Sunday, January 10, 2016

College Sports and Deadweight Loss

The amount of money generated by college sports is staggering: broadcast rights alone are worth over a billion dollars annually, and this doesn't include tickets sales for live events, revenue from merchandise, or fees from licensing. But the athletes on whose talent and effort the entire enterprise is built get very little in return. As Donald Yee points out in a recent article, these athletes are "making enormous sums of money for everyone but themselves." Even the educational benefits are limited, with "contrived majors" built around athletic schedules and terribly low graduation rates.

Since colleges cannot compete for athletes by bidding up salaries, they compete in absurd and enormously wasteful ways:
Clemson’s new football facility will have a miniature-golf course, a sand volleyball pit and laser tag, as well as a barber shop, a movie theater and bowling lanes. The University of Oregon had so much money to spend on its football facility that it resorted to sourcing exotic building materials from all over the world.
The benefit that athletes (or anyone else for that matter) derives from exotic building materials used for this purpose are negligible in relation to the cost. Only slightly less wasteful are the bowling lanes and other frills at the Clemson facility. The intended beneficiaries would be much better off if they were to receive the amounts spent on these excesses in the form of direct cash payments. This squandering of resources is what economists refer to as deadweight loss.

But are competitive salaries really the best alternative to the current system? I think it's worth thinking creatively about compensation schemes that could provide greater monetary benefits to athletes while also improving academic preparation more broadly. Here's an idea. Suppose that athletes are paid competitive salaries but (with the exception of an allowance to cover living expenses) these are held in escrow until successful graduation. Upon graduation the funds are divided, with one-half going to the athlete as taxable income, and the rest distributed on a pro-rata basis to each primary and secondary school attended by the athlete prior to college. A failure to graduate would result in no payments to schools, and a reduced payment to the athlete.

This would provide both resources and incentives to improve academic preparation as well as athletic development at schools. Those talented few who make it to the highest competitive levels in college sports would clearly benefit, since their compensation would be in cash rather than exotic building materials. But the benefits would extend to entire communities, and link academic and athletic performance in a manner both healthy and enduring. It's admittedly a more paternalistic approach than pure cash payments, but surely less paternalistic than the status quo.

Monday, January 04, 2016

The Order Protection Rule

The following is a lightly edited version of my comment letter to the SEC in reference to the application by IEX to register as a national securities exchange. Related issues were discussed in a couple of earlier posts on intermediation in fragmented markets and in this piece on spoofing in an algorithmic ecosystem. 


In 1975, Congress directed the SEC, “through enactment of Section 11A of the Exchange Act, to facilitate the establishment of a national market system to link together the multiple individual markets that trade securities.” A primary goal was to assure investors that “that they are participants in a system which maximizes the opportunities for the most willing seller to meet the most willing buyer.”

To implement this directive the SEC instituted Regulation NMS, a centerpiece of which is the Order Protection Rule:
The Order Protection Rule (Rule 611 under Regulation NMS) establishes intermarket protection against trade-throughs for all NMS stocks. A trade-through occurs when one trading center executes an order at a price that is inferior to the price of a protected quotation, often representing an investor limit order, displayed by another trading center…. strong intermarket price protection offers greater assurance, on an order-by-order basis, that investors who submit market orders will receive the best readily available prices for their trades. 
To a layperson, the common sense meaning of a National Market System and the Order Protection Rule is that an arriving marketable order (say Order A) should be matched with the best readily available price in the market as a whole, before any order that is placed after Order A has made first contact with the market begins to be processed.

Given the large number of trading venues now in operation and the speeds at which communication occurs, it is important to be very clear about what these terms mean. If a marketable order arrives at an exchange, is partially filled, and then routed to another exchange, there will be a small gap in time before the second exchange receives what is left of the order. It is technologically possible for a third party to observe the first trade (either because they are a counterparty to it or have access to the data generated by it) and to act upon this information by sending orders to other exchanges. These may be orders to trade or to cancel, and may arrive at other exchanges before the first order has been fully processed.

Should these new orders, placed after Order A has made first contact with the market, be given priority over Order A in interacting with resting orders at other exchanges? It seems to me that the plain meaning of Congress’ directive and the order protection rule says that they should not.

IEX’s proposed design prevents this kind of event from taking place by delaying the dissemination of information generated by Order A’s first contact with the market until enough time has elapsed for the order to be fully processed. This brings the market closer to the national system envisaged by Congress, and indeed by the SEC itself.

It appears that the following example in a comment letter by Hudson River Associates, while submitted as an objection to the IEX application, actually supports this interpretation:
Example 3: IEX BD Router – IEX bypasses the POP allowing it beat a member to another exchange
  • Member C has an order to buy at 10.00 resting on IEX. 
  • IEX has a routable sell order that fully executes Member C’s buy interest on IEX. 
  • When executed, Member C decides to update its buy order prices on another exchange from 10.00 to 9.99. 
  • The POP would delay Member C’s execution information by 350 microseconds. As a result, although Member C’s buy order on IEX has been executed, it does not know this for at least 350 microseconds. 
  • Before Member C is informed of its buy order execution, the IEX BD Router sends an order to the other exchange to execute against Member C’s buy order at 10.00 on the other exchange. 
  • Since Member C was not informed of its execution on IEX, its order at 10.00 on the other exchange is executed by the IEX BD Router before Member C can update the price to 9.99. 
This example refers to cancellation, but there is nothing to prevent Member C from placing marketable sell orders at 10.00 that trade ahead of the routable order. In either case, liquidity that was “readily available” when the routable sell order made first contact with the market is removed before this order has been fully processed.

What the author of this letter appears to want is that Member C should be able to place an order (to cancel or trade) after the routable sell order has made first contact with the market, and to have these orders interact with the market before the routable sell order has been fully processed. This kind of activity is currently permitted by the SEC, but to me seems to clearly violate the spirit if not the letter of Congress’ directive.

The design proposed by IEX, by preventing orders from trading out of sequence (measured with respect to first contact with the market) would bring the system closer to that envisaged by Congress. In a true national market system with multiple exchanges, each order would receive a timestamp marking its first contact with the market, and no order would begin to be executed until all orders with earlier timestamps had been fully processed. In making a determination on the IEX application, I would urge the commission to consider whether approval would bring the system closer to this ideal. And indeed, to think further about what other changes to the rules governing market microstructure would also achieve the same goal.