Understanding Today’s Market Structure
The Expert View
Featuring Justin Schack
Published on: July 2nd, 2019 • Duration: 36 minutesAs investors’ options have grown exponentially, the underlying market structure has become incredibly complex. And according to market structure expert Justin Schack, no one with a blank slate would recreate today’s market structure. Schack, a partner at Rosenblatt Securities, says that despite all the complexity, it’s not a fundamentally unfair system that should be “blown up”. Instead, he believes investors have largely benefitted from the changes in market structure. He also argues that some advocates for structural change have ulterior motives. Filmed on April 9, 2019 in New York.
ED And here, we're doing Market Structure as our Tuesday Trend topic this month. And our first interview is going to be with Justin Schack, who gives a little taste of the history of market structure. Think of this interview as a prelude to the Friday interview that we're going to have with Ronan Ryan of IEX. We hope that you enjoy this interview with Justin.
JUSTIN SCHACK: I'm Justin Schack. I'm a partner and managing director at Rosenblatt Securities and I had the market structure group there. Market structure is probably best described as the how and the what of buying and selling stocks, what happens after you make the decision, this is a security that I want to buy, or this is a security that I want to sell. And a lot of people think an awful lot about that part of it, but don't think about or know about what happens behind the scenes after they ask their broker, okay, yes, please buy me that 100 shares of XYZ or sell me this 300 shares of ABCD. So, it's the rules, the regulations, the plumbing, where your orders are executed and how your orders are executed.
Where we are today is a pretty complex system that I like to say a lot and a lot of other people who do what I do for a living like to say a lot, no one would ever design on a blank sheet of paper. There are 13 different stock exchanges in the United States, there are dozens of other off-exchange destinations. And when a retail investor using an online broker or a mutual fund or a hedge fund that may have some retail investors money in his or her fund chooses to buy or sell something, the orders can be- and the shares can be bought and sold in any one of those places. And it wasn't always that way. It used to be a lot simpler, it used to be a lot more manual with more human beings involved.
Today, it's very automated and very speedy with computers taking care of a lot of the decision making with obviously human programming beforehand. But what used to happen, and this was probably 20 plus years ago, when things started changing, is it was a much simpler system that as I said, there were a lot of human beings involved. And if a stock was listed on the New York Stock Exchange, it pretty much traded on the floor of the New York Stock Exchange. If it wasn't, it was noticed in over-the- counter stock or a NASDAQ stock and it traded among a bunch of dealers upstairs the way bonds trade today.
There was a human being there in both of those cases, either on the other end of the phone, most of the time, on the other end of the phone, where whoever the customer was, could first give the order in person to that- or verbally to that person. And then keep in touch throughout the execution and say well, how are we doing? If it was a big order, particularly I'm thinking of how a mutual fund or a pension fund might transact if they had to buy 500,000 shares of something or a million shares of something. There would be someone to keep in touch with or someone to say, okay, you're done on this and now, we can move on to the next thing.
And for a lot of reasons that I don't know that I want to go into super fine detail on, at least not yet, lot of regulatory changes, a lot of changes in technology and the way the market reacted to those, we have a much more complex system that's not as obvious to people on the surface, and I think more difficult for them to understand. And that brings a lot of conflicts of interest into play.
How did market structure get so complex?
A lot of the awareness first started to come to the fore around the time of the financial crisis. Flash Boys certainly was a flashpoint, if you will, where a lot of people who had never heard the phrase market structure before, probably heard it for the first time or heard about a lot of what market structure is for the first time. But as a practitioner, who is teaching people market structure and my job is to understand it and explain it to people, I really started to see a step change around 2008, fall of 2008, early 2009, where people started to discover a lot of the changes that had been happening behind the scenes for a decade plus.
And it's interesting, whether it was then or whether it's when you read a book like Flash Boys, it's a common and understandable reaction to say, why does this have to be so complex? Why does the system have to look this way? I often use a Rube Goldberg as an analogy, or it's a jury rigged system. It's been put together piecemeal, over many, many years. And as I said before, no one would design the system we have today from scratch. And I think as you come to that as a newcomer, and you haven't been living it for the entire evolution, you say to yourself, it doesn't have to be this way. It's ridiculous. And because it's so complex, people who understand it and are sophisticated, can use their knowledge of it to take advantage of people who don't.
And I think some of that has happened. But by and large, when I look at the evolution of market structure since the mid to late 1990s and I've covered it every step of the way, both of my job today and as a journalist previously, it has coincided with and I think, in large part caused a lot of deficiency that has put more money in the pockets of end investors. It's taken a lot of the Vig, if you will out of the system for intermediaries and put it into the pockets of investors, implementation costs for investors are lower than they've ever been. And I think that is in large part to a lot of the structural changes that we've seen over the years that have come along with a lot of complexity that need to be managed. So, there's two sides to the coin. But I think on the whole, it's been a good trade for the little guy.
What's your overall assessment of US equity markets?
I think, look, it's far from perfect, and there are always things that you can make better. We've done a decent job as an industry and as a regulatory and legislative community, trying to get at some of those things over the past 10 or so years. But if one thing, if you compare the way equity markets work, the stock market works with bond markets, foreign exchange markets, all kinds of other asset classes that are less liquid, traded over the counter with a lot less transparency and a lot less regulation. Investors and stocks get a fantastic deal, whether you're a retail investor, and you're trading for 999, or for free in terms of commissions, and you get a pretty good execution in terms of the price that you're executed at as well, because there are a lot of market makers competing for that business, or institutional investors that I've seen, their implementation costs go down over a long period of time.
So, another thing I would say about this is market structure has become a bit of a commercial battle ground. It always was in various ways. But I think what we're seeing now is there are folks who are in the industry who look at market structure as the reason why maybe their operating costs are too high, and their profit margins are lower than they might otherwise like. And they are agitating for market structure changes that would help them commercially. And there's a whole marketplace of ideas or battleground of ideas, if you will. There are people advocating for their own interests.
But what I worry about is unintended consequences. So, I look at the system we have today and say, yeah, it's far from perfect. Again, we wouldn't design it this way if we were starting from scratch. But the outcomes people get are pretty good. And if you look at various points along the way in that evolution, particularly in, say the early to mid-2000s, where the market was reacting to a lot of regulatory and competitive and technological change that had come over the past five, six, seven, eight, nine years, there were some periods where things got worse before they got better.
And the system that we have today, I liken it a lot and using all these metaphors, but a Jenga tower is another one that I use, I think everybody's played that game Jenga before where you have all the different wood blocks. And we've put one block on top of the other or year over year over year, both in terms of regulatory initiatives, and then in the way that market participants have reacted to those regulations and built elements of the structure. What I fear is we're going to go see one block there and see, well, that looks really tempting, rebates that exchanges pay, for instance. This looks like it's an obvious conflict of interest, let's get rid of that one. And then there's a whole lot of other stuff that's resting on that. And we have negative unintended consequences.
So, I take the market is not fundamentally broken approach. And if it isn't fundamentally broken, we probably shouldn't try to institute major fixes.
What do investors need to know about market structure?
I think the thing that the average investor needs to understand is, market structure does matter. Even though I'm saying the system works very well for them. And it undoubtedly does. That's not to say it's perfect. And I think of one thing that we focused a lot on with our clients or not retail investors, we're dealing with the asset managers, the mutual fund companies, the pension funds that aggregate a lot of that retail money in and invest it in the markets. One of the things that we've told them a lot for better part of a decade now is because the market structure is so complex, there are conflicts of interest embedded in that.
And what I mean particularly by that is, when a mutual fund company or a pension fund sends a big order to a broker, that broker has a lot of choices. And I alluded to this at the outset of 13 different exchanges, dozens of different off-exchange venues, which are often called dark pools. And where they choose to go with your order or pieces of your order sometimes helps them and not you or not necessarily you. And so, I think it's very important that investors generally, but particularly the professionals that sit in between what the chairman of the SEC likes to call Mr. And Mrs. 401K and the markets. The mutual fund companies, the pension funds, the hedge funds in some, in some instances, that they really understand this market structure in all its complexity.
They know what the potential conflicts of interest are. And they're watching what their brokers do. They're asking for data from their brokers about where are you routing my orders when I send them to you? Again, back in the old days, it was, hey, I have given this order to a broker on the floor, and I'm talking to him are all day long as the order gets executed. And know what's going on. Today, a very large order for a mutual fund is typically broken into lots and lots of smaller pieces, and executed throughout the day, or maybe even multiple days, and goes to perhaps all of those 13 exchanges and dozens of dark pools and other venues off-exchange.
And there's different rules at each one of those venues, there's different fees that the brokers pay, and those fees don't get passed on to the end customer. And that is the source of a lot of conflict where a broker might say, well, the best price is sitting there on an exchange, and I really should just go get that price, I should buy the stock on the exchange where I can see a displayed quotation, but it's going to cost me money to do that. And I don't want to pay that money because I want to keep as much of my customers commission dollar as possible. So, instead, I'm going to try going around in some of these off-exchange destinations, or maybe some of the exchanges that would pay me a rebate for that already, rather than charging a fee.
And that can be detrimental to the client because it takes time to do and in that time, price might move away. You might wind up getting a worse price if you find nothing in those other places and then wind up taking that exchange quotation that might be buying the stock for more or selling the stock for less. And then you also might be leaking information, which would affect prices negatively for the end investor. So, we've been really focused on educating our customers about that. And as I said, it's the thing where the average person at home who might be watching this, or who might be thinking about their 401K, or their personal portfolio, probably doesn't need to spend a ton of time on it.
But whoever standing between them and the markets, if it's a mutual fund company or a pension fund or something like that, they absolutely should be on top of all this stuff and collecting data and trying to root out those conflict of interest and change broker behavior when necessary.
How does the existing price model work?
If you really want to dig into some of the specifics of how we got to where we are today compared to the system that existed before, which really existed for like hundreds of years. It was, you think about what the New York Stock Exchange was in the 1790s. There were a bunch of people that were trading stocks out on the street, and they met under a Buttonwood tree and said, well, we're just going to do business with one another. And that became the foundation of what is today, the New York Stock Exchange. And what, until about 20 years ago, was a not-for-profit utility, basically, that was owned by and operated for the benefit of the biggest firms on Wall Street.
And it was only in the mid-1990s that that started to change. Yes. So, you mentioned the book, Flash Boys, before and the author of that book around the time that it was published became infamous for saying that he thought the stock market was rigged. And that became like a big buzzword and a big debate. Is the market rigged? Is the market not rigged? And I think most of the people in the industry that I work in thought that and know that it wasn't and isn't rigged. If you leave that aside for a second, I bring it up because back in the mid-1990s and before, it actually was rigged.
It literally was a rigged marketplace. And the United States Department of Justice in 1996 came to a settlement where a bunch of I think was 24 different big Wall Street firms basically pled guilty- not pled guilty but reached a settlement where they were accused of rigging the market and keeping the spreads artificially wide. And this was the portion of the market that I referred to earlier as over-the-counter was not the on-exchange piece. It's what today is known as NASDAQ stocks. But NASDAQ was not yet an exchange then, so it was like an over-the-counter dealer market, the way bonds get traded today.
And the big dealers who dominated that market, first of all, the minimum tick or the minimum increment at which a price could move back then was an eighth of $1, we still worked in eighth increments, fractional increments rather than decimals, which actually goes back to when there were Spanish coins that were actually called pieces of eight were circulated in lower Manhattan. That's how long that system had been in place. And so, the spread effectively between what a dealer would be quoting on a bid, I'll buy the stock for this, and I'll sell the stock for that, could not be narrower than one eighth of $1, which in today's terms, if you think about the most liquid actively traded stocks, that spread is a penny, as opposed to 12 and a half cents, which was an eighth of the dollar.
But that 12 and a half cents wasn't good enough for those dealers. And they were found to be conspiring with one another, colluding to set the spreads at a quarter per dollar. And they were recorded on the phone like yelling at each other saying no, no, no, don't quote the odd eighths. There was a famous academic paper by guys named Schultz and Christie who noticed that the NASDAQ market makers would never quote the odd eighth increments, they would only quote the even eighths. And so, the Justice Department came in, investigated that and there was the settlement. And then there were some rules passed to make sure that something like that never happened again.
And this is a classic case of unintended consequences, which was the thing I worry about today. And the regulatory response was, okay, one way that the dealers were able to keep that spread artificially wide was that if a customer came in and had an order that was better than their quote. For example, the dealer is quoting, I'll buy them for 10. And I'll sell them for 10 and a quarter. If a customer came in and said I'll buy that stock for 10 and an eighth, or I'll sell it at 10 and an eighth. What typically happened back then was the dealer would say, okay, thanks for that order, and then keep this quote at 10 to 10 and a quarter. And eventually, when the market would move, the customer would get filled at 10 and an eighth, but the spread that the dealer collected, which was the source of the dealer's profit would stay at a quarter wide.
So, the regulators said, from now on, if you have a customer order that comes in and would narrow the spread that you're quoting on the NASDAQ screen, you have to display it, but they did not say how the dealers had to display it. And this started this chain of market structure evolution and the building of that Jenga tower that I mentioned earlier. Because one way that the dealers did this at first was they would ship it off to other places, not the NASDAQ screen, which is where most of the business went. But there was a system called Instinet, which became known as an electronic communications network. It was an inner dealer broker where the dealers traded with one another at slightly better prices and offloaded their risk.
And eventually, Instinet started to get all these customer limited orders. And then there were a bunch of other copycats to Instinet that got formed. And these were known as ECNs, electronic communications networks. And they had names like Island or Archipelago or Brute or Strike. There were like eight or nine of them in the late 1990s after this set of order handling rules was passed in 1996-1997. After that Justice Department investigation.
And by the turn of the century, a third of the volume in that NASDAQ OTC stock universe was done on those ECNs and not with the main dealers. And that got Wall Street nervous. And this you might recall or some of your viewers might recall if they're as old as me, this was also about the time that firms like Ameritrade, E-trade, Charles Schwab were becoming really popular as online brokers and taking business away from the Merrill Lynches and Dean Witters and Paine Webbers of the world. A lot of the big brokerage firms at that time, they didn't really understand how the outcome of that scandal was going to play out. And they saw that they were losing market share.
And then they started to fund a lot of these new proto- electronic exchanges, these ECNs, and they started agitating for regulatory changes that would help them compete with the existing markets, the NASD and the New York Stock Exchange. And that, to hopefully make a long story shorter, forced those entities to shed their for profit or not-for-profit mutualized structure where the brokers owned them. And they were not-for-profit, they were run for the benefit of the brokers, because now, they had this new class of competitors that their biggest customers were funding and trying to pave the way with regulators for so that they could be more competitive with the NASD, which now is NASDAQ and New York Stock Exchange decided to demutualize and become for profit publicly traded companies as a result of this.
This happened at around the same time when a lot of this business was going to these ECNs. And they were faster. And they were automatic execution. And you mentioned maker taker before. One of these ECNs, which was called Island in 1998 to try to get business said you know what, instead of just paying us a fee for everything, if you put an order on our order book, and someone removes that liquidity, someone hits your bid or lifts your offer, we're going to pay you a rebate.