8-27-13 3:16 PM EDT | Email Article

By David Weidner, MarketWatch


SAN FRANCISCO (MarketWatch) -- Investors have been complaining about unfair treatment in the markets since they started trading stocks under the buttonwood tree at 68 Wall Street more than 210 years ago.


So, the hand-wringing that followed last week's "black squirrel" -- as MarketWatch columnist Chuck Jaffe described the trading glitch -- shut down at the Nasdaq, operated by Nasdaq OMX Group Inc. (NDAQ), was hardly a surprise. It was more like a tradition. The market itself is a middleman between buyers and sellers. And you know what they say about middlemen. Eliminate them.


The last decade was supposed to change all of this. Electronic markets were supposed to bring a new democracy to investing. No longer would institutions, favored because of the big fees they generated, be ushered to the front of the line. Human temptation, in the form of market makers and specialists, was made extinct.


This move from dealers to digits was crystallized in 2007 by the Securities and Exchange Commission. The law was called Regulation NMS, for National Market System.


Much of Regulation NMS had been implemented in the years prior; the final law consolidated them. But, effectively, the law made sweeping changes -- decimalization, which cut exchange and specialist fees; order protection; and the trade-through rule, which eliminated the need for investors to comparison shop exchanges for the best-priced bids and offers.


These changes were supported by investor advocates -- and fought vigorously by the exchanges, which were doing a good business in the margins on trades where the bid was at, say, 1 1/4 and the offer was at 1 5/8.


But the loss of margins and other advantages was one thing; preventing new opportunities for big, or resourceful, traders to squeeze them was another. Regulators got the first part right and failed miserably at the second.


As Dick Grasso, the former chairman of the New York Stock Exchange, now under the aegis of NYSE Euronext Inc. (NYX) said in 2011 when the NYSE was planning to merge with the Deutsche Boerse that the exchange had no choice but to embrace the new system, which, in turn, left those who benefited from the old system to game the new one.


"We went from fractions to pennies, which was a congressional mandate, SEC-supported," Grasso said. "Structure-of-the-market initiatives from the policy makers basically took what was once a central form of price discovery with four or five perimeter alternatives to a business now where there are 80-plus different alternatives to points of execution: Some exchanges. Some alternative trading platforms. Some dark pools. Some of them kind of in-between."


In other words, institutions and the big brokerages coveted the anonymity and ability to, if not manipulate part of the market, at least influence or sway it. A pure electronic market, linked to all markets, was just too big for them to push or pull the price of a security.


So, the change to electronic markets essentially led them down two avenues: embracing technology and quantitative trading through algorithms along with entering or creating off-market private exchanges, such as dark pools, as private exchanges where trades occur outside of the public markets are known, and BATS Global Markets Inc.


And -- no surprise -- they learned and adapted pretty fast. Within a couple of years of Regulation NMS, almost all trading was being done electronically -- with less than 5% taking place on the NYSE floor -- and much of it away from the public, to a point where 13% of stock-trading volume is in dark pools.


Combined, all of these changes had two hugely consequential effects. They restored market inequity by tilting advantages to Wall Street brokerages and institutions, and they unleashed a new raw dynamic into the marketplace: unproven and untested computers, software and other technology that at times overloads or overwhelms systems that weren't really meant for the kind of stresses they impose.


Imagine trying to race a Ford Focus at 90 miles an hour on a twisting mountain highway or simultaneously running a dozen memory-intensive apps on your computer, and you get the sense of what happened in the "" of May 2010 or in last week's Nasdaq "flash freeze."


Regular investors like you and me, of course, lose. Big institutions have access to the dark pools, the fast-linked computers, the market makers and the data that put them back at the front of the line. The rest of us find ourselves not only suffering through outages and crashes but in the same old situation as before: trading on information that's too often a day late and a dollar short.


In that way, it's not unlike the inequity that traders who couldn't get close enough to the action under the buttonwood tree 200-plus years ago complained of.


But in many ways, today's markets are worse. Regulators are woefully undermanned and overwhelmed by the speed and changing landscape of the markets. And Mary Jo White's SEC seems no more able to ferret out what happened last week than Mary Schapiro's SEC was in investigating the flash crash a couple of years ago.


At this stage it's impossible to put the genie back in the bottle. Electronic trading, the dark pools and the gamesmanship aren't going away.


That doesn't mean regulators can't slow things down. They can review new trading platforms and require greater disclosure from private markets. They can fine and discipline exchanges that blow a circuit and disrupt trading.


Or they could continue the current course, which, to put it in 18th-century terms, is to just ask everyone to gather under a tree and hope lightning doesn't strike.

-David Weidner; 415-439-6400; AskNewswires@dowjones.com


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08-27-13 1516ET

Copyright (c) 2013 Dow Jones & Company, Inc.
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