SIP and the Law of Unintended Consequences

buysellA venerable economic [or sociological] principle goes by the name, “the law of unintended consequences.” In brief: the unintended consequences of an action regularly swamp those that are intended.

The principle may be read into writings of centuries past, but its first explicit statement under something akin to the above name came about roughly 76 years ago. Robert K. Merton [the father of the Robert Merton whom one associates with Fischer Black and Myron Scholes] wrote “The Unintended Consequences of Social Action” in 1936. He invoked “active asceticism” as an example. People who live an ascetic life – who produce wealth, spend little of it, and thus accumulate savings –and who do this because that is written into their moral code – such people often find that they have helped undermine that very moral code in the next generation. They have created a large family estate that enables a life of unproductive luxury among their descendants. That, surely, is for most such ascetics not only an unintended but an unwelcome consequence.

Merton, portrayed here, was advancing an important idea, and one that transfers readily into the discussion of legislation and regulation. A common example involves protectionist tariffs. In 2001, the U.S. established tariffs on the importation of low-cost imported steel. If we are to believe the protestations of everyone involved, the purpose of this legislation, its intended consequence, was the revival of the U.S. domestic steel industry, and consequent assistance to the economies of Pennsylvania, West Virginia, and Illinois.

Another effect, though, was the loss of jobs in other sectors of the U.S. economy – in virtually every industry where steel is a manufacturing input. In those industries, jobs depended on that low-cost steel. The price of that input increased by 54% as a consequence of the tariff.

The Playing Field of Capital Markets

To these old examples of the L of UC we can add this one. A regulation of the Securities and Exchange Commission apparently intended to “level the playing field,” to make stock prices available to all at the same price throughout the National Market System, has had what seems to have been the unintended consequence of … encouraging front runners. At any rate, the L of UC is the thought that came to mind when listening recently to testimony about the Securities Information Processor, and its role in the capital market structure.

The Securities and Exchange Commission’s Reg NMS, implemented in 2007, designed to level playing fields, requires that trading centers offer buyers “order protection,” that is, assurance that their trades will not be executed at prices inferior to those available at the same time at other trading centers. The supposed best price accordingly became known as the “national best bid and offer,” or NBBO, a new standard for execution.

The 13 stock markets within the National Market System pool their prices into the Securities Information Processor (SIP) so SIP can offer the same picture of the market prices to all investors.

In the formal language of the regulation, NBBO means “the best bid and best offer for such security … calculated and disseminated on a current and continuing basis by a plan processor [i.e. by SIP] pursuant to an effective national market system plan….”

In the view of critics of the system, SIP just became the convenient target that the high frequency trading crowd learned to front run. They learned to use direct feeds, which are not “plan processors” and so are outside the definition of NBBO above.

Merely a “perception”?

SIP is a critical element in the regulatory structure and a crucial element in debates over the functionality (or otherwise) of that structure kicked up earlier this year by Michael Lewis’ book.

One of the critical contentions of that book is that the “wider market” trades in the basis of SIP, whereas specialized high-tech traders trade on the basis of more up-to-the-microsecond data feeds, allowing the latter to take advantage of the sort of retail traders who do depend on SIP.

Months after its publication one sometimes encounters arguments that everybody now actually uses direct feeds, or executes through a broker that uses direct feeds, or the like … so that SIP has become irrelevant, so the only problem is a “perception of unfairness” rather than any actual unfairness.

I don’t believe there is merit to that contention, but it does illustrate how convoluted can be the consequences of the best-laid plans.

I hope to write more about the “nobody actually uses SIP” contention in the near future.

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