EC What Will It Take To Regulate The Stock Markets?

Better data and better cooperation are needed.

Past efforts to regulate the U.S. stock markets have brought mixed success and more than a few unintended consequences.

With momentum building after the 2008 crisis to implement further regulations to financial markets, Torben G. Andersen, a professor of finance at the Kellogg School, thinks now is the time to push for a better understanding of the markets as they exist today. “If this ongoing regulation is to have bite and be sensible and be structured the right way, we do need to understand what is right and wrong in the current way things are organized,” says Andersen.

“The amount of message traffic in the system, because of the way it’s structured, is absolutely enormous.”

Once scholars have a better idea of how dark pools operate, for instance, or how high-frequency traders behave in the current market landscape, they could work with regulators to determine the impact of different kinds of regulations before they are put in place.

“It’s very dangerous to throw regulation out there, because you don’t want to kill trading in the U.S.,” says Andersen. This is why experimentation will be so important, he continues: “We take a subset of the markets, a subset of the stocks, make them subject to some regulation, follow it for 3 or 6 months, see what happens, and then decide whether you want to do this for all the stocks and all the exchanges.”

But before this kind of experimentation can happen, researchers will need access to better datasets—and the right tools to deal with this data.

A History of Regulation
The U.S. stock markets used to be dominated by just a few exchanges, each of which had a near monopoly on certain stocks. The markets relied heavily on human interaction to operate. But as technology for trading securities began to improve around the world, the U.S. was slow to change.

Nervous that electronic exchanges elsewhere would overtake the U.S. financial markets, in 2007 the SEC implemented regulation designed to propel domestic markets into the digital age. “They wanted to make the system better,” says Andersen, “more competition and more access.”

This regulation, known as Reg NMS, spelled out a number of ground rules for both exchanges and brokers. Some of these rules have worked largely as expected. For instance, regulations on tick size—the minimum increment in which a price can move up or down—have successfully prevented brokers from jumping ahead of other traders by fragmenting prices further and further, and in the process making price comparisons nearly impossible.

But other rules, says Andersen, have placed unintended burdens on brokers and market infrastructure: “You’re forcing an interconnectedness that doesn’t necessarily have to be there.”

More Transparency, More Complexity
The most substantial regulations prodded the exchanges to publically post the best price at which a particular stock could be bought or sold and forced brokers to check all of these prices to get the best deal for their customers. The goal was to increase transparency and access to the markets, spurring competition.