Want to know a dirty little secret? Our stock markets no longer work.
They have grown so complex, fragmented and opaque that they don't serve their stated purpose. Rather than a place where individual and professional investors can put a value on shares and where companies go to raise capital, the markets today look more like a video game. The trouble is, it's one where only a few understand all the rules.
Excessive complexity has costs. Individuals, wary of an uneven playing field, may choose not to invest. Long-term investors, frustrated by a market that doesn't value their participation, may take their trading to overseas venues or alternative private networks. Companies, unprepared for the amount of work needed to go public, may look for other forms of capital, such as debt or private equity.
Capital markets work best when all the participants - investors and companies - come together in one place. Although everyone may not have the same interests, at least there is an understanding that a common set of rules exists.
Today, you need a doctorate to understand the rules of the stock market. So it isn't surprising that there is a perception that you have no chance of getting a fair price in the market. Why go to a store if you think there are two prices - one for the regular person and one for those with inside knowledge?
In the old days, it was pretty simple. There were a few types of trades and only a couple of places where you could executive them. There were orders at the market price, those with price limits and good-till-canceled orders; you could go long in a stock, betting on its appreciation, or short, expecting it to fall.
Today, there are more than 100 order types - and when you add on variables such as time of day, participant designation and session type, it multiplies very quickly.
In 2004, when the New York Stock Exchange first looked into changing the order-handling rules, the objective was to integrate the existing trading environment with new technology. The market would be faster and more efficient, one that was fair to the individual investor and attractive to larger participants.
But the Securities and Exchange Commission, in its effort to be viewed as independent from the NYSE, permitted multiple exceptions to the rules. Small operators could enter the market with different order-handling procedures. As long as their volume remained at less than 10 percent of the total trading in a security, alternative marketplaces could operate with limited regulation.
In addition, brokerage houses used their influence to move more order flow away from the stock exchanges and to their own private trading sessions, or pools, of securities. It was less expensive and gave them a captive audience for their best customers. Order flow no longer went straight to one centralized marketplace. Unfortunately, it was only the beginning of fragmentation.
Technology advances continued, fueling the rise of high-frequency trading, which exploits discrepancies in prices of different exchanges that might last for less than a 1,000th of a second. Order-handling rules became so complicated that few people could understand what each change meant. The SEC lost control. We now have hundreds of mini-markets within markets.
In 2006, more than 80 percent of market volume was controlled by less than 20 percent of the participants. Today, high-frequency traders alone control more than 50 percent of the volume.
By allowing markets to descend into a mire of complexity, the SEC has abdicated its mandate, which its website says is "to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."
When only firms with the most advanced technology have an advantage, the markets aren't fair. When market participants can no longer understand order types, the markets aren't orderly. When there is no cost to using capacity without making actual trades, as high-frequency firms do, the markets aren't efficient.
The SEC needs to simplify the markets. It could start by mandating a limit to the types of orders allowed - say, no more than 10. The agency also should draft a rule book that we can all read and understand.
The SEC should require that traders pay a transaction fee for both trades and capacity. Right now, there is no limit to the number of "looks" at the order flow for high-frequency traders, who then craft their strategies with advance knowledge of what other participants are doing. Such fees would help to return the markets to a place where capital formation, not just high-speed arbitrage, is the primary objective.
Here's one more suggestion: Require that the SEC be able to explain market structure and order types to a high-school senior. This isn't a test that the agency can afford its students to fail.
Amy Butte is the former chief financial officer of the New York Stock Exchange. She wrote this for Bloomberg News.