Search Results for: market making exemption

Starting Point

The starting point for good decisions is understanding what’s going on. 

I find it hard to believe you can know what’s going on when you’re authorizing trillions of dollars of spending.  But I digress.

Illustration 22981930 / Stock Trading © John Takai | Dreamstime.com

Investor relations professionals, when was the last time you called somebody – at an exchange or a broker – to try to find out what’s going on with your stock? I can’t recall when the Nasdaq launched the Market Intelligence Desk but it was roughly 2001.

Twenty years ago.  I was a heavy user until I learned I could dump trade-execution data from my exchange into my own Excel models and see which firms were driving ALL of my volume, and correlate it to what my holders told me.

That was the seed for ModernIR. 

Today, market behaviors and rules are much different than they were in 2001. Active money back then was still the dominant force but computerized speculation was exploding.  What started in the 1990s as the SOES Bandits (pronounced “sews”) – Small Order Execution System (SOES) – was rapidly metastasizing into a market phenomenon.

Regulation National Market System took that phenomenon and stamped it on stocks. What was a sideshow to ensure retail money got good deals now IS the stock market.

Nearly all orders are small.  Block trades are about a tenth of a percent of total trades.  For those struggling with the math, that means about 99.9% (not volume, trades) aren’t blocks.  The trade-size in the stocks comprising the S&P 500 averaged 108 shares the past week.  All-time record low.

Realize, the regulatory minimum for quoting and displaying prices is 100 shares.  Trades below that size occur at prices you don’t even see.  I have a unique perspective on market machinery.  I’ve spent 26 years in the IR profession, a big chunk of that providing data on market behaviors to public companies so they know what’s going on (the starting point for good management).

Now I run a decision-support platform too for active traders that gives them the capacity to understand changing supply/demand trends in stocks – the key to capturing gains and avoiding losses when trading (we say take gains, not chances).  And I trade stocks too.  I know what it means when my NVDA trade for 50 shares executes at the Nasdaq RLP for $201.521.

Yes, a tenth of a penny.  It means my broker, Interactive Brokers, routed my trade to a Retail Liquidity Program at the exchange, where a Fast Trader like Citadel Securities bought it for a tenth of a penny better than the best displayed price, and was paid about $0.015 for doing so.

For those struggling to calculate the ROI – return on investment – when you spend a tenth of a penny to generate one and a half pennies, it’s a 1400% return.  Do that over and over, and it’s real money.  Fast Trading is the least risky and most profitable business in the stock market.  You don’t have to do ANY research and your investment horizon is roughly 400 milliseconds, or the blink of an eye.  Time is risk.

For the record, NVDA trades about 300,000 times per day. Do the math. 

Which leads to today’s Market Structure Map singularity – infinite value.  Trades for less than 100 shares sent immediately for execution – that’s a “market order” – must by law be executed.  The Securities Exchange Commission has mandated (does the SEC have that authority?) a “continuous auction market” wherein everything is always buying or selling in 100-share increments or less.

So algorithms almost always chop trades into pieces smaller than 100 shares that are “marketable” – meant to execute immediately.  And retail traders are browbeaten relentlessly to never, ever, ever enter marketable trades.  Only limit orders. That ensconces information asymmetry – an advantage for machines.  Every time I send a marketable trade for execution, I have to check a box acknowledging that my trade is “at the market.”

That’s the truth.  Algorithms pulverize orders into tiny pieces not to make them look like tiny trades, but because tiny trades are required by law to execute.  Large trades are not.  Limit orders are not.  Those both may or may not match.  But tiny trades will. There’s one more piece to that puzzle – the market-making exemption from short-locate rules.  For more on that, go to the youtube channel for sister company EDGE and watch my presentation on meme stocks at The Money Show.

Moral of the story:  The entire structure of the stock market is tilted toward the people and the machines who actually know what’s going on, and away from those who don’t.

Now.  What do you know about the stock market, investor-relations professionals?  You are head of marketing for the stock.  Got that?  Do you know how the stock market works?

If you don’t, you need us.  We know exactly how it works, and exactly what’s going on, all the time.  You should have that information in your IR arsenal. 

Nothing is more important. It’s the starting point.

Supply and Demand

Happy Bastille Day!  Also, Goldman Sachs made $15 per share, 50% over expectations. The stock declined.

JP Morgan earned $12 billion on revenue of $31 billion, doubling views. Shares fell.

Why are banks making 36% margins when you can’t earn a dime of interest?

I digress.

Illustration 98288171 / Goldman Sachs © Alexey Novikov | Dreamstime.com

I told the Benzinga Premarket Prep show July 12 on Market Structure Monday (which we sponsor) that falling demand and rising supply in the shares of JPM and GS predicted the stocks would probably perform poorly despite widespread views both would batter consensus like Shohei Ohtani on both sides of the plate (baseball humor for you).

Sure, you could say everybody already knew so they sold the news. This is the kind of copout we get from people who want to tell us stocks are always expectations of future outcomes while simultaneously telling us “they were down because growth wasn’t quite good enough to get past the whisper number.”

That is BS.  Plain and simple. 

ModernIR can measure supply and demand in JPM and GS and observe that demand is falling and supply is rising.  Even amid the farcical characteristics of the modern stock market, that means prices will fall.

We can meter these conditions in your stock too, by the way.

The best thing about the stock market today is how well it reflects supply and demand.  Currency markets don’t. The Federal Reserve continuously jacks with currency supplies in such manipulative ways that almost no economic measure, from growth to inflation, can be believed.

But in the stock market, the math is so sacrosanct that it’s impervious to the ubiquitous interference by Congress and regulators with the mechanisms of a free, fair and open market. No matter how bureaucrats assail the battlements, nothing disguises the stark supply/demand fluctuations apparent in the data.

Wow, mouthful there, Quast.

I know it. I’m not kidding.

Look, regulators REQUIRE brokers to buy and sell stocks even when there are no buyers and sellers.  That’s called a “continuous auction market.”  That’s what the US stock market is.

Contrast that with an art auction.

Stay with me. I have a point.

The first requirement of an art auction is actual ART.  Even if its pedigree is suspicious, like Nonfungible Tokens (NFT).  There’s still art for sale, and an audience of bidders pre-qualified to buy it.  No shill bidders allowed.

Nothing so provincial impairs the stock market. While you can make stuff up such as always having 100 shares of everything to buy or sell, even if it doesn’t actually exist, you STILL HAVE TO REPORT THE MATH.

Think I’m joking about shares that don’t exist?  Educate yourself on the market-maker exemption to Reg SHO Rule 203(b)(2). Or just ask me. 

Anyway, everything is measurable. Thanks to rules dictating how trades must be executed. In GS trading the day before results, Short Volume (supply) was rising, Market Structure Sentiment (demand) was falling.

Unless stock-pickers become 300% greater as a price-setter than they’ve been in the trailing 200 days – a probability approaching zero – the stock will decline.

I don’t care how good your story is.  Story doesn’t change supply or demand. Only ACTIONS – to buy or sell or short or leverage – do.

This math should be the principal consideration for every public company. Were we all in the widget business, selling widgets, we wouldn’t say, “I hope the CEO’s speech will juice widget sales.”

Now maybe it will!  But that’s not how you run a widget business.  You look at the demand for widgets and your capacity to supply widgets to meet demand. That determines financial performance. Period.

The stock market is the same.  There is demand. There is supply. Both are measurable. Both change constantly because the motivation of consumers differs. Some want to own it for years, some want to own it for 2 milliseconds, or roughly 0.05% of the time it takes to blink your eyes.

Both forms of demand set price, but one is there a whole lot more than the other. If the only behavior you consider is the one wanting to own for years, you’re not only a buffoon in the midst of courtiers. You’re wrong.  And ill-informed.

Thankfully, we can solve that social foible. And sort the data for you.

The stock market is about supply and demand. Earnings season is upon us again.  The market will once more tell us not about the economy or earnings, but supply and demand.

Ask us, and we’ll show you what your data say comes next.

The Missing Wall

If your house was missing a wall, would you worry whether the front door was locked?

Well, the stock market is missing a wall. 

And yes, the image here is not a missing wall but the walls you can ski at Steamboat.

To our story, investors and public companies need to understand what it means to have a market with a gaping maw in its structure.  Imagine if you went around the house before bedtime shutting off lights, closing windows, locking the front door.

And a wall was missing.

That’s funny like The Truman Show.  Yet glaring structural flaws are no laughing matter.  For investor relations, the profession linking Wall Street to public companies, the job is keeping the house in order.

The lights and windows represent things long done to promote differentiators.  Earnings calls.  Non-deal roadshows (that means visiting holders without pitching a stock or debt offering). Analyst days.  Investor-targeting. Perception studies. On it goes.

You’d be surprised at the work and effort directed at these missions, you who are not in the profession.  We have an entire body of knowledge around the discipline of investor-communication, internally and externally.  Sums spent on tools and services and regulatory compliance and listing fees and so on total billions of dollars annually.

Keeping the house up is a full-time job. But the house is missing a wall. And too often the profession acts like everything is fine.

Evidence of it splashed again through the stock market yesterday. Rocket Companies (NYSE:RKT) slammed into at least three trading-volatility halts en route to a 71% gain.

It’s a great company.  CEO Jay Farner – I heard him on Squawk Box via Sirius Radio last Friday after results as I was descending from the Eisenhower Tunnel to Silverthorne off the Continental Divide – is so impressive. The cynosure of a prepared spokesperson.

And they’re a rocket, no doubt. RKT had $17 billion of revenue and $9 billion of net income, a 53% margin. Who knew selling loans was a more profitable business than selling data?

But.

That’s not what juiced RKT.  Sure, it was up Feb 26, up again Mar 1. But Active investment – the money focused on fundamentals – was 6.8% of RKT volume Mar 1.  So 93.2% of it was something else.

What’s more, Short Volume exploded at the very time rumors surged across the media that we had another Gamestop (GME) here, another “short squeeze,” now in RKT.

I’ll explain everything, so stay with me.

On Feb 19, Short Volume, the percentage of daily trading representing borrowed stock, was 29% of RKT volume.  By Feb 26 as the stock began to jump, it was 55%.

This is the draft you feel, public companies. This is the missing wall leaving you utterly exposed to what’s outside your control, no matter how much you spend, no matter the windows and doors you lock.

Investors, we’ll get to the meaning for you too.

There is only one way for a stock to rise.  Somebody sells stock at a higher price.  Not what you expected?  You thought I’d say, “Somebody must be willing to pay more.”

Yes. That’s true.  But suppose no owners want to sell, because they believe a mortgage company growing more than 100% year over year with 53% margins is a stock to hold.  And suppose the shorts don’t react.

Where does stock come from then?

Answer: That explosion in Short Volume we saw before the stock skyrocketed.

Somebody SHORTED the stock to make it available for sale at a higher price.  Sound cognitively dissonant?  It’s not. It’s called a “market-making exemption.”

We’ve written about it often before.  Read what we wrote on GME.

Truth is, most of the time when investors buy stock, somebody shorts it first and buys it back for the buyer.  At any moment, this can happen to any of you, public companies. And it doesn’t require high short interest – that 1975 measure still in use like a Soviet relic.

No, it can happen on belief. It can happen on nothing more than a machine-driven updraft.  And it could as easily be a downdraft.  What’s to stop market-makers from creating stock to SELL instead of buy? Correct. Nothing.

No matter what your story, your fundamentals, Fast Traders sitting in the middle can create shares out of whole cloth, because regulators have given them leeway to do so, and your stock can behave in unimaginable ways.

Public companies, if you directed 10% of what you spend on story and compliance to targeting Congress for a solution, we might shore up structure.

A solution starts with understanding the problem. And we do.  We can help you (and your board and c-suite).

Investors, your turn.  Market structure is to me the most important trading factor because it trumps everything else.  If you were modeling RKT market structure, you’d have seen the entry point Feb 22.

How many more situations like these will it take before we start looking at the missing wall? 

The Daytraders

 

A year ago, Karen and I were flying to Fiji, 24 hours of travel from Denver to LA, to Auckland, to Nadi.

We took a ferry out of Denarau Island into Nadi Bay and north toward the Mamanuca Islands, all the way past the castaway home for television’s Survivor Fiji to our South Pacific gem, Tokoriki.

It’s not that I wish now to be a world away.  We can ride bikes past this gem, Catamount Lake, any crisp Steamboat morning (while the fruited plain radiates, it’s 45 degrees most days at 630a in northern Colorado).

It’s the shocking difference a year makes. Everybody’s trading. Instead of going to Fiji or whatever.

Schwab and Ameritrade have a combined 26 million accounts. Fidelity has 13 million in its brokerage unit. E*Trade, over 5 million.  Robinhood, the newest, has 13 million users.

Public companies wonder what impact these traders have on stock prices.  The old guard, the professional investors, seem to be praying daily that retail daytraders fail.

In some sense, the Dave Portnoy era (if you don’t know Barstool Sports and Davey Daytrader – perhaps our generation’s most adroit marketer – you must be a hermetic) has pulled the veil off the industry. It appears the pros know less than they led us to believe.

The pros say just wait.  The wheels are going to come off the retail wagon in a cacophony of sproinging springs and snapping spokes.

Of course, as Hedgeye’s Keith McCullough notes, if the wagon splinters, we’re all in the smithereens because there’s just one stock market.

We wrote in our widely read June 10 post, Squid Ink, about what happens to the millions of online retail trades.  They’re sold to what we call Fast Traders, machines that trade everything, everywhere, at the same time and thus can see what to buy or sell, what to trade long or short.

How does this flow that Citadel Securities, the biggest buyer of retail trades, says is now about 25% of market volume, affect the stock market, public companies and investors?

Two vital points about market structure here.  First, market-makers like Citadel Securities enjoy an exemption from rules governing stock-shorting.  Second, Fast Traders run trading models that predict in fleeting spaces how prices will behave.

Put these two factors together and you have the reason why stocks like TSLA can double in two weeks without respect to business fundamentals – or even the limitations of share supply.

If three million accounts at Robinhood want fractional exposure to TSLA, the problem for Fast Traders to solve is merely price and supply.  If you go to the grocery store and they don’t have shishito peppers, you go home without shishitos.

If you’re a retail trader wanting TSLA, you will get TSLA, and the price will rise, whether any shares exist or not.  Fast Traders will simply manufacture them – the market-maker SEC exemption on shorting.

The market-maker will cover before the market closes in 99% of cases.  So the market-maker isn’t short the stock anymore.  But maybe TSLA will have 25% more shareholdings than shares outstanding permit.

Worse, it’s impossible to understand supply and demand. If market-makers could only sell existing shares – back to shishito peppers – TSLA would skyrocket to $5,000 and plunge to $500.  Frankly, so would much of the market.

Which is worse?  Fake shares or fake prices?  Ponder it.

And machines will continuously calculate the supply or demand of shares of a stock versus others, and versus the exchange-traded derivatives including puts, calls and index futures (oh, and now Exchange Traded Funds which like prestidigitated shares have no supply limitations), to determine whether to lift prices.

As we said in Squid Ink, we believe Fast Traders buying order flow from retail brokers can see the supply in the pipeline.

Combine these features. Fast Traders see supply and demand. They relentlessly calculate how prices are likely to rise or fall. They manufacture shares to smooth out imbalances under SEC market-making exemptions.

And the market becomes this mechanism.

Risks? We’ve declaimed them for years.  The market will show a relentless capacity to rise, until something goes wrong. And then there won’t be enough stock to sell to meet redemptions, and prices will collapse. We’ve had tastes of it.  There will be more.

But it’s not the fault of the daytraders.

Squid Ink

Is retail money creating a Pandemic Bubble? Sort of. Really, it’s Fast Traders turning those orders into clouds of squid ink.

There are 47 million customer accounts at Schwab, Fidelity, Ameritrade, E*Trade and Robinhood.  These big online brokers sell their flow to Citadel, Two Sigma, Susquehanna’s G1X options platform, Virtu, UBS, options trader Wolverine, and others.

Nearly all of the orders are “non-directed,” meaning the broker determines where to send them.  Also, more than three paragraphs of market structure goop and people grab a bottle of tequila and go back to day-trading.

So, let me explain.

Do you know CHK?  A shale-oil play, it’s on the ropes financially. In May it was below $8. Yesterday CHK was near $70 when it halted for news. Which never came, and trading resumed. (Note: A stock should never, ever be halted for news, without news.)

It closed down hard near $24. Rumors have flown for weeks it’ll file bankruptcy.  Why was it at $70? People don’t understand that public equity often becomes worthless if companies go bust. Debtholders convert to equity and wipe out the old shareholders.

Hertz (HTZ) went bankrupt May 26 and shares closed at $0.56.  Monday it was over $5.50, up about 900%. HTZ debt is trading at less than 40 cents on the dollar, meaning bondholders don’t think they’ll be made whole – and they’re senior to equity.

This is bubble behavior. And it abounds. Stocks trading under $1 are up on average 79% since March, according to a CNBC report.

ABIO, a Colorado biotech normally trading about 10,000 shares daily with 1.6 million shares out made inconsequential reference to a Covid preclinical project (translation: There’s nothing there). The stock exploded, trading 83 million shares on May 28, or roughly 50 times the shares outstanding.

Look at NKLA.  It’s been a top play for Robinhood clients and pandemic barstool sports day-trading. No products out yet, no revenue. DUO, an obscure Chinese tech stock trading on the Nasdaq yesterday jumped from about $10 to $129, closing above $47.

Heck, look at Macy’s.  M, many thought, was teetering near failure amidst total retail shutdown. From about $4.50 Apr 2, it closed over $9.50 by June 8.

W, the online retailer that’s got just what you need, is up 700% since its March low despite losing a billion dollars in 2019.

When day traders were partying like it was 1999, in 1999, stocks for businesses with no revenues and products boomed.  Then the Nasdaq lost 83% of its value.

About 95% of online-broker orders are sold to Fast Traders – the Citadels, the Two Sigmas, the Virtus.  They’re buying the tick data (all the prices) in fractions of seconds. They know what’s in the pipeline, and what’s not.

Big online brokers sell flow to guarantee execution to retail traders.  I shared my experience with GE trades. The problem is retail prices are the ammunition in the machine gun for Fast Traders. They know if clips are being loaded, or not. And since retail traders don’t direct their trades (they don’t tell the broker to send it to the NYSE, Nasdaq, Instinet, IEX, etc., to hide prices from Fast Traders), these are tracer rounds stitching market prices up and down wildly.

The Fast Traders buying it can freely splatter it all over the market in a frenzy of rapidly changing prices, the gun set on Full Automatic.

This is how Fast Traders use retail trades to cause Wayfair to rise 700%. The order flow bursts into the market like squid ink in the Caribbean (I’ve seen that happen snorkeling), and everyone is blinded until prices whoosh up 30%.

A money manager on CNBC yesterday was talking about the risk in HTZ. She said there were no HTZ shares to borrow. Even if you could, the cost was astronomical.

Being a market structure guy with cool market structure tools (you can use them too), I checked HTZ.  Nearly 56% of trading volume is short. Borrowed. And the pattern (see here) is a colossus of Fast Trading, a choreographed crescendo into gouting squid ink.

How? Two Sigma, Hudson River Trading, Quantlab, etc., Fast Trading firms, enjoy market-making exemptions. They don’t have to locate shares. As high-speed firms “providing liquidity,” regulators let them do with stocks what the Federal Reserve does with our money. Digitally manufacture it.

Because they buy the flow from 47 million accounts, they know how to push prices.

That’s how ABIO traded 83 million shares (60% of the volume – nearly 50 million shares – was borrowed May 28, the rest the same shares trading many times per second).

It’s how CHK exploded up and then imploded as the manufactured currency vanished. And when stocks are volatility halted – which happened about 40 times for CHK the past two trading days – machines can game their skidding stop versus continuing trades in the ETFs and options and peer-group stocks related to the industry or sector.

This squid ink is enveloping the market, amid Pandemic psychology, and the economic (and epic) collapse of fundamental stock-pricing.

Dangerous.

You gotta know market structure, public companies (ask us) and investors (try EDGE).

Pricing Everything

As the colors of political persuasion in the USA ripple today, what matters in the equity market is what the money is doing.

We measure Sentiment by company and sector and across the whole market daily. It’s not mass psychology. Rational thought sets a small minority of prices (your board and execs should know, investor-relations professionals, or they will expect you to move mountains when the power at IR fingertips now is demographics – just as in politics).

We’re measuring ebbs and flows of money and the propensity of the machines executing the mass of trades now to lift or lower prices.

When the market is Oversold by our measures, it means Passive money is likely to be underweight relative to its models and benchmarks, and probability increases that machines will lift prices for stocks because relative value – the price now versus sometime in the past 20 days – is attractive. We call it Market Structure Sentiment.

In Oct 2016, before the Presidential election, Market Structure Sentiment saw its worst stretch since Sep-Oct 2014 when the Federal Reserve stopped buying debt, sending the dollar soaring and the energy industry into a bear market.

We at ModernIR thought then that after pervasive monetary intervention the next bear market would be two years out. On the eve of the Presidential election two years ago, and two years out, the Dow 30 traded at Dec 2014 levels.

We figured we’d called it.

We were wrong (the market makes fools of most who propose to prophesy).  Donald Trump won, and stocks surged until October this year.

As I write Nov 6, Market Structure Sentiment has bottomed at 3.5/10.0 on our 10-point scale. In 2016 it bottomed Nov 9, the day of the election (and stocks surged thereafter).

Conclusions?  Maybe rational thought means little.

Consider: The SEC has approved Rule 606(b)(3) (if rules need parentheses it means there are too many – but I digress) for brokers, requiring that they disclose (thank you, alert and longtime reader Walt Schuplak) when they’re paid by venues for trades and trade for their own accounts.

Public companies and investors, why do we need rules requiring brokers to tell us if they’re getting paid for orders or trading ahead? Because they’re doing it. And it’s legal.

If we want to suppress both things, why not outlaw them?

Because the market now depends on both to price everything.

Let me explain. When the SEC exempted Exchange Traded Funds from the Investment Company Act’s requirement that fund-shares be redeemable for underlying assets, they did so because ETFs had an “arbitrage mechanism,” a built-in way for brokers to profit if ETFs deviated from its underpinning index.  (NOTE: If you don’t know how ETFs work, catch the panel at NIRI Chicago next week.)

Those exemptions preceded Regulation National Market System, which capped trading fees – but left open what could be PAID for trades. I bet the SEC never saw this coming.

Rule 606(b)(3) forces brokers to tell customers when they get paid for trades and if they are trading for themselves at the same time.

In ETFs, the two dovetail. Brokers can earn trading incentives legitimately because they’re fueling the SEC-sanctioned arbitrage mechanism, which requires changing prices. Rules let you get paid for it!

Second, since ETFs are created and redeemed by brokers (not Blackrock), much ETF market-making is principal trading – for a broker’s own account.

So ETFs create opportunity for brokers to get paid for setting price, and to put their own trades ahead of customer orders – the things 606(b)(3) wants to highlight.

Now ETFs are the largest investment vehicle in markets, and Fast Trading prices stocks more often than anything else. Suppose you’re the SEC. What would you do?

Let’s put it in mathematical terms. Our analytics show 88% of trading volume is something besides rational investment. We blame rules that focus on price. Whatever the cause, there’s a 12% chance rational thinking is why Sentiment is bottomed at midterms.

I think the SEC knows. Can they fix it? Well, the SEC created it to begin.

For now, public companies, every time you look at stock-price, there’s a 12% chance it’s rational. Does your board know? If not, why not? Boards have fiduciary responsibility.

And investors, are you factoring market structure into your decisions? You’d best do so. Odds favor it.

Going Naked

Today this bull market became the longest in modern history, stretching 3,453 days, nosing out the 3,452 that concluded with the bursting of the dot-com bubble.

Some argue runs have been longer before several times. Whatever the case, the bull is hoary and yet striding strongly.

Regulators are riding herd. Finra this week fined Interactive Brokers an eyebrow-raising $5.5 million for short-selling missteps. The SEC could follow suit.

Interactive Brokers, regulators say, failed to enforce market rules around “naked shorting,” permitting customers to short stocks without ensuring that borrowed shares could be readily located.

Naked shorting isn’t by itself a violation. With the lightning pace at which trades occur now, regulators give brokers leeway to borrow and sell to investors and traders to ensure orderly markets without first assuring shares exist to cover borrowing.  I’m unconvinced that’s a good idea – but it’s the rule.

Interactive Brokers earned penalties for 28,000 trades over three years that failed to conform to rules. For perspective, the typical Russell 1000 stock trades 15,000 times every day.

What’s more, shorting – borrowed shares – accounts for 44% of all market volume, a consistent measure over the past year.  Shorting peaked at 52% of daily trading in January 2016, the worst start to January for stocks in modern history.

In context of market data then, the violations here are infinitesimal. What the enforcement action proves is that naked shorting is not widespread and regulators watch it closely to ensure rules are followed. Fail, and you’ll be fined.

“Wait a minute,” you say.  “Are you suggesting, Quast, that nearly half the market’s volume comes from borrowed shares?”

I’m not suggesting it. I’m asserting it.  Think about the conditions. Since 2001 when regulations forced decimalization of stock-trading, there has been a relentless war on the economics of secondary market-making. That is, where brokers used to carry supplies of shares and support trading in those stocks with capital and research, now few do.

So where do shares come from?  For one, SEC rules make it clear that market makers get a “bona fide” exemption from short rules because there may be no actual buyers or sellers. That means supply for bids and offers must be borrowed.

Now consider investment behaviors.  Long-term money tends to buy and hold. Passive investors too will sit on positions in proportion to indexes they’re tracking (if you’re skewing performance you’ll be jettisoned though).

Meanwhile, companies are gobbling their own shares up via buybacks, and the number of public companies keeps falling (now just 3,475 in the Wilshire 5000) because mergers outpace IPOs.

So how can the shelves of the stock market be stocked, so to speak? For one, passive investors as a rule can loan around a third of holdings. Blackrock generates hundreds of millions of dollars annually from loaning securities.

Do you see what’s happening?  The real supply of shares continues to shrink, yet market rules encourage the APPEARANCE of continuous liquidity.  Regulators give brokers leeway – even permitting naked shorting – so the appearance of liquidity can persist.

But nearly half the volume is borrowed. AAPL is 55% short. AMZN is 54% short.

Who’s borrowing? There are long/short hedge funds of course, and I’ll be moderating a panel tomorrow (Aug 23) in Austin at NIRISWRC with John Longobardi from IEX and Mark Flannery from Point72, who runs that famous hedge fund’s US equities long/short strategy.  Hedge funds are meaningful but by no means the bulk of shorting.

We at ModernIR compare behavioral data to shorting. The biggest borrowers are high-frequency traders wanting to profit on price-changes, which exceed borrowing costs, and ETF market-makers.  ETF brokers borrow stocks to supply to ETF sponsors for the right to create ETF shares, and they reverse that trade, borrowing ETF shares to exchange for stocks to cover borrowings or to sell to make money.

This last process is behind about 50% of market volume, and hundreds of billions of dollars of monthly ETF share creations and redemptions.

We’re led to a conclusion: The stock market depends on short-term borrowing to perpetuate the appearance of liquidity.

Short-term borrowing presents limited risk to a rising market because with borrowing costs low and markets averaging about 2.5% intraday volatility, it’s easy for traders to make more on price-changes (arbitrage) than it costs to borrow.

But when the market turns, rampant short-term borrowing as money tries to leave will, as Warren Buffett said about crises, reveal who’s been swimming naked.

When? We’d all like to know when the naked market arrives. Short-term, it could happen this week despite big gains for broad measures. Sentiment – how machines set prices – signals risk of a sudden swoon.

Longer term, who knows? But the prudent are watching short volume for signs of who’s going naked.

Tray Dat

We’ll be listening in the car to a song on satellite radio’s The Pulse, trying to keep current, and I’ll say to Karen, “Do you understand what he’s saying?”

You may feel the same way about equity-market rules. Take for instance the Trade-At Rule.  No it’s not Tray Dat, but I think I heard that in a song on The Pulse.  We didn’t hear something sounding like Tray Dat during the Little River Band concert Sunday at Denver’s Hudson Gardens, the band touring 39 years with a revolving cast still delivering goose-bump harmonies on Lady, Take It Easy on Me, Cool Change and Reminiscing.

Anyway, the Trade-At Rule matters to IR because it sharply impacts the buyside and sellide – your two core constituencies. And if the CFO stops you in the hallway and says, “What do you think of this Tray Dat thing the SEC is considering?” you don’t want to stammer.

So here’s what’s happening.  The SEC in June directed exchanges and Finra, the regulatory body for brokerages, to develop a plan for testing wider spreads in stocks. The SEC wants three test groups for a year-long pilot program.  All three will include stocks with market caps under $5 billion, volume below one million daily shares, and prices over $2.

One group, the control, will trade as it does now.  The second will have greater tick sizes, or spreads between prices for buying and selling shares, called the best Bid (to buy) and Offer (to sell). The plan is still conceptual – the SEC in June gave market participants 60 days to craft their proposal – but it’s probable we’d see five-cent spreads.

The third group will incorporate along with bigger ticks another idea: The Trade-At Rule. Best way to describe it? If you’ve read the book Flash Boys, there’s a story Brad Katsuyama tells about seeing 25,000 shares for sale on his screen, and readying his own order to buy those 25,000 shares. His finger is poised over the keyboard, counting down, 5-4-3-2-1…click. He presses the button to buy – and the orders disappear and he gets but a small portion of what he could clearly see was available.

The Trade-At Rule would ostensibly remedy this problem by prohibiting somebody from front-running the displayed price. It would seem to force trades out of dark pools where prices can’t be seen, onto exchanges, where they can. There are exemptions for big block dark pools like Liquidnet and Aqua, and for exchanges with the best price right before the new “marketable” order arrives. (more…)

NYSE Goes Retail

The recent SEC approval of plans by the NYSE to attract retail dark liquidity generated a nationwide acronym alert.

Just kidding. Mostly. But acronyms in hordes do assault readers of the NYSE rule. It was not readily apparent that the filing had been composed in English.

If you didn’t hear, the SEC last week approved plans by the NYSE to host undisplayed orders originating from retail investors for matching against high-frequency trades in sub-penny increments.

We don’t fault the NYSE. It’s trying to compete for data revenue under plans that require it to match at least 25% of trades to earn revenue from the data those trades generate. With its share of market slipping below that level in May, the need was urgent.

But there are problems here for IR pros and public companies beyond that fact that it represents an abrupt and contradictory about-face from the SEC. We could go on for pages but because some of you would become alcoholics as a result, we’ll confine ourselves to a single, overriding flaw:

The rule effectively establishes 1,000 price points per dollar. In Regulation National Market System, Rule 612, called the Sub-Penny Rule, states: “No national securities exchange, national securities association, alternative trading system, vendor, or broker or dealer shall display, rank, or accept from any person a bid or offer, an order, or an indication of interest in any NMS stock priced in an increment smaller than $0.01 if that bid or offer, order, or indication of interest is priced equal to or greater than $1.00 per share.” (more…)

Do Traders Use Protection?

It’s a question that burns in the minds of IROs daily. No, not that one. This one: “Will an ISO post to the Nasdaq if the TIF modifier is one other than an IOC?”

Sentences like that are why alcoholism remains widespread. It’s also the reason IR folks don’t want to know how markets work. Too complicated.

Yet if we’re brutally honest, we know we should understand more. I mean, you can’t claim to be a great Yankees fan and not know the rules of baseball.

The sentence above from Nasdaq Reg NMS FAQs says: If I’ve chosen to fill my order up to the designated number of shares at a set price without leaving the Nasdaq to check for better prices elsewhere, suppose the time to complete the order is something besides “immediately or forget it.” Will that order be accepted at the Nasdaq?

This is how markets work. If you want homework, Google “Rule 611 Reg NMS.” (more…)