'Market Quality' and Moral Hazard in Financial Market Design

Abstract

Infrastructure matters. Markets are designed by market participants for the benefit of market participants and assessed measuring utility to market participants. The natural result is that market structure becomes a tool used by the most powerful market participants to extract rents from the ultimate users of markets – issuers and investors, in particular. Our measures of market quality do not detect this moral hazard and its fruits because these measures mainly ascertain quantitatively whether the machine itself runs smoothly and cheaply, not whether the machine performs the function that a legislator or a teacher of securities regulation might say it should, such as to allocate capital effectively within an economy by providing optimal opportunities to invest savings. This paper examines our current measures of market quality against the background of the significant interests and arising structural distortions that exist in the US indirect holding system for the transfer of securities and the fragmented ‘national market system’ on which high frequency traders can prey on traders less well armed to navigate the complex array of matching platforms that major broker-dealers have built, financed or purchased. The paper closes with a recommendation that market quality be assessed for social efficiency rather than merely by meeting quantitative measures of mercenary efficiency to its operators and immediate users.

Keywords: market quality, market efficiency, securities regulation, high frequency trading, moral hazard, clearing and settlement, market microstructure, financial regulation

JEL Classification: G14, G38, K22, K23, L11, O16