Thomas Murray - Market Structure and its Importance for Infrastructures and Custody

Market Structure and its Importance for Infrastructures and Custody

Conversation with Justin Schack, Partner and Head of Market Structure, Rosenblatt Securities

Rosenblatt is a boutique securities firm based in New York whose core business is institutional brokerage in US equities. Its roots are on the floor of the New York Stock Exchange, where it pioneered in offering asset managers direct access to NYSE trading during the 1980s. Today, it is the biggest broker on the NYSE floor, offering clients services unique to floor brokers, such as greater flexibility when participating in the closing auction. Rosenblatt also serves the buy side through its upstairs desk, which specialises in portfolio trades for quantitative asset managers as well as single-stock execution.

Justin Schack joined the firm 10 years ago, when Richard Rosenblatt, founder and chairman, and Joe Gawronski, its president, had begun offering views for clients on what was then a rapidly evolving market structure for US equities. Demand for market-structure analysis was soaring, so Justin’s focus enabled the firm to publish more extensively and regularly. Since then, two other market structure analysts were hired in New York, and one in London. Rosenblatt also provides bespoke market-structure intelligence to clients, and engages in a variety of consulting assignments with investors, banks, exchanges, regulators, and proprietary trading firms.

For Thomas Murray’s clients, how an order is executed is the beginning of the chain of events that swiftly leads to settlement and then a period of safekeeping by a custodian before being resold. In the custody period, securities held are often lent back into the market at varying conditions depending on the market interest of the moment. Those same market conditions must have their effect on the processes later on in the chain, intuitively.

  1. We are years on from the implementation of Regulation ATS in the US and MiFID I in the European Union, which led to the multiplication of public market execution facilities, in both number and nature. To keep its professional edge for its clients, Rosenblatt research was deployed to differentiate the firm’s offer by enabling its clients to keep up with how their orders were being executed relative to the many possibilities. Can you tell readers how that strategic decision was taken? Can you step back and reflect on how well the research effort has gone in this regard?
  2. We became one of the first firms in the world to offer market-structure research to institutional investors largely because Dick Rosenblatt was passionate about it. He had views and insights to share with our clients when US equity market structure was undergoing sweeping change in the mid-2000s. At that time, Dick and Joe Gawronski were writing long essays to clients about the debate over Regulation NMS, which was proposed in 2004, and other market-structure issues. Clients liked it, so Dick and Joe naturally wanted to give them more.

    It really was a matter of Dick and Joe listening to our customers and deciding to expand in an area that could differentiate us from other agency brokers. Over the years, we’ve informed lots of clients about how market structure has evolved and how to cope with the complexity, automation, and speed that characterise today’s landscape. Overall, our message has been that investors get better outcomes in today’s structure than in the one it replaced, but they need to be educated about how and why things have changed so they can protect themselves in a complex market. Specifically, we’ve hammered home the message that brokers face profound conflicts of interest when routing investor orders among the dozens of exchanges and off-board execution venues, with their dizzying array of fee structures, order types and other features. Investors need to collect and analyse routing and execution data to keep their brokers honest — and examine whether their own workflows and trading decisions might be resulting in sub-optimal outcomes. We’re pleased that so many clients regard us as an independent voice of reason in a world of market-structure commentary that can be emotionally charged and self-interested.

  3. What were some of the surprises you came across as the market structure changed, by regulation and also by technology? What was foreseeable? Some say the markets have never been better, though I am not sure what that actually means – but to what extent might this be true?
  4. Your question about what has been surprising or foreseeable is a very good one. When I joined Rosenblatt, I’d been following the evolution of US market structure for a decade already, as a journalist. So I’d seen how the unintended consequences of regulation had led to greater complexity, which many market participants found undesirable.

    Reg NMS was in large part an effort to knit a fragmenting market back together. It did that in some respects, but also contributed to even more fragmentation and complexity, largely because market participants changed their behavior in ways that even the smartest regulators could not easily foresee. Probably the best example is how brokers responded to Reg NMS and its order-protection rule by creating an array of dark ATSs. Many had assumed that the new rule would force brokers to route orders to exchanges. But, importantly, it states only that transactions cannot occur at prices worse than protected quotations, not that orders must be routed to those quotations.

    Big brokers creatively took advantage of Reg ATS to establish an entirely new class of venue, in which they systematically internalised customer orders at prices equal to or better than protected exchange quotations, avoiding exchange fees in the process. Reg ATS itself was also made necessary by the unintended consequences of the so-called Order Handling Rules that grew out of a mid-1990s dealer price-rigging scandal in the US. Those rules forced dealers to publish customer orders that were better than their own quotes, but did not specify how. The dealers chose to do so not on the NASD automated quotation screens that customers used when seeking liquidity, but instead on smaller, less-used alternative platforms called ECNs.

    As those ECNs proliferated, the SEC decided to create a new regulatory status for them: the ATS. At the time these ATSs were all markets that displayed price quotations. After Reg NMS, the vast majority — dozens — were dark pools, an outcome that likely was not contemplated by the authors of the Order Handling Rules, Reg ATS or Reg NMS. Much of the structure we have today, then, was largely unforeseeable until the rules became real and market participants adapted.

    Importantly, if we compare institutional-investor outcomes today with before this great transformation — implementation cost is the best benchmark, in my view — they’re dramatically better. It’s not clear whether that’s because of or in spite of these structural changes, but I think some of them clearly played a positive role. That wasn’t the case at every step along the way, however. At about the time Reg NMS was being debated, the combination of the Order Handling Rules and the decimalisation of US price quotations led to a period of dislocation where costs went up and asset managers were not happy. I remember writing several long articles about this as a journalist back then. This is why we believe regulators need to be extremely careful when making major changes to a market structure that, for the most part, serves the investing public well.

    It’s almost impossible to see around corners and envision how Wall Street will find creative ways to comply with new rules while continuing to engage in activities that regulators may have wanted to curtail or change. We’re seeing this play out now in Europe with parts of MiFID II, which were designed by politicians to bring more trading on-exchange, but instead have pushed activity to periodic auctions and Systematic Internalisers (SIs). It’s too early to tell what the impact of that will be. But generally, we’re wary that even the most well-intentioned reforms could create unintended consequences that make things worse.

  5. Rosenblatt’s work on lit and dark markets has been world-leading from the start. Please explain why the decision was taken to build this research effort, and how the firm went about gathering the data and then interpreting it. Please also update readers on where things stand these days in the battle between lit and dark, and which actors are dominant? Does Rosenblatt perchance find these two modes of order execution complementary?
  6. We’re a broker, first and foremost. So when dark pools started proliferating in the mid-2000s, we needed to find out how they worked, as well as how much and what kinds of liquidity were available in them. We started doing this a little while before I joined the firm, so that our traders could take full advantage of every available tool when executing client orders. One of the problems we noticed at that time was a lack of transparency and standardisation among dark pools. Some would freely share volume statistics and other information with the wider world, others wouldn’t. Some would count both sides of a trade, as well as routed-out volume, in their data, while others single-counted and excluded routed shares. We quickly realised that the work we were doing internally to collect and standardise that data would also be valuable to clients who were also trying to make sense of this new world. That was the genesis (pardon the pun) of our Let There Be Light report.

    In time we also started monthly reports on exchange activity in equities and options, and expanded this work to cover Europe. The dark and off-exchange worlds have evolved during the past decade. The bigbroker-owned pools that proliferated and grew rapidly following Reg NMS have mostly plateaued, for a variety of reasons, even as total off-exchange activity has continued to rise slightly in the US. Internalisation of retail orders remains a big portion of the total off-board picture, and likely has grown a bit during the bull market we’ve been in the past few years. We’re seeing a lot of interest now in single-dealer pools. These are not regulated as ATSs, primarily because they have just one liquidity provider instead of also facilitating client crossing. So far this space has been limited to electronic market makers that have launched single-dealer pools to supplement their on-exchange or other off-exchange activities. A few of these have been around for many years. But as the market-making business has gotten more competitive and less profitable in recent years, more firms have seen single-dealer pools as an attractive way to provide liquidity on a bilateral basis, with less adverse-selection risk than on exchanges and ATSs.

    We also wouldn’t be surprised to see banks increasingly offer liquidity in this manner through their central risk books, in which many have been investing in recent years. Market-makers and banks are pursuing similar strategies in Europe with SIs, which appear to be benefiting from some of the new rules under MiFID II. Those new regulations are driving a broader re-shaping of dark trading in Europe, especially as market participants find ways to adapt to the hard caps on trading in small size without pre-trade price transparency. SIs, periodic auctions, and large-in-scale facilities are all benefiting somewhat from this, frustrating some who wanted MiFID II to bring dark trading into lit markets. As brokers, we subscribe to the principle that all of these tools can be valuable under the right circumstances. But if used improperly they can hurt execution quality.

  7. If Rosenblatt had two regulatory changes to propose for market structure each in the US and EU or elsewhere, what would they be?
  8. We’re generally not advocates for big regulatory changes, for the reasons I stated previously. If I had to pick one initiative for each region, it would be a consolidated tape for Europe and mandatory institutional-routing-and-execution-data disclosure in the US.

    So many market participants complain about the lack of reliable consolidated market data in Europe. It’s a very heavy lift given the strong commercial interests at stake, but it would be great if regulators — or better yet, the industry — could find a way to make it happen without too much disruption. In the US, we’ve been frustrated at how long it’s taken to get a rule in place requiring brokers to give institutional investors data showing how they route orders among the various execution venues. We were happy to be part of the industry working group to come up with a standardised template for this rule, which started way back in 2014. The SEC proposed the rule in July 2016 but has yet to adopt it. Many big asset managers are already doing this work on their own, and brokers have gotten much better over the years about providing such firms with the detailed data they need to analyse routing behavior. But there are many more mid-sized and smaller managers that would benefit from the rule being on the books. SEC officials have indicated that they plan to adopt it later this year, so we’re hopeful it will finally happen.

  9. With the markets we have today, what are some of your thoughts about the quality of pricing and how it might affect collateral valuations for margin posted and also securities lending and borrowing operations, topics which are of particular interest to Thomas Murray’s clients?
  10. That’s a tough one. There probably are some effects, but isolating them in such a complex environment is near impossible. Generally speaking, markets have been growing more efficient with the march of technology and regulatory initiatives to encourage transparency and standardisation. That should result in more-accurate price discovery, which would benefit all of the functions you ask about here.


The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.