Oscar Wilde once wrote that “Everything popular is wrong.” He was describing our natural tendency to find comfort with well-established people and widespread ideas. Regulators, faced with the opportunity to open markets to alternative choices, hear a chorus of respected voices resistant to change. The SEC took until the year 2000 to repeal Rule 390—the rule that gave the New York Stock Exchange a monopoly in trading Blue Chip securities. The principles of open, transparent and connected public markets prevailed.

We raise this as the old idea underlying Rule 390, centralization of trading, is now being pushed as a popular fix for small company liquidity and capital formation.   Of course, individual traders are determined to make trades in many different places, which means government intervention would be required to force stock trading back onto the largest stock exchanges[1]. Rent-seeking regulations are often cloaked in the language of “reform” and the public good.

We Believe in Open Markets

“Curb of bigness is indispensable to true Democracy & liberty.”

—Louis D. Brandeis

Experience teaches that the best products develop from the race for consumers, not due do regulatory mandates.  Competition creates diversity of choice, and not just between exchanges—but between brokers and dealers, and between exchanges and alternative markets.  This is not a new idea. In the 1970s, Congressional rulemaking[2] advocated for the principle of opening markets to fair competition when it directed the SEC to create economically efficient securities markets enhanced by technology.

The inverse of big monopolies is a decentralized and fragmented marketplace—an energetic condition of capitalism beneficial to consumers.  Twenty years ago, the underdog automated quotation system, NASDAQ, bragged about the multiplicity of market centers it supported. They boasted about their network of over 300 market makers, agency brokers and ECNs—linked together by technology and transparency—competing for every trade. They lobbied hard against Rules 390 and 500 that enabled a despised monopoly.[3] Today, a more established NASDAQ promotes the misperception that small company liquidity must be bolstered by banning other exchanges from competing with the NASDAQ order book.

We Believe in Transparent Markets

“Electric light the most efficient policeman.”

—Louis D. Brandeis

On the positive side, transparency and data availability are now fueled by improved technology, empowering the daily decisions of traders and investors. Driving transparency is also not a new idea. The Exchange Act of 1934 included public disclosure principles that formed the very DNA of the SEC. Congressional rulemaking[4] in the 1970s required the availability of public market prices. Regulators will only succeed by focusing on broader access to useful information. As an industry, we must encourage increased transparency to make markets work effectively and enable investors to easily analyze, value and trade securities.

We Believe in Connected Markets

“Organization can never be a substitute for initiative and for judgement.”

—Louis D. Brandeis

Those SEC Congressional mandates from the 1970s also endorsed two critical practices: connecting trades with competitive price providers and matching investor orders directly [5].  These policies challenged market monopolies and unnecessary markups from specialists. A direct connection allows a trade to follow the shortest or most efficient path to its best destination. Every player who touches a trade—a broker, a dealer or an exchange—will take a cut of the transaction in some form.  However, for the past twenty years, rather than rely on the wisdom of the crowd to choose winners and losers, regulators have favored the supposed simplicity of the agency brokerage business and exchange-matching engines over dealer market making.   If we want vibrant markets, we should treat all intermediaries equally.

Rather than reducing small-company trading to a single, centralized exchange—which studies show harms investor execution quality —[6] let’s allow the market to decide. Traders should choose whether a trade goes directly to an exchange, to the market makers creating the best liquidity, or to a lower-fee dark pool. This freedom empowers market participants to optimize execution quality, add intermediaries that increase the value chain and steadily remove extraneous costs.

 

These Principles Foster Progress & Innovation

“There are no shortcuts in evolution.”

—Louis D. Brandeis

Finally, we need a more imaginative and sweeping approach to enhancing capital formation. Regulatory restrictions—not secondary market structure—prevent more companies from going public. Disclosure drives investor protection and efficient market prices.   But we must continually find ways to lower the costs for issuers and empower investors with the internet’s open access to data.  Small investors can keep themselves out of harms way if we shine a clear light on the actions of powerful players.  To level the playing field, investors need timely, consistent facts on company share issuance and insider buying and selling, as well as understanding of large long and short positions.  The muddy plumbing of transfer agents, clearing, custody and stock loans must finally be unclogged through better data sharing and trusted record keeping.  The creatures and structures that investors cannot see should keep regulators up at night.

Smaller public companies should not have to raise capital—at a significant discount to market prices—through opaque private offerings from unregulated intermediaries. We need to make crowdfunding regulations work, expand access to shelf offerings and invent alternative methods[7] for companies to directly connect with share trading liquidity. And of course, more benefits, such as Employee Stock Ownership Plans and margin eligibility, should be offered to companies that choose transparency.  In the future, going public should be easier than remaining private.

Open, transparent, connected: these three qualities describe a public market where competitive forces can thrive over the long term. We live in a democracy founded on the revolutionary idea of individual liberty. That freedom is enshrined in open markets that foster greater transparency and build connections. While our tactics and technology will change, these enduring principles will chart a path to the most informed and efficient markets. The potential for true innovation must outshine the false-promises of centralized control and complacent popularity.

 

Footnotes:

[1] A recent example is the NASDAQ Total Markets proposal, a slickly written marketing piece for government mandated monopolies and duopolies.  See, Nasdaq Total Markets: A Blueprint for a Better Tomorrow.

[2]Congressional findings of the 1975 Amendments to the Securities Exchange Act of 1934 codified in Section 11A of the Exchange Act provide, among other things, that [“i]t is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure

(i) economically efficient execution of securities transactions

(ii) fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets” (15 U.S.C. § 78k-1(a)).

[3] See, Jenny Anderson, “Nasdaq Asks SEC to Open ‘Roach Motel’” NYPost.com (May 14, 2003), available at: https://nypost.com/2003/05/14/nasdaq-asks-sec-to-open-roach-motel/

[4] “It is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure . . . the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities” (15 U.S.C. § 78k-1(a)).

[5] “It is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure . . . the practicability of brokers executing investors’ orders in the best market and an opportunity, . . . for investors’ orders to be executed without the participation of a dealer.”  Id.

[6] AQR Capital Management conducted a study that used live trade execution data across 21 developed equity markets over a 19-year period, to measure the real-world trading costs and price impact.  Lack of competing exchanges, no OTC trading, and intraday auctions were the three largest negatives for investor execution quality.    See, Frazzini, Andrea and Israel, Ronen and Moskowitz, Tobias J., Trading Costs (April 7, 2018), available at SSRN: https://ssrn.com/abstract=3229719.

[7] See, Cromwell Coulson “Give Companies Easier Access to Public Markets” Bloomberg (March 22, 2017), available at:  https://www.bloomberg.com/opinion/articles/2017-03-22/give-companies-easier-access-to-public-markets