Unintended consequences and the fall of the specialist

When Regulation National Market System (“Reg NMS”) passed in 2005, the SEC promised it would modernize the U.S. exchange system, streamlining trading efficiency and increasing investors’ access to market and price information. But the new rules have had troubling long-term consequences for exchange-traded fund specialists and their investors.

In particular, the “Order Protection Rule” of Reg NMS requires trading centers to always seek the best prices for their orders, regardless of exchange. In the past, traders had the option of “trading through” a bid or offer to take an inferior price, but now under Reg NMS, displayed top-of-book prices cannot be ignored. If a better price appears on another exchange, the trade must take place there instead.

The rule’s theoretical appeal is obvious: investors get the “best” possible price for their trades. But like any major market change, there have been significant consequences that were likely not anticipated when the rule was originally designed.

For starters, the Reg NMS protection extends to the best bid/offer for automated quotations, from block trades to 100-share orders. But prices for hidden orders kept in reserve—the kind many specialists handle for their institutional clients—are not similarly protected, even if they may be better than the current quoted price.

In addition, the Order Protection Rule requires speed to execute effectively— after all, traders aren’t going to make 10 phone calls for each order. To keep up, the New York Stock Exchange was forced in 2007 to adopt a hybrid electronic trading model, finally giving up its all-human floor system.

Together, these two changes have dramatically reduced business opportunity for specialists, who managed liquidity on the NYSE for more than 200 years. Specialists are still allowed to handle trades for clients upon request, or to work trades involving less-liquid or highly volatile securities, but their importance has decayed in an automated world.

The demise of specialists causes problems for new ETFs. Historically, specialists provided the “seed capital” for launching new ETFs: the initial $10 million, $20 million or $50 million investments that help create a liquid market for fund shares. Specialists did this because they were compensated for providing liquidity to the market—and because it gave them access to market information.

Under Reg NMS, however, a specialist’s trading advantage has eroded, and so they have little incentive to funnel capital to new and potentially illiquid ETFs. Therefore, ETF sponsors have had to scramble for initial capital. Of the 222 ETFs launched in 2008, 49% had total assets under management under $5 million at the end of the year, and two-thirds had assets under $10 million.

Small size often deters investors and financial advisors, making organic asset growth extremely difficult for new funds. That’s one reason why 58 ETFs and ETNs were liquidated last year, even though investors poured another $178 billion into ETFs, and trading volume soared 70% above 2007 levels.

“Reg NMS has made speed more important than price,” says Dan McCabe, CEO of ETF-construction experts NEXT Investments.

This opens up the market to increased volatility, which invites high-frequency traders to flood the space in search of liquidity rebates. “High-frequency traders don’t have a franchise to protect. They have no skin in the game,” says McCabe. It’s a stark contrast to the markets of the late 20th century, where membershipbased exchanges ensured a level of longterm participation.

“Who does the market really exist for?” he adds. “These recent changes have put traders at the market core. But investors must always come first—it’s their money.”

(Data courtesy IndexUniverse.com, February 2009)