SEC again set about to modernize its rules about stock trading, the agency sought a massive amount of input from all the players. The result was the Regulation National Market System, otherwise known as Reg NMS, which was authored by many industry participants in collaboration with the SEC. Proposed in late 2004, Reg NMS was supposed to serve as the framework for the evolving stock markets for the coming century. Due to delays, lobbying, industry comment letters, and reworking, it wasn’t implemented until late 2007.

Reg NMS created the concept of a National Best Bid and Offer (NBBO). The NBBO was an aggregation of the best priced orders on all exchanges and ECNs, and it was protected. This meant that if one market center, say the NYSE, had a participant with an order to buy stock at $10.00 and did not have a matching sell order at $10.00, while another exchange, say NASDAQ, did, then the NYSE would have to route out that buy order to NASDAQ, which would then match the buy and sell order. As a result, Reg NMS commoditized trading destinations. Speed of execution became paramount. The slower, specialist-oriented NYSE was forced to become a fast, electronic market.

By the time Reg NMS was implemented, the stock exchanges had beefed up their systems, changed from member-owned, nonprofit corporations, to for-profit exchanges, and many of them became publicly traded companies. Although some say the exchanges did this to respond to Reg NMS while at the same time to protect themselves, they did it with an “eye on the prize,” lobbying for the regulations to turn out exactly as they wanted, when they wanted it. You can’t help but wonder whether the changed market structure is less the result of “unintended consequences” and more of a well-executed plan.

The changes brought about by Reg NMS have turned the market from an investor-focused mechanism, which welcomes traders and investors of all types and speeds, to a subsecond, trader-focused mechanism, where the concerns and confidence of investors are an afterthought. These changes are hurting you by making the market more dangerous and prone to another severe crash. This crash may start with a news event—a default on debt in Europe, an economic crisis in Asia, or a major bank bankruptcy in the United States. But make no mistake, the real reason will be that the stock market is based on business models that are rife with conflicts of interest that cater to hyper-short-term traders. The real reason for the crash will be structural.

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