James Angel, Lawrence Harris, and Chester S. Spatt
USC Marshall School of Business
The U.S. equity market changed dramatically in recent years. Increasing automation and the entry of new trading platforms has resulted in intense competition among trading platforms.
Despite these changes, traders still face the same challenges as before. They seek to minimize the total cost of trading including commissions, bid/ask spreads, and market impact. New technologies allow traders to implement traditional strategies more effectively. For example, dark pools and indications of interest are just an updated form of tactics that NYSE floor traders used search for counterparties while minimizing the exposure of their clients’ trading interest to prevent front running.
Virtually every measurable dimension of U.S. equity market quality has improved. Execution speeds and retail commission have fallen. Bid-ask spreads have fallen and remain low, although they spiked upward along with volatility during the recent financial crisis. Market depth has increased. Studies of institutional transactions costs find U.S. costs among the lowest in the world. Unlike during the Crash of 1987, the U.S. equity market mechanism handled the increase in trading volume and volatility without disruption. However, our markets lack a market-wide risk management system that would deal with computer generated chaos in real time, and our regulators should address this.
“Make or take” pricing, the charging of access fees to market orders that “take” liquidity and paying rebates to limit orders that “make” liquidity, causes distortions that should be corrected. Such charges are not reflected in the quotations used for the measurement of best execution. Direct access by non-brokers to trading platforms requires appropriate risk management. Front running orders in correlated securities should be banned.