Do you swear to tell the truth, the whole truth and...?

The explosion of media coverage of equity market structure has been driven by a series of high profile regulatory settlements, a best-selling book (Flash Boys), and the debate over IEX's application to become a stock exchange. It is time for this debate, which has been driven by accusations, innuendo, and anecdotal analysis, to shift from qualitative arguments to facts. Investors need statistically valid data on markets' trading quality to evaluate their particular order types and services. Today, however, it is difficult to acquire such data and to know if the data has been verified by an independent third party. As a result, we believe that there is a clear and present need for new regulations on trading quality disclosures, including the public dissemination of trading data.

We propose two guiding principles for regulatory reform:

1) All brokers, trading systems, and exchanges should be required to report the execution quality of each order type they offer. This information should be made accessible to the public on a delayed and aggregated basis to avoid disclosing sensitive data and include information from firms that route orders, match orders, or execute orders as principal.

2) All statistical disclosures used in marketing or released to the media should be validated by an objective third party or otherwise be labeled "unverified." This would help investors know whether the statistics being presented could be exposed to potential conflicts of interests. This follows the model used by corporations that report financial results or fund managers who promote their investment returns.

To put these principles into the proper context, consider the history of financial market regulation. After the Great Depression, the US passed a series of rules designed to protect investors. In the decade after the 1929 stock market crash, the Exchange and Securities Acts were passed, establishing the SEC and the regulatory environment for brokers and exchanges. Next the Investment Company Act of 1940 known as the "40 Act" introduced a regulatory framework for asset management and mutual funds. There was also regulation on margin, accounting standards and advertising in securities solicitation. The cumulative impact of these rules was to create an equity market where the vast majority of trading was conducted by professionals instead of individuals. Retail trading was handled by licensed brokers, and the majority of those trades were executed either on the floor of the NYSE or by Nasdaq market makers. The explicit cost of trading was the main concern of investors, since both bid-offer spreads and commission rates were multiples of what they are today.

The pace of change accelerated in the last 15 years of the 1900s driven by a combination of new technologies and innovation. Charles Schwab, Ameritrade, Fidelity investments among others revolutionised retail trading by offering a combination of dramatically lower commissions and online access to trading tools. Retail trading at these so-called "upstarts" rapidly outpaced the trading volumes of the long dominant full service brokers resulting in the transformation to self-directed retail trading away from registered stock brokers. To protect this growing class of retail investors and other investors, the SEC passed a series of rules including the limit order display rule and the "Manning" rule which gave retail orders priority for execution over orders coming from a broker's own account. In addition, the SEC passed Rules 605 and 606 to mandate that market centers provide execution quality statistics and brokers publicly disclose where they route their orders.

After the transition to penny spreads at the start of this century, trading volumes grew by an order of magnitude as commissions and bid-offer spreads collapsed. This was fueled by Regulation NMS and the markets' adapting to the new and complex set of rules which transformed the structure of the market. We saw the explosion of and trading venues, such as Alternative Trading Systems (ATS), "for profit" exchanges and market making systems. Brokers built electronic trading systems, including suites of order handling algorithms, ATS, and smart order routers (SOR) to handle these changes. Meanwhile, the market has transitioned from two dominant markets to 12 automated stock exchanges that offer sophisticated matching parameters and their own SORs that use proprietary networks of external liquidity providers. These innovations have led to significantly lower average trading costs, but these reductions have not been the same in all types of stocks and for all types of investors.

Not surprisingly, the greatest beneficiaries of these changes have been self-directed retail investors and quantitative money managers that invested heavily in trading research. Left behind, at least on a relative basis, are the professional money managers that control the vast majority of pension assets and retirement savings for Americans. These managers' primary sources of information are the exchanges, brokers and markets that are competing for their trading business. Consequently, their decisions are based on anecdotal and often incomplete data.

One of the most glaring examples of misinformation was Michael Lewis' infamous claim on 60 Minutes that "the market was rigged." In his bestseller "Flash Boys" Lewis also claimed that retail investors were being taken advantage of "once the button was pushed." Data collected for Rule 605 shows that retail investors have seen their trading costs drop dramatically over the past 15 years, but that hasn't stopped the false narratives.

"Flash Boys" also purported that "latency arbitrage" is a significant cost to institutional investors. This view was based on a narrative, not on statistical evidence. The book described a situation where traders used a bank's system to buy or sell a large block of stock but were unable to successfully complete the trade before the market moved. While that sounds like there was a fundamental flaw in the market, the fault was actually in the system that the book's characters used. When Flash Boys chronicled this "defect" in 2009, most of the systems used by the more sophisticated firms did not have it. Trading algorithms were already "smart" enough to avoid trying to buy or sell too much stock at one time, and the better SORs used parallel sweeping technology to avoid giving enough time for arbitrageurs to get in front of their orders.

More important than the false narratives, however, is the absence of validated data available to investors, particularly from exchanges and some alternative trading systems. NYSE, NASDAQ, and BATS all have multiple routing options, specialty retail programs, multiple exchange options for posting orders. None of these programs have independently verified statistics publicly available. The NYSE, for example, does not subject its Rule 605 regulatory filings to independent verification.

IIEX produces more public statistics than the incumbent exchanges, but it selects which data to display and use in its marketing. IEX recently disclosed routing statistics showing that its router does a good job accessing available liquidity, and they used some of those statistics to criticise the NYSE. However, they do not show the execution quality of those orders. This is critical since very aggressive routing is not always the best choice. While it will achieve higher fill rates, it can also result in higher execution costs when trading through multiple price levels.

Retail execution quality has also been an issue in the news. In their comment letters to the SEC regarding IEX's exchange application, Markit and Citadel argued that wholesale market makers, as a group, do the best job handling retail market orders. (The data discussed in each letter was intended to support market makers and segmentation of retail orders.) Despite providing analysis of over 40% of IEX's total executed volume, there were comments in the media that our study did not do exactly this. It is worth noting that these critics did not cite their data sources or disprove our study's validity when making these comments.

Our conclusion, however, is not solely to criticise exchanges for their lack of disclosures, but rather to make a general point about the need for third party validation of order quality data. Companies should be required to disclose when data was not compiled and audited by a third party. There is more than ample precedent for this view. Listed companies are not allowed to report financial results without an independent audit. SEC rules prohibit asset managers from publicly disseminating unaudited investment return information without disclosing them as such.

We have been calling for an overhaul of the nation's best execution rules for some time. We believe that the tenor of the current debate underscores the urgency for such rulemaking.

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.