Why Is The Structure Of The Stock Market So Complicated?

The unfortunate reality of the U.S. stock market is it is extremely complicated. 

There are exchanges. Broker-dealers. Dark pools. High-frequency traders. Alternative trading systems. And all of these bodies are interacting with each other millions of times daily for fractions of a second at a time.

This fragmented nature, according to market structure experts, is partly the result of Regulation National Market System, also known as Reg NMS. 

What Is Reg NMS

Reg NMS is a 523-page rule passed by the SEC in 2005 and implemented in 2007. It’s goal was to level the playing field and promote fair market pricing by requiring that all stocks trade at what is known as the National Best Bid or Offer, or NBBO. 

This regulation, though admirable in nature, is what led to the market becoming more complicated. Reg NMS made it so no single body—be it an exchange, broker-dealer, or otherwise—could have disproportionate control over trading activity. But this decentralization of the market created the fragmentation that exists today. 

“[Reg NMS] took businesses that were distinct and independent and required them to connect and share prices and customers,” said Tim Quast, founder and CEO of ModernIR and MarketStructureEDGE. “And so to make that system work...requires an immense amount of complexity and data technology. And what has arisen out of that, and where all the complexity comes from, is what the businesses that comprise this ecosystem system have done to adapt to that.”

What To Know About How The Stock Market Is Structured

High-frequency traders and broker-dealers benefit from what is known the maker-taker model, where exchanges offer rebates to market participants for providing liquidity in the form of buy and sell orders. This is also known as payment for order flow. 

When a trader or investor places a buy or sell order with their broker, that order will get sent to high-frequency trading firms before going to the exchange. The HFT then has the option to “jump in line” ahead of your order. 

“I liken the marketplace today out of Reg NMS as a pool table, and at the corners are all the exchange groups and in the middle are all of the balls,” he said. “How do you get them to roll to you? What those exchanges do is they pay traders to set the price. That's what's called the maker-taker model. And all of this matters to traders and investors, because if you consider all prices to be the same, you will lose.”

According to Quast, since March the share of the stock market activity controlled by high-frequency traders has risen by 20%. Thistw is a direct result of the increased retail trading activity, which he likened to free clips at a shooting gallery.

“Retail flow is like handing everybody at a shooting gallery free clips. And [high-frequency traders] can just go out there and change price, and that becomes the end. It's not about whether Tesla should be trading at $1900. That's irrelevant. The equation is purely what are the prices surrounding Tesla? That's it. All prices depend on proceeding prices.”

The Implications For Retail Traders

The bottom line, according to Quast, is that traders—even small retail traders—should at least be aware of what happens after they hit the “buy” or “sell” button on their trading platform. 

“If you don't understand the basic ecosystem, you won't understand why prices behave the way they do. There are logical, rational mathematical reasons for it. I'm not saying that the market is necessarily rational, but there is an explanation for how it works.”

Tim Quast will be discussing how to gain a trading edge using market structure sentiment at the next Benzinga Boot Camp, Friday, August 28 at 12:00 pm ET. Click here to register and reserve your spot. To learn more about Market StructureEDGE and sign up for a free two-week trial click here.