Since the May 6 Flash Crash, there has been a beehive of regulatory activity that has drilled into the minutiae of the U.S. trading system. The concepts start to blur after a while--flash quotes, Flash Crash, flash dancing (just kidding), stub quotes, quote stuffing, lit market, dark pools, IOIs, naked access, sponsored access and on and on. What has been missing for a lot of people, myself included, is a look at the big picture.

In that spirit, I highly recommend a recent letter from Sen. Edward Kaufman to the SEC for its willingness to try and touch on specific solutions without losing sight of the big picture of the U.S. equity markets, which should be more than casino. It should be a service that facilitates capital formation (though the idea that the majority of corporate capital is raised on exchanges is a myth) and long-term investing for all. 

The recommendations in the letter are compelling in many ways. (We'll discuss some in more detail at a later date.) But the point here is not to discuss specific pieces of the overall solution--there's been enough of that--but rather to re-think the very philosophy behind the direction of the markets over the last two decades. Kaufman boldly asserts that maybe it's time to re-think the idea that narrow spreads and low commissions are the best yardsticks by which to measure the progress in market structure. 

If you mull this, you start to get a sense of how powerful the concept is. Indeed, since the 1970s days of fixed commissions, it seems like every significant move has been to promote competition as measured by declining commissions and reduced spreads. The big regulatory milestones all push toward these twin goals, from the order handling rules of the mid-1990s to the sanctioning of ECNs to Reg ATS to a really big moment in 2001, the switch to decimals. All of that pointed toward Reg NMS, dark pools and super-fast trading and then another big move--toward maker-taker pricing, which high-frequency firms have used so adroitly. These innovations were done in the name of competition and better commissions for all investors--especially retail investors. 

But have we reached the point where we have to think about whether ever lower spreads and lower commissions are the best yardsticks? Kaufman says yes. Perhaps the better goal--instead of ever narrower spreads--would now be wider spreads, deeper order books and a larger protected quote size. The costs may be more predicable but not necessarily larger. Narrow fluctuating spreads may have encouraged the opposite, with hidden costs built in somehow in the form of a "thin crust" of liquidity and hard-to measure price impacts. 

It's true that some high-frequency firms have little incentive to let orders not at the top of the order book sit. About 10 orders are cancelled for every hit. So would it be worth it to widen spreads a little but perhaps create conditions in which more people have a decent chance at an execution. Is this a step backward? Food for thought. - Jim