Daniel Gorfine
Adjunct Fellow; Vice President, External Affairs and Associate General Counsel, OnDeck
Capital Access and Capital Markets and Demographics and FinTech and Global Economy and Public Policy
Daniel Gorfine is an adjunct fellow at the Milken Institute and vice president, external affairs and associate general counsel at OnDeck, a technology-based company focused on transforming small business lending.
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MI-GU Hill Briefing: Financial market quality: The changing structure of exchanges
By: Daniel Gorfine
June 11, 2012
The Milken Institute's Center for Financial Markets and Georgetown University's Center for Financial Markets and Policy at the McDonough School of Business hosted the latest in their joint Capitol Hill briefing series, focusing on the quality of and changes in the structure of financial markets. Speakers were James Angel, associate professor of finance at Georgetown University's McDonough School of Business; Roger Freeman, a director of equity research at Barclays; and Joseph Gawronski, president and COO of Rosenblatt Securities. Reena Aggarwal, McDonough professor of business administration and professor of finance at Georgetown University's McDonough School of Business, moderated the panel.

The speakers discussed the benefits and risks of rapid structural changes in financial markets marked by the decentralization of exchanges and advances in trading technologies. They also suggested policy prescriptions that could help to improve market depth and liquidity.

Some noteworthy takeaways from the panel discussion:

• The speakers agreed that the architecture of stock exchanges has changed significantly in the last two decades. One panelist highlighted the shift to nearly 100% computerized, decentralized, automated trading platforms, which has largely eliminated the role of traditional floor-based brokers and dealers. These advances in trading technologies have made trading more efficient by reducing transaction costs and enhancing price discovery.

• The panelists also discussed possible new risks posed by changes in market structure. First, the May 2010 Flash Crash highlighted the systemic risks of trading platforms driven by high-frequency trading algorithms not bound by human judgment. Second, the potential for trade volumes to overwhelm infrastructure remains a potential source of market disruption. And there are concerns that off-exchange equity trades, which make up 1/3 of total volume, might be hindering robust price discovery.

• As for potential policy action to mitigate these risks, the panelists expressed differing views. On the issue of high-frequency trading, one panelist argued that these traders aid capital formation in primary markets by lowering transaction costs in the secondary markets through more efficient real-time price discovery. Another panelist questioned whether the price discovery benefits from trading in milliseconds were worth the systemic risks, and argued in favor of robust circuit breakers and bans to "naked access" trades, whereby a high-frequency trader can bypass a brokeraEUR(TM)s standard filters or pre-trade checks in order to process trades faster. Another panelist suggested subjecting high-frequency traders to the same rules that govern traditional market makers in order to ensure market liquidity.

• As for off-exchange trading platforms, or so-called "dark pools," the panelists also held differing views. These platforms enable traders to buy and sell equities without publicly providing bid and ask prices, as long as final transaction prices are reported. One panelist stated that because one-third of all U.S. equity trades now occur off-exchange, the price discovery process may be negatively affected. A second panelist countered that there was still sufficient price information in the marketplace to render the impact of dark pool trading on price discovery negligible. Another panelist argued in favor of regulating dark pools the same as exchanges aEUR" in order to level the playing field with respect to the variegated and lower fees dark pools are allowed to charge traders as compared to the exchanges.

• Finally, with respect to liquidity and excess trade volumes, one panelist suggested that exchanges be prepared for trade volumes ten-times the daily average to prevent the types of trading glitches that snarled the recent Facebook IPO.