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ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

Let me frame that statement with backstory. I consider it our mission to help you understand market behavior. The biggest currently is arbitrage – taking advantage of price-differences. Insert that phrase wherever you see the word.  We mean that much of the money behind volume is doing that.  Yesterday eleven of the 25 most active stocks were Exchange-Traded Funds (ETFs). Four were American Depositary Receipts (ADRs).

Both these and high-frequency trading turn on taking advantage of price-differences. Both offer the capacity to capitalize on changing prices – ADRs relative to ordinary-share conversions, and ETFs relative to the net asset value of the ETF and the prices of components. In a sense both are stock-backed securities built on conversions.

For high-speed traders, arbitrage lies in the act of setting prices at different markets. Rules require trades to match between the best bid to buy and offer to sell (called the NBBO). Generally exchanges pay traders to sell and charge them to buy.

In fact, the SEC suspended an NYSE rule because it may permit traders to take advantage of price-differences (something we’ve long contended). We’ll come to that at the end.

Next, ETFs are constructed on arbitrage – price-differences. Say Blackrock sponsors an ETF to track a technology index. Blackrock sells a bunch of ETF shares to a broker like Morgan Stanley, which provides Blackrock with either commensurate stocks comprising the tech index or a substitute, principally cash, and sells ETF shares to the public.

If there’s demand, Morgan Stanley creates more ETF shares in exchange for components or cash, and then sells them. Conversely, if people are selling the ETF, Morgan Stanley buys the ETF shares and sells them back to Blackrock, which pays with stocks or cash.

The trick is keeping assets and stock-prices of components aligned. ETFs post asset positions daily. Divergences create both risk and opportunity for the sponsor and the broker alike. Blackrock cites its derivatives-hedging strategies as a standard risk associated with ETF investing. I’m convinced that a key reason why ETFs have low management fees is that the components can be lent, shorted, or leveraged with derivatives so as to contribute to returns for both the sponsor and the broker.

On the flip side, if markets are volatile as they have been post-Brexit and really since latter 2014, either party could lose money on unexpected moves. So both hedge.

For arbitragers, a perfect market is one with little direction and lots of volatility. Despite this week’s move to new market highs, there remains statistically little real market movement in the past two years. If a market is up or down 2% daily, does it over time gain, lose or stay the same?

Run it in Excel. You’ll see that a market declines over time. Thus arbitragers short securities using rapid tactics to minimize time-decay. If you want a distraction, Google “ETF arbitrage shorting” and read how traders short leveraged ETFs to make money without respect to the market at large.

In fact, this is the root problem: Taking advantage of price-differences is by nature a short-term strategy. Sixteen of the most actively traded 25 stocks yesterday (64% of the total!) were priced heavily by arbitrage, some by high-speed traders and some by investors and the market-makers for ETFs.

Offering further support for arbitrage ubiquity, the market is routinely 45-50% short on a given day. Short volume this week dipped below 45% for the first time since December, perhaps signaling an arbitrage squeeze and certainly offering evidence that arbitragers hate a runaway market.

If the market rises on arbitrage, it means parties SUPPLYING hedges are losing money. Those are big banks and hedge funds and insurance companies. Who’d take the market on a run to undermine arbitrage that’s eating away at balance sheets (big banks and hedge funds have suffered)?  Counterparties.

In our behavioral data Active investment is down and counterparties have been weak too, likely cutting back on participation. That comports with fund data showing net outflows of $70-$80 billion from US equities this year even as the market reverts to highs. The only two behaviors up the past 50 trading days are Fast Trading (arbitrage) and Asset Allocation (market-makers and brokers for ETFs and other quantitative vehicles). Yet more evidence. And both are principally quantitative.

Assemble these statistics and you see why the market seems oblivious to everything from US racial unrest, to a bankrupt Puerto Rico, to foundering global growth and teetering banks.  The market is running on arbitrage.

What’s the good news, you ask?  The SEC is aware of rising risk. It suspended an NYSE rule-filing on fees at the exchange’s Amex Options market after concluding the structure may incentivize arbitrage.  The SEC is scrutinizing leveraged ETFs and could end them.

But most important is the timeless self-regulation of knowledge. If we’re all aware of what’s driving the market then maybe the arbitragers will be their own undoing without taking the rest of us with them.

Janus ETFs

Everybody adapts, including institutional investors like Janus.

Rattle off a top-ten list of the best active stock pickers visited by teams of company execs and investor-relations pros trundling through the airports and cities of America, and Denver’s Janus likely makes the cut.

Ah, but.  In 2014 Janus bought VelocityShares, purveyor of synthetic exchange-traded products.  Just as a drug manufactured in a laboratory rather than from the plant that first formed its mechanism of action is a replica, so are these lab-made financial instruments. They replicate the act of investment without actually performing it.

It’s neither good nor bad per se, as I explained yesterday to the NIRI San Diego chapter. But synthetics are revolutionizing how public stocks trade – without owning public stocks. Describing its effort at adaptation, Janus says on its website that it’s “committed to offering distinctive strategies for today’s complex market environment. Leveraging almost a half century of investment experience, we are now pleased to make our expertise available through Exchange Traded Funds.”

Janus says it’s intending to offer a range of returns beyond simple capital-appreciation, including “volatility management” and “uncorrelated returns.” Janus’s VelocityShares directed at volatility aim to produce enhanced or inverse returns on the VIX, an index called the “fear gauge” for reflecting volatility in forward rights to the S&P 500.

But traders and investors don’t fear volatility. They invest in it.  On Monday May 16, four of the top 20 most actively traded stocks were exchange-traded products leveraging the VIX.  Those offered by Janus aren’t equity investments but a debt obligation backed by Credit Suisse. Returns derive from what is best described as bets using derivatives.

The prospectus for the most active version is 174 pages, so it’s hard to decipher the nature of wagers. It says: “We expect to hedge our obligations relating to the ETNs by purchasing or selling short the underlying futures, listed or over-the-counter options, futures contracts, swaps, or other derivative instruments relating to the applicable underlying Index…and adjust the hedge by, among other things, purchasing or selling any of the foregoing, at any time and from time to time, and to unwind the hedge by selling any of the foregoing, perhaps on or before the applicable Valuation Date.”

Got that?  Here’s my attempt at translation: “We’ll do the exact opposite of whatever return we’ve promised you, to keep from losing money.”

During the mortgage-related financial crisis there was a collective recoil of horror through media and into Congress that banks may have been betting against their clients. Well, come on.  It’s happening in equities every day!  Exactly how do we think somebody who says “sure, I’ll take your bet that you can make double the index without buying any assets” can possibly make good without farming the risk out to someone else?

In the mortgage crisis we learned about “credit default swaps” and how insurers like AIG were on the hook for hundreds of billions when real estate stopped rising. Who is on the hook for all these derivatives bets in equities if stocks stop rising? It’s the same thing.

Last Friday the 13th, five of the top 20 most actively traded instruments on the Nasdaq and NYSE were synthetic exchange-traded products attempting to produce outsized returns without correlating to the market. That’s 25% of the action, in effect.

For stock-picking investors and public companies it means a significant contingent of price-setting trades in the stock market are betting on moves uncorrelated to either fundamentals or markets. You’ll find no explanation in ownership-change.

What do you tell management and Boards about a market where, demonstrably, top price-setting vehicles like TVIX owned by conventional stock-pickers aren’t buying or selling stock but betting on tomorrow’s future values using derivatives?

In fact, everyone is betting against each other – traders, banks, investors. I take you back to the mortgage-backed securities crisis. The value of underlying assets was massively leveraged through derivatives the values of which bore no direct connection to whether mortgages were performing assets.  That by any definition is credit-overextension. A bubble.  A mania. Then homes stopped appreciating. The bubble burst two years later.

Look at stocks. They’ve not risen since Nov 2014. Is anyone out there listening or paying attention to the derivatives mess in equities?

ETFs and Divine Creation and Redemption

There’s a saying: It’s easier to keep the cat in the bag than to get it back in there once you’ve let it out. Nobody is likely to stuff the Exchange Traded Fund (ETF) cat back in the bag.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea. (more…)

Watch the Machines

As dawn spreads across the fruited plain today, we’re plunging into Iceland’s Blue Lagoon.  If we learn market-structure secrets here, we’ll report back next week.

Meanwhile, stocks have been emitting the effervescence of a Sunday brunch mimosa bubbling a happy orange hue.  Market Structure Sentiment™ for stocks as measured daily has posted a record stretch at 6.0/10.0 or higher.

What’s that mean ahead?

Here’s back-story for those new to the Market Structure Map. We formalized what we first called MIRBI (merbee), the ModernIR Behavioral Index, in Jan 2012. Market Structure Analytics is the science of demographics in the money behind prices and volume. We can measure them in your stock, a sector, the whole market.

Correlated to prices, volatility and standard deviation, behaviors proved predictive. We built a ten-point quantitative scale from Oversold at 1 to Overbought at 10. Stocks mean-revert to 5.0 and trade most times between 4.0-6.0. Market Structure Sentiment™ has signaled nearly every short-term rise and fall in stocks since 2012, large and small.

In both late January 2018 and late Sep 2018 preceding market corrections, Market Sentiment topped weakly, signaling stocks were overbought and pressure loomed.

If corporate fundamentals consistently priced stocks, this math wouldn’t matter. Active Investment can only blunt market structure periodically. Just the way it is.

It reflects a truth about modern markets: Machines set prices more than humans. So, if you want to know what prices will do, watch the machines. Investor-relations professionals and investors must know market structure now. Otherwise we blame humans for things machines are doing.

Getting back to the future, we recorded a couple long 6.0+ stretches in 2012. They presaged plateaus for stocks but nothing else. It was a momentum market rich with Fed intervention, and European bond-buying to prop up the euro.  Scratch those as comparatives.

Same drill in two 2013 instances, May and July. We had a blip, but the rocket sled was burning central-bank nitrous oxide and barely hiccupped.

After the Federal Reserve hiked rates in December 2015 for the first time in ten years, the market nearly imploded in January. This would prove – till further notice – to be the last time the Fed overtly intervened.

After stocks showed gaping cracks to begin the year, by Mar 2016 excess reserves at the Fed had soared by $500 billion.  The dollar swooned.  Stocks surged. And Market Structure Sentiment™ marked the longest recorded stretch above 5.0.

By Nov 1, 2016, before Donald Trump’s election, however, stocks were back to Dec 2014 levels. I think the bull market was ending but Trump’s ascendency gave it new life.

Cycles have shortened because the bulk of behaviors changing prices every day are motivated by arbitrage – profiting on price-differences. True for Fast Traders, ETF market-makers, market-neutral strategies, global-macro allocations, counterparties.

The length of trading cycles, I believe, depends on the persistence of profits from arbitrage.  Volatility bets expire today, index options tomorrow, with full options expirations and index true-ups Feb 15th.

We may not yet mark a cycle terminus, but arbitrage profits are thinning. For the week ended Feb 2, spreads between sector ETFs and sector stocks totaled 10.5%. Last week it was down to 5.6%.

Further illustrating, Healthcare stocks were up 1.6% the five days end Feb 2, and down 1.6% the week of Feb 8 (and the sector is down the past five days). Real Estate and Utilities offered behavioral data saying they were market hedges – and they’re the two best performers the past five trading days.

I’m confident we’ll see this trading cycle end first in peaking Market Structure Sentiment™ (linked here for Sep 4-Feb 11). It faltered briefly but hasn’t fallen.

As to a big prediction? Past performance guarantees nothing, yet forgetting history condemns us to repeating mistakes. There’s a balance. Seen that way, this long positive run may be the earliest harbinger of the last bull run ending 6-9 months out. Machines will be sifting the data. We’ll watch them.

Now if you’ll excuse us, we’re going to slip into this wildly blue lagoon.

 

Flowing

The Investment Company Institute (ICI) says US equities saw net outflows of $5.1 billion Jan 2-23, the latest data. Add the week ended Dec 26 and a net $26.2 billion left.

So how can stocks be up?

Maybe flows reversed after the 23rd?  Okay, but the S&P 500 rose 12.2% from Dec 24-Jan 23.  It’s now up about 16%, meaning 75% of gains occurred during net outflows.

Is the ICI wrong?  In a way, yes.  It treats redeemed Exchange Traded Fund (ETF) shares as outflows – and that’s not correct.

Let me explain. The stock market is up because of whatever is setting prices. We measure that stuff. The two big behaviors driving stocks Dec 26-Feb 4 were Passive Investment, and Risk Mgmt, the latter counterparties for directional bets like index options.

That combination is ETFs.

ETF shares are redeemed when brokers buy or borrow them to return to ETF sponsors like Blackrock, which exchanges them for stocks or cash of equal value.

If ETF shares are removed from the market, prices of ETFs tighten – and market makers bet long on index and stock options. That’s how derivatives rally underlying assets.

See, ETFs depend on arbitrage – different prices for the same things. And boy do prices differ. We track that data too.  When ETFs rise more than underlying stocks, the spreads are small. Stocks are far less liquid than ETFs because share-supplies don’t continually expand and contract like ETFs.

As an example, Consumer Discretionary stocks were up 1.6% last week (we meter 197 components for composite data on behaviors, shorting, Sentiment, etc.).  But the State Street Sector SPDR (pronounced “spider,” an acronym for S&P Depository Receipts, an ETF) XLY was up just 0.2%.

XLY is comprised of 65 Consumer Discretionary stocks. As we’ve explained before, ETFs are not pooled investments.  They’re derivatives, substitutes predicated on underlying assets.

So it really means State Street will take these stocks or similar ones in exchange for letting brokers create ETF shares, and vice versa.

You can’t short a mutual fund because it’s a pooled investment.  You can short ETFs, because they’re not. In fact, they’re a way to short entire sectors.

Want to pull down a swath of the market? Borrow key components correlated to the ETF and supply them to a big broker authorized to create ETF shares, and receive off-market blocks of a sector ETF like XLY. Then sell all of it on the open market.

It happened in December.

Here’s how. A staggering $470 BILLION of ETF shares were created and redeemed in December as the market plunged, putting the Nasdaq into bear territory (down 20%) and correcting major indices (down 10% or more).

And guess what?  There were $49 billion more creations than redemptions, which means the supply of ETF shares expanded even as the market declined.

I doubt regulators intended to fuel mass shorting and supply/demand distortion when they exempted ETFs from key provisions of the Investment Company Act of 1940 (and how can they do that, one wonders?).

But it’s happening. More proof: shorting in stocks topped 48% of all volume in December.

Returning to spreads, we’ve since seen the reverse of that trade. Stocks are being arbitraged up in value to reflect the supply of ETF shares outstanding, in effect.

And shorting has come down, with 5-day levels now below 20- and 50-day averages.

We’ve showed you ETF patterns before. Here’s the Industrials sector, up 5% the past week. Those purple and green bars?  ETFs. Stocks, plus leverage.  The purple bars are bigger than the green ones, meaning there is more leverage than assets.

That was true Jan 8-15 too, ahead of expirations the 16th-18th, the only period during which the sector and the market showed proportionally flat or down prices (see linked image).  Traders used their leverage (options volumes in 2018 crushed past records – but the culprit is short-term ETF leverage, arbitrage. Not rational behavior).

Why should you care about this stuff, investor-relations professionals and investors? We should know how the market works and what the money is doing. With ETF-driven arbitrage pervasive, the market cannot be trusted as a barometer for fundamentals.

Your boards and executive teams deserve to know.

What can we do? Until we have a disaster and the SEC realizes it can’t permit a derivatives invasion in an asset market, we must adapt. Think ahead.

For companies reporting results next week or the week after, risk has compounded because this trade is going to reverse. We don’t know when, but options expire Feb 14-16. Will bets renew – or fold?

Whenever it happens, we’ll see it coming in the data, by sector, by stock, across the market, just as we did in late September last year before the tumult.

Short-Term Borrowing

Half the volume in the stock market is short – borrowed. Why?

It’s the more remarkable because stocks since late December have delivered an epic momentum rebound. A 15% gain is a good year. Half the sectors in the market were up 15% in just the last 25 trading days.

Yet amid the stampede from the depths of the December correction, short volume, the amount of daily trading on borrowed shares, rose rather than fell, and remains 48%.  That means if daily dollar-volume is $250 billion, $120 billion is borrowed stock.

What difference does it make? We’ve written before that the stock market now has characteristics of a credit market.  That is, if lending is responsible for half the volume, the market depends on short-term loans rather than long-term investment.

And share-borrowing, credit, will give the market a false appearance of liquidity.

Think about the sudden and massive December declines that included the worst-ever points-loss for the Dow Jones Industrial Average.  Was that a liquidity problem? Does a V-shaped recovery signal a liquidity problem?

Before the Dodd-Frank financial legislation, large banks might carry a supply of shares to meet the needs of customers, especially stocks covered by equity research.

With rigid value-at-risk regulations now, banks don’t hold inventory.  The supply chain for the stock market has shifted to proprietary fast traders, which don’t carry inventory either. They borrow it.

We define liquidity as the number of shares that can be traded before the price changes.  Prior to electronic markets, trade-sizes were ten times larger than today.  The mean trade-size the last five days was 181 shares, or about $13,500 against an average market price of $74.61.

But a few liquid stocks skew the average.  AAPL’s liquidity is over $23,000, its average trade-size. WMT is the average, about $13,000. GIS is half that, about $6,800.

AAPL is also 57% short – over half its liquidity is borrowed.  And AAPL is used as collateral by 270 Exchange-Traded Funds (ETFs). Related?

(Side note: Why would AAPL be used more than other stocks in an index if ETFs are tracking an index? Because ETFs only use a sample, often the biggest stocks that are liquid and easy to borrow.)

These three elements – fast traders, high borrowing levels, ETFs – are intertwined and they create risks of inflation and deflation in stocks that bear no correlation to fundamentals.

The market, as we’ve said before, always reflects its primary purposes. If the parties supplying the market with shares are borrowing them, they have an economic interest that will compete with the objectives of those buying shares as an equity investment.

Second, borrowing is a back-office brokerage function. With massive short-term securities lending, the back office becomes as important as the cash equities desk. And it’s a loan business, a credit market (a point made by the insightful academics comprising the Bogan family).

And ETFs? If you want to know how they work, read our white paper. ETFs are not pooled investments. They are collateralized stock substitutes. Derivatives.

Collateral is something you find in a credit market. ETF collateralization, the wholesale market where ETF shares are created and redeemed, is a staggering $400 billion per month in US equities, says the Investment Company Institute.

It’s cheap and easy for brokers to borrow the shares of a basket of stocks and supply them as collateral to the Blackrocks of the world (does Blackrock then loan them out, perpetuating the cycle?) for the right to create and sell ETF shares (or provide them to a hedge-fund customer wanting to short the whole Technology sector).

And how about the reverse? Brokers can borrow ETF shares and return them to Blackrock to receive collateral – stocks and/or cash that Blackrock puts in the redemption basket to offer in-kind for ETF shares.

These are the mechanics of the stock market.  It works well if there’s little volatility – much like the short-term commercial paper market that froze catastrophically during the financial crisis.

We are not predicting doom. We are highlighting structural risks investors and public companies should understand. The stock market depends for prices and liquidity on short-term borrowing. In periods of volatility, that dependency will amplify moves.

In extreme cases, it’s possible the stock market could seize up not through investor panic but because short-term borrowing may freeze.

How might we see that risk? Behavioral volatility. When the movement of money becomes frantic behind prices and volume where only a few firms like ours can see it, market volatility tends to follow (as Sept 2018 behaviors presaged October declines).

Currently, behavioral volatility is muted ahead of the Fed meeting concluding today, loads of earnings, and jobs data Friday. It can change on a dime.

Form Follows Function

We’re told that on Friday Jan 18, the Dow Jones Industrial Average soared on optimism about US-China trade, then abruptly yesterday “global growth fears” sparked a selloff.

Directional changes in a day don’t reflect buy-and-hold behavior, so why do headline writers insist on trying to jam that square peg every day into the market’s round hole?

So to speak.

It’s not how the market works. I saw not a single story (if you did, send it!) saying options expired Jan 16-18 when the market surged or that yesterday marked rare confluence of new options trading and what we call Counterparty Tuesday when banks true up gains or losses on bets.

Both events coincided thanks to the market holiday, so effects may last Wed-Fri.

The point for public companies and investors is to understand how the market works. It’s priced, as it always has been, by its purposes. When a long-term focus on fundamentals prevailed, long-term fundamentals priced stocks.

That market disappeared in 2001, with decimalization, which changed property rights on market data and forced intermediaries to become part of volume. Under Regulation National Market System, the entire market was reshaped around price and speed.

Now add in demographics.  There are four competing forces behind prices. Active money is focused on the long-term. Passive money is focused on short-term central tendencies, or characteristics. Fast Traders focus on fleeting price-changes. Risk Management focuses on calculated uncertainties.

Three of these depend for success on arbitrage, or different prices for the same thing. Are we saying Passive money is arbitrage?  Read on. We’ll address it.

Friday, leverage expired. That is, winning bets could cashier for stock, as one would with the simplest bet, an in-the-money call option. The parties on the other side were obliged to cover – so the market soared as they bought to fulfill obligations.

Active money bought too, but it did so ignorantly, unaware of what other factors were affecting the market at that moment.  The Bank for International Settlements tracks nearly $600 trillion of derivatives ranging from currency and interest-rate swaps to equity-linked instruments. Those pegged to the monthly calendar lapsed or reset Friday.

Behavioral volatility exploded Friday to 19%. Behavioral volatility is a sudden demographic change behind price and volume, much like being overrun at your fast-food joint by youngsters buying dollar tacos, or whatever. You run out of dollar tacos.

That happened Friday like it did in late September. The Dow yesterday was down over 400 points before pulling back to a milder decline.

And there may be more. But it’s not rational thought. It’s short-term behaviors.

So is Passive money arbitrage?  Just part of it. Exchange-Traded Funds (ETFs) were given regulatory imprimatur to exist only because of a built-in “arbitrage mechanism” meant to keep the prices of ETFs, which are valueless, claimless substitutes for stocks and index funds, aligned with actual assets.

Regulators required ETFs to rely on arbitrage – which is speculative exploitation of price-differences. It’s the craziest thing, objectively considered. The great bulk of market participants do not comprehend that ETFs have exploded in popularity because of their appeal to short-term speculators.

Blackrock and other sponsors bake a tiny management fee into most shares – and yet ETFs manage nobody’s money but the ETF sponsor’s. They are charging ETF buyers a fee for nothing so their motivation is to create ETF shares, a short-term event.

Those trading them are motivated by how ETFs, index futures and options and stocks (and options on futures, and options on ETFs) may all have fleetingly different prices.

The data validate it.  We see it. How often do data say the same about your stock?  Investors, how often is your portfolio riven with Overbought, heavily shorted stocks driven by arbitrage bets?

What’s ahead? I think we may have another rough day, then maybe a slow slide into month-end window-dressing where Passive money will reweight away from equities again.  Sentiment and behavioral volatility will tell us, one way or the other.

Ask me tomorrow if behavioral volatility was up today. It’s not minds changing every day that moves the market. It’s arbitrage.

Exchanging Data

Do we need another stock exchange?

I’ve been asked this question repeatedly since Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*TRADE, Fidelity Investments, Morgan Stanley, TD Ameritrade, UBS, and Virtu Financial agreed Jan 7 to collaborate on seeking approval for a 14th official US stock market.

The answer? It depends on who “we” is, or are.

Adam Sussman of block-trading firm Liquidnet wrote that it’s an effort to lower trading costs which, thanks to high prices from exchanges for data feeds, have gone the opposite direction of trading commissions.

As to further fragmentation – more venues, less aggregation of buyers and sellers – Sussman says amusingly (the whole piece is funny) that “fragmentation is like having kids – after you have three of them, you just go numb to the pain.”

Michael Friedman, formerly of proprietary trading shop and technology vendor Trillium Management, said at TABB Forum (registration required) that these trading firms representing perhaps more than half of all volume resent how the exchanges keep raising prices for market data that brokers themselves create.

Before the exchanges IPO’d – all but IEX are now owned by public shareholders – they were member-owned, and members didn’t pay for data. Coincidentally the new market is called MEMX, or Members Exchange, anachronistically hailing a different era.

Friedman artfully unfolds market structure, explaining how a bid to buy shares at $9.08 at the NYSE cannot execute if the Nasdaq has a bid to buy at $9.10 because buyers willing to pay more are given legal priority and the trade must route out to the Nasdaq.

What if these firms were to route all the best trades – ones wanting to be the highest bid to buy or offer to sell – to themselves?  They could conceivably ravage market-share among big exchange groups until costs fell to a new equilibrium.

I think there are two other big reasons for this new cooperative.

One is easy to understand. Brokers are required to prove to customers that they provide “best execution,” or trading services that are at least as good as the average.  Paradoxically, that standard is predicated on averages for customer trades in the market – which concentrate heavily into the largest firms, including several MEMX backers.

If the order flow is consistently better than the average, it’s conceivable these firms could use their own data for free to meet best-execution requirements, a tectonic fist-bump amidst market rules.

So how would they boost odds that their data are better?  Look at who’s involved. They are mostly retail brokerage firms, or firms buying retail flow.

At Fidelity, about 97% of the firm’s retail orders are “nondirected,” lacking instructions about where the trades should occur. And well over 50% of those orders are sent to Virtu and Citadel.

Schwab says 99.6% of its trades are nondirected and 70% of them go to Virtu, Citadel and UBS.

And guess what?  Retail orders are permitted under rules to, in the jargon of market structure, “price-improve” trades.  The NYSE says its Retail Liquidity Program “can be used by retail firms directly as well as by the brokers who service retail order flow providers.”

Interactive Brokers, a firm for sophisticated retail traders and hedge funds, says retail orders with a limit, or set price, can be hidden from display at exchanges in increments of a thousandth of a dollar better than the displayed one, and the orders will float with a changing bid to buy or offer to sell.

That is, if the best bid to buy everyone sees is $9.08, a hidden limit order can be set at $9.081 and bounce like a bobber, staying always a fraction of a penny better than visible prices.

Under market rules, stocks cannot quote in increments below a penny. But they sure can trade in smaller increments, and they do all the time.

By aggregating retail order flow that market rules give a special dispensation to be better than other orders the members of MEMX believe they can not only match more orders but create the best market data.

How is it possible? Regulators wanted to be sure the little guy wouldn’t get screwed, so they give retail trades preference. They never dreamed innovative high-speed traders would buy it, or take advantage of rules permitting these trades to have narrower spreads.

It may work.

The problem is that the advantage MEMX hopes to leverage is a regulatory one that gives special access to one kind of activity.  (Editorial note: As we’ve written repeatedly, it’s just as Exchange Traded Funds have proliferated not by being better but through unique regulatory advantages giving them a private, wholesale block market with no transparency).

What’s it mean to investors and public companies? Investors, you could be picked off because MEMX could have compounded capacity to price-improve non-displayed orders. Public companies, something other than capital-formation is driving markets, which is not in your best interest.

We’d prefer a fair, level playing field serving investors and issuers, not rules permitting exceptions traders can game.

Leveraged Market

Paul Rowady writing at Alphacution says 67% of securities in US stock markets are derivatives dependent on an underlying 33%, made up of company stocks. It’s leveraged.

We can talk about ramifications at the end. To begin, the point is to understand, investors and investor-relations professionals, what it means to how stocks perform.

A derivative is a security that gets its value from an underlying asset. Mr. Rowady is referring to the proliferation of stock and index options and exchange-traded funds (ETFs) predicated on stocks.

It seems helpful to understand the linkage between how the market falls or rises, and how instruments that are derived from shares comprising market capitalization contribute to these cycles.

With derivatives outnumbering stocks two-to-one, the market behaves in a sense like a 2x leveraged vehicle, such as QLD, the ProShares Ultra QQQ ETF, which aims to correspond to two times the performance of the Nasdaq 100.

I’m oversimplifying. For a pure comparison, all the derivatives would have to be long, and they’re not of course, and there’s wide disparity in performance among securities across the market.

Follow me here.  Leveraged markets compound performance both directions. Take QLD. Suppose its underlying asset, the Nasdaq 100 represented by QQQ, is up 5%. QLD would rise 10%. Say for simplicity QQQ trades at $100. QQQ closes at $105, QLD at $110.

QQQ then retreats 5% the next trading day, back to $100. QLD closes at $99, 10% below $110. Compound that daily 5% up-and-down pattern over 30 days and QLD loses 50% of its value while QQQ is still worth $100.

Borrowing is leverage.  If I buy 100 shares of AAPL and borrow $15,000 or so to buy another 100 shares, and AAPL drops 8%, I’m down not 8% but the compounding effect of losses on the asset serving as collateral. I may be forced to sell core portfolio positions to cover my losses on borrowings.

Routinely, brokers are borrowing stocks to supply to ETF sponsors like Blackrock for the right to create ETF shares. We’ve studied shorting in ETFs and component stocks and have found them inversely correlated – validation.

Borrowed stock here isn’t a bet on declines but a defined value. If I exchange $1 million of borrowed stock for the right to create ETF shares that then fall to $950,000, I’ve lost 5% of my money.

I’ve got an obligation to cover borrowings even though I’ve lost money creating and selling ETF shares.  I may be forced to sell something else to align value at risk with internal compliance requirements.

This isn’t a dissection of detailed trading practices but rather a reflection on what can happen in volatile markets when leverage is pervasive. At Jan 7, 48% of all stock-trading volume was short – borrowed. That’s 1x leveraged. On top of the derivatives-to-stock ratio.

When considerations of losses or gains on leverage are ubiquitous, the market isn’t a reliable barometer for how the economy is faring, what investors think of trade practices or government shutdowns, or how your business is performing fundamentally.

The good news is it’s measurable! IR pros, we track every day what behavior is long or short, the role of Risk Mgmt reflecting leverage, and what trends signal. Investors, Sector Insights meter Sentiment, behaviors, shorting, intraday volatility and other factors by industry group.

Investors, you can turn market structure to your advantage (ask us about Market Structure EDGE). IR people, you can proactively inform management – a key action as chief intelligence officers for the capital markets. Ask us how to learn more.

Is there systemic threat in leveraged markets? Of course. We wrote about how stocks have taken on characteristics of a credit market, and credit is always leverage, which grows where interest rates are low and money is artificially plentiful. The reset at the end of the gravy train tends to wipe out leverage.

When? Who knows?  Debt deflations that follow credit booms begin with outlier failures that cause people to say, “Huh. Wonder what happened there?”  Let’s watch trends.

Down Maiden Lane

For the Federal Reserve, 2018 was the end of the lane. For us, 2019 is fresh and new, and we’re hitting it running.

The market comes stumbling in (anybody remember Suzy Quatro?). The Dow Jones dropped 6% as it did in 2000. The index fell 7% in 2001 and 17% in 2002. The last year blue chips were red was 2015, down 2%.

Everybody wants to know as the new year begins what’s coming.  Why has the market been so volatile? Is a recession at hand? Is the bull market over?

We only know behavior – what’s behind prices. That’s market structure.

Take volatility. In Q4 2018, daily intraday volatility marketwide (average high-low spread) averaged 3.7%, a staggering 61% increase from Q3.  Cause? Exchange-Traded Funds. It’s not the economy, tariffs, China, geopolitics, or Trump.

Bold assertion?  Nope, math.  When an index mutual fund buys or sells stocks, it’s simple: The order goes to the market and gets filled or doesn’t.

ETFs do not buy or sell stocks. They move collateral manually back and forth wholesale to support an electronic retail market where everything, both ETF shares and stocks serving as collateral for them, prices in fractions of seconds. The motivation isn’t investment but profiting on the difference between manual prices and electronic ones.

When the market goes haywire, that process ruptures. Brokers lose collateral exchanged for ETF shares, so they trade desperately to recoup it. There were over $4.1 trillion of ETF wholesale transactions through Nov 2018.

The other $4.1 trillion that matters is the Fed’s balance sheet. If the bull market is over, it’ll be due to the money, not the economy. We have been saying for years that a reckoning looms, and its size is so vast that it’s hard to grasp the girth (rather like my midsection during the holidays).

On Dec 18, 2008, the Federal Reserve said its balance sheet had been “modified to include information related to Maiden Lane II LLC, a limited liability company formed to purchase residential mortgage-backed securities (RMBS) from…American International Group, Inc. (AIG).”

The biggest Fed bank sits between Liberty Street and Maiden Lane in New York. Maiden Lane made the Fed over the next six years owner of seas of failed debts.

Ten year later, on Dec 27, 2018, The Fed said its balance sheet had been “modified to reflect the removal of table 4 ‘Information on Principal Accounts of Maiden Lane LLC.’ The table has been removed because the remaining assets in the portfolio holdings of Maiden Lane LLC have been reduced to a de minimis balance.”

There were at least three Maiden Lane companies created by the Fed to absorb bad debts. At Dec 2018, what remains of these bailouts is too small to note.

Wow, right? Whew!

Not exactly. We used the colossal balance sheet of US taxpayers – every Federal Reserve Note in your wallet pledges your resources to cover government promises – to save us.  We were able to bail ourselves out using our own future money in the present.

We’ve been led to believe by everyone except Ron Paul that it’s all worked out, and now everything is awesome.  No inflation, no $5,000/oz gold.  Except that’s incorrect.  Inflation is not $5,000/oz gold.  It’s cheap money.  We’ve had inflation for ten straight years, and now inflation has stopped.

Picture a swing set on the elementary-school playground. Two chains, a sling seat, pumping legs (or a hand pushing from behind). Higher and higher you go, reaching the apex, and falling back.

Inflation is the strain, the pull, feet shoved forward reaching for the sky.  What follows is the stomach-lurching descent back down.

We were all dragged down Maiden Lane with Tim Geithner and Hank Paulson and Ben Bernanke. They gave that sling seat, the American economy, the biggest shove in human history. Then they left. Up we went, hair back, laughing, feet out, reaching for the sky.

Now we’re at the top of the arc.

The vastness of the economic swing is hard to comprehend. We spent ten years like expended cartridges in the longest firefight ever to get here. We won’t give it up in a single stomach-clenching free-fall.

But the reality is and has always been that when the long walk to the end of Maiden Lane was done, there would be a reckoning, a return to reality, to earth.

How ironic that the Fed’s balance sheet and the size of the ETF wholesale market are now roughly equal – about $4.1 trillion.

It’s never been more important for public companies and investors to understand market structure – behavior. Why? Because money trumps everything, and arbitraging the price-differences it creates dominates, and is measurable, and predictable.

The trick is juxtaposing continual gyrations with the expanse of Maiden Lane, now ended. I don’t know when this bull market ends. I do know where we are slung into the sling of the swing set.

It’s going to be an interesting year. We relish the chance to help you navigate it. And we hope the Fed never returns to Maiden Lane. Let the arc play out. We’ll be all right.