The Frontier

A war of words is unfolding in our profession.

In case you’ve not followed, it’s about the market for the product you manage as investor-relations officers. Many of you have read Flash Boys, Michael Lewis’s (The Big Short is soon coming to movie screens) engaging story of high-speed trading in equities. IEX, the upstart Lewis profiles, aims now to become a stock exchange, listing and trading your shares. Its application is up for public comment.

The dirt’s flying. IEX is accused by establishment exchanges of operating an unfair structure. The broker earned its stripes by offering investors a transparent alternative trading system characterized by the Magic Shoe Box – a fiber optic coil standardizing access to prices. You ought to read what’s been said and how IEX is responding.  We suspect its future fellows may regret having hurled recriminations. Seriously. See the comment letters from foes and friends (Southeastern Management’s supportive letter, signed by fellow investment managers in Declaration of Independence fashion, is a must-read. We’re finalizing ours now.).

Why care from the IR chair? Can your CFO explain to the Board how the company’s shares trade?  Public companies have left responsibility for the market to somebody else. The small city of Bell, CA followed this strategy and later found its managers were paying themselves a million dollars. Do you know what your exchange sells?

We’re picking no fights with the Big Two though you regular readers know we’re critical of their arbitrage incentives, how exchange revenue-drivers shift focus from investment to setting prices. When they match a baseline percentage of trades in your shares (and quote best prices often enough), then under the rules of the Consolidated Tape Association, exchanges receive the lion’s share of market-data revenues from the national system tracking prices and volumes. I think the establishment simply resists sharing with IEX a piece of this pie (how about growing the pie bigger?).

By setting prices continuously the exchanges create additional proprietary data that they sell back to traders and market centers. Why do they buy it?  Any participant serving customers must offer best prices and to ensure that they do, rules say they must buy all the data. Fee schedules for the exchanges show data-feeds can cost vast sums.

Yet in a perverse irony that cannot be blamed solely on the exchanges, traders with no customers often set most prices. These firms are the high-frequency traders about which Flash Boys unfolds its racy narrative.

IEX won’t be paying fast traders to set prices. It’s got a straightforward approach to matching customers. Read the comments on both sides and send a couple along to your executives. Ultimately the equity market exists for you, public companies, and your active investors, not so traders can arbitrage some split-second spread. We should then ask why legacy exchanges are paying for split-second prices.

We admire our friends at IEX and want them to succeed. Where companies once listed on many exchanges – Pacific, Boston, Philadelphia, Chicago, Cincinnati and other markets – the choices today are Either Or.  BATS has no current plans for listings beyond ETFs so it’s a duopoly. Our profession should welcome a fresh third option.

As the tryptophan turkey high tomorrow washes by and you give thanks (in the USA we worship turkey on the 4th Thursday of November, international readers), be glad about the ever-present opportunity for say on market structure, about which issuers are notoriously silent. Resolve to be louder.  Go forth boldly and lay claim to the frontier.


If the stock market reflects all information currently known, why are buyout deals nearly always done at a premium to market price?

“Because, Quast, deals involve proprietary pricing models that account for synergies.”

Sure. But I want you to think about prices. The Wall Street Journal recently reported that Blackrock cut fees on several exchange-traded funds (ETFs) to three cents per $100 of assets annually.

Low fees appeal. But how are they doing it?  After all, ETFs are notoriously high-turnover vehicles. The Investment Company Institute says conventional institutions sell about 42% of asset annually. Data from ETF Database showed ETF turnover of 2,200% annually, and leveraged ETFs using derivatives to achieve returns turning over a shocking 164 times more than underlying assets. At that rate, a $1 billion ETF could trade $164 billion of shares in a year. Tally your volume over the trailing year and divide by your average market-cap and it’s probably 1-3 times.

It’s an axiom of financial markets that churning assets consumes returns. So how can ETFs be low-cost vehicles? In June 2011, Financial Times of London writer Isabella Kiminska brilliantly observed that ETFs are built around what she termed “manufactured arbitrage.” If ETFs aren’t making money on fees it’s because they make it elsewhere.

In fact shares of ETFs represent something that exists elsewhere. Every day, ETF sponsors like Invesco and Blackrock give their brokerage agents called authorized participants (APs) a creation basket, a list of securities or other assets held by the ETF. The AP assembles this list for the ETF and receives in kind a bunch of paper – a chunk of ETF shares to sell. The AP may substitute cash for the creation basket too.

APs thus always know before everyone else whether demand is rising or falling. An AP could buy underlying securities (or borrow them) and supply them to the ETF, and then sell the ETF shares, and if the ETF is later discounted to the underlying securities, buy the ETF shares and redeem them to the ETF. The ETF industry in fact touts this continual arbitrage opportunity in ETFs as a key efficiency feature.

Actually, it explains why ETFs have low costs. There’s a lot of money in trading paper back and forth while not having to compete with anybody else.  ETFs and APs are a closed market that collectively is always a step ahead.

High-frequency traders (HFT) also claim to offer efficacy through frenzy.  Modern Markets Initiative, the HFT industry lobbying group, says HFT fuels “market efficiency” because automated markets reduce costs, enhance access and increase competition. It defies logic to propose you can reduce costs by doing more of something (politicians often make this claim, which future financial outcomes refute).

“Market efficiency” is a euphemism for arbitrage. We’ve been led to believe that because arbitrage occurs where pricing gaps form, created arbitrage will eliminate gaps. No, what goes away are real prices.

There’s yet a third instance of this pricing contradiction amid the market’s core building blocks. Reg NMS capped the fee for buying shares at $0.30 yet all three big exchanges pay sellers more than that. The NYSE pays its best trading customers about $0.34 per hundred traded shares, the Nasdaq about the same. BATS Group pays top customers in thinly traded stocks $0.45 per hundred shares to sell while charging just $0.25 per hundred to buy.  All three will pay extra to traders active in both stocks and derivatives, the latter called “Tape B” securities denoting the facility for most derivatives trades.

Why are they paying more than they charge? Arbitrage, here between the trades and the value of data. By paying traders to set prices, data become more valuable. All three sell feeds and technology to brokers and traders for sums ranging from $5,000 monthly for a cabinet in a collocation facility to $100,000 monthly for an enterprise data feed.

What drives most of the volume in markets? ETFs are behind disproportionate amounts. HFT gets paid to set prices.  And APs – the big prime brokers like Goldman Sachs and Morgan Stanley – drive half the market volume. A key motivation across the three is profiting on spreads.

These gaps aren’t occurring through information asymmetry or market inefficiencies but are manufactured through the form ETFs take as derivatives and through the fee-structure and function of the National Market System.

No wonder there’s a premium on go-private deals.  They cut out the middle men arbitraging away real prices. And no wonder it’s so difficult to match the market to reality. It’s deliberately and mechanically manufacturing prices. That’s apparent when one understands ETFs, HFT and exchange market-access fees.

The Obvious

Algorithmic trading is Wall Street’s last best hope.

So said the lead sentence in a story called Algo Wars in the May 30, 2005 edition of Investment Dealer’s Digest. That publication is gone and so is Lehman Brothers, co-leader of program-trading at the NYSE in May 2005, and computers were then rapidly displacing humans in driving it.

Algorithms, computerized mathematical models for trading, are ubiquitous now not just in equities but across a spectrum of electronically traded securities ranging from currencies and options to futures and US Treasuries.

History illuminates origins. It’s the reason to be a student of it, paraphrasing the Spanish philosopher called George Santayana (his actual name is a lot longer), who made the cover of Time Magazine in 1936 and observed that those who cannot remember the past are condemned to repeat it.

Algorithms, the article says, were birthed by “market developments and regulations that made trading equities more complicated and less profitable.” It quotes Sang Lee, founder of then brand-new market consultancy Aite Group, now a thought leader on market structure, saying algorithms “emerged from this hostile institutional trading environment where it’s getting increasingly difficult to move large blocks of orders.”

That was ten years ago. I had started ModernIR a few months earlier. Josh Friedlander, author of Algo Wars, wrote near the beginning that “because the democratization of algorithmic trading has just begun, its impact on the corporate world is still uncertain,” referring to ambiguity about how algorithms would affect stocks of companies.

Friedlander also wondered if small-caps, victimized then by decimalization and a regulatory separation of research and trading, would suffer further. The JOBS Act, made law in 2012, made it easier for small firms to go public but didn’t address structural woes for small stocks.  Today analyst coverage is a Rorschach blot on the biggest 750 firms, leaving 3,000 largely in uncovered white space. And the buyside and sellside have spent billions on technologies for hiding trades in a complex market.

Exchange Traded Funds (ETFs) grew out of this milieu. Moving big orders was a problem a decade ago.  Now look at it. We have Blackrock and Vanguard with $8 trillion of assets and a stock market with $24 trillion of capitalization. ETFs are the next evolution for a market built on rules meant to fuel movement but which paradoxically paralyze it.

I looked up one of our small-cap clients with about $1 billion of market cap and compared it to one with $10 billion. The small-cap was in 58 ETFs, 15% more than the $10 billion stock, and short volumes for it are in the highest 20% marketwide. It’s not that ETFs are focused on small-caps. Our typical large-cap client with $25 billion or more of market-cap is in about 100 ETFs.  Borrowing and derivatives predominate.

What should be obvious from the IR chair upon retrospection is how little faith one can have in what’s observable on the surface of price and volume.  ETFs move positions relentlessly and without respect to news save for reactions to prices and direction where applicable. Algorithms proliferating for a decade are designed to hide intention.

If as an institutional seller you wanted to obscure your disbursements, would you employ algorithms that pressured prices?  Selling would be patently obvious and the billions spent on sleights of hand wasted.  Clients, you know we routinely observe contrarian patterns in the data – Positive sentiment signaling impending pressure, Negative sentiment a bottom and probable buying.

Let me summarize. The obvious lesson of history here is that a decade of profound stock-market transformation coupled with leviathan investment from its core participants in purpose-obfuscating trading technologies will not produce a market where you look at your price and volume and say, “I think we have a big seller.”

Every now and then that might be right. But 90% of the time what seems to be apparent is probably not what’s occurring.  Thus ModernIR thrives today and we can help anybody regardless of size or trading volume observe reality under the market’s skin.

Stein’s Law

Why are stocks rising if earnings and revenues are falling?

FactSet’s latest Earnings Insight with 70% of the S&P 500 reporting says earnings are down 2.2% versus the third quarter last year, revenues off 2.9%.  Yardeni Reseach Inc. shows a massive stock-disconnect with global growth. Yet since the swale in August marked a correction (10% decline), stocks have recouped that and more.

We’re not market prognosticators. But the core differentiation in our worldview from an analytical standpoint is that we see the stock market the way Google views you:  possessing discrete and measurable demographics. When you search for something online you see what you sought served up via ads at Google, Facebook, Twitter, etc. Advertising algorithms can track your movement and respond to it. They don’t consider you just another human doing exactly the same things as everybody else.

If your stock rises because your peer reports good results, your conclusion shouldn’t stop at “we’re up thanks to them,” but should continue on to “what behavior reacted to their results and what does it say about expectations for us?” Assuming that investors are responsible for the move requires supposing all market behavior is equal, which it is not.

I saw a Market Expectation yesterday for one of our clients reporting today before the open predicting a higher price but not on investor-enthusiasm. Fast traders were 45% of their volume, active and passive investors a combined 40%. So bull bets by speculators trumped weak expectations from investors.  Bets thus will drive outcomes today.

Which leads back to the market. We separate monetary behaviors into distinct groups with different measurable motivation. By correlating behavioral changes we can see what sets prices. For instance, high correlation between what we call Risk Management – the use of derivatives including options and futures – and Active Investment is a hallmark of hedge-fund behavior. The combination dominated October markets. And before the rebound swung into high gear, we saw colossal Risk Management – rights to stocks.

What led markets higher in October are the very things that led it lower Aug-Sep. The top three sectors in October: Basic Materials, Technology, Energy.  Look at three representative ETFs for these groups and graph them over six months: XLB, XLK, XLE.

We might define arbitrage as a buy low, sell high strategy involving two or more securities. The data imply arbitrage involving derivatives and equities. Sell the derivatives, buy the stocks, buy the derivatives, exercise the derivatives.

That chain of events will magnify recovery because it forces counterparties like Deutsche Bank (cutting 35,000 jobs, exiting ten countries), Credit Suisse (raising capital), Morgan Stanley (weak trading results), Goldman Sachs (underperformance in trading) and JP Morgan (underperformance in trading) among others to cover derivatives.

And since the market is interconnected today through indexes and ETFs, an isolated rising tide lifts all boats.  A stock that’s in technology ETFs may also be in broad-market baskets including Russell, midcap, growth, S&P 500, MSCI and other indices.  As these stocks, rise, broad measures do.

At October 22, the ModernIR 10-point Behavioral Index (we call it MIRBI) was topped, signaling impending retreat. That day, the European Central Bank de facto devalued the Euro. The next day, the Chinese Central Bank did the same.  The Federal Reserve followed suit October 28 by holding rates steady. Stocks suddenly accelerated and haven’t slowed. The MIRBI never fell to neutral and is now nearing a back-to-back top.

You’ll recall that Herb Stein, father of famous Ben, coined Stein’s Law: “If something cannot last forever, it will stop.” The rally in stocks has been led by things that cannot last. In fact, the conditions fueling equity gains – everywhere, not just in the US – are comprised of what tends to have a short shelf life (options expire the week after next). Bear markets historically are typified by a steep retreat, followed by a sharp recovery, followed by a long decline.

Whatever the state of the market, what’s occurring won’t last because we can see that arbitrage disconnected from fundamental facts drove it. Understanding what behavior sets prices is the most important aspect of market structure. And it’s the beginning point for great IR.

Your Voice

I debated high-frequency trader Remco Lenterman on market structure for two hours.

Legendary financial writer Kate Welling (longtime Barron’s managing editor) moderated.  Your executives should be reading Kate so propose to your CFO or CEO that you get a subscription to The blow-by-blow with Remco is called Mano-a-Mano but the reason to read is Kate’s timely financial reporting.

Speaking of market structure, yesterday the SEC’s Equity Market Structure Advisory Committee (EMSAC…makes one think of a giant room-sized flashing and whirring machine) met on matters like high-frequency trading and exchange-traded funds.

Public companies have a friend or two there (IEX’s Brad Katsuyama, folks from Invesco and T Rowe Price) but no emissaries. Suppose we were starting a country to be of, for, and by the people but the cadre creating it weren’t letting the people vote?

It makes one think the party convening the committee (the SEC) can’t handle the truth.  After all, it was the person heading that body, Mary Jo White, who proclaimed in May that the equity market exists for investors and issuers and their interests must be paramount.  It’s a funny way to show it.

And now the NYSE and the Nasdaq, left off too, are protesting. BATS is on while listing only ETFs. The Nasdaq generates most of its revenue from data and technology services, not listings.  Intercontinental Exchange, parent of the NYSE, yesterday bought Interactive Data Corp, a giant data vendor, for $5.6 billion.

How long have we been saying the exchanges are in the data and technology businesses? They’re shareholder-owned entities that understand market structure and how to make money under its rules. That’s not bad but it means they’re not your advocates (yet you get the majority of your IR tools through them, which should give you pause).

On CNBC yesterday morning the Squawk Box crew was talking about one of our clients whose revenues near $2 billion were a million dollars – to the third decimal point in effect – shy of estimates. Droves of sellsiders have shifted to the IR chair, suggesting diminishing impact from equity research and yet that stock moved 8% intraday between high and low prices.

What long-term investor cares if a company’s revenues are $2.983 billion or $2.984 billion (numbers massaged for anonymity)? So how can it be rational?

I hear it now:  “It’s not the number but the trend.”  “It’s the color.”  “Revenues weren’t the issue but the guidance was.”

You’re making the point for me. IR professionals have vast and detailed knowledge of our fundamentals as public companies, as we should.  We know each nuance in the numbers, as we should.  We understand the particulate minutia of variances in flux analysis. As we should.

But we don’t get the mechanics of how shares are bought and sold, or by whom. We don’t know how many can be consumed without moving price.  We trust somehow the stock market works and it’s somebody else’s responsibility to ensure that it does.

Ask yourselves:  Would we trust our sales and revenues to a black box? Then why do we trust our balance sheets – underpinned by equity – to one?

Read my debate with Remco Lenterman about what constitutes liquidity and what sets price today (throw in with the c-suite on a subscription to

We picked two of scores of reporting clients this week and checked tick data at the open. Prices for both were set by one traded share.  Suppose you’re the CEO with a stake worth $300 million. We’ve got one of those reporting tomorrow.  What if the first trade is for one share, valued at say $80, and it shaves 8% off market-cap? That’s $24 million lost in that moment, on paper, for your CEO on a trade for $80.

Now you can say, “You’re caught up in the microsecond, Quast. You need to think long-term.”

Or you could wonder, “Why is that possible?  And is it good for long-term money?”

It’s easier for a camel to pass through the eye of a needle than for rational investors to price a stock at the open in today’s market structure.  But we have the power to change that condition by demanding to be part of the conversation. It starts with caring about market structure – because you don’t want the CEO coming back to you later asking, “Why didn’t you tell me?”

Somebody from among us must be on that SEC committee, whirring lights and all.


Earnings season.

Late nights for IR professionals crafting corporate messages for press releases and call scripts. Early mornings on CNBC’s Squawk Box, the company CEO explaining what the beat or miss means.

One thing still goes lacking in the equation forming market expectations for 21st century stocks: How money behaves. Yesterday for instance the health care sector was down nearly 2%. Some members were off 10%. It must be poor earnings, right?

FactSet in its most recent Earnings Insight with 10% of the S&P out (that’ll jump this week) says 100% of the health care sector is above estimates. That makes no sense, you say. Buy the rumor, sell the news?

There are a lot of market aphorisms that don’t match facts.  One of our longtime clients, a tech member of the S&P 500, pre-announced Oct 15 and shares are down 20%.  “The moral of the story,” lamented the IR officer, an expert on market structure (who still doesn’t always win the timing argument), “is you don’t report during options-expirations.”

She’s right, and she knew what would happen. The old rule is you do the same thing every time so investors see consistency. The new rule is know your audience. According to the Investment Company Institute (ICI), weighted turnover in institutional investments – frequency of selling – is about 42%.  Less than half of held assets move during the year.

That matches the objectives of investor-targeting, which is to attract money that buys and holds. It does.  In mutual funds, which still have the most money, turnover is near 29% according to the ICI.

So if you’re focused on long-term investors, why do you report results during options-expirations when everybody leveraging derivatives is resetting positions?  That’s like commencing a vital political speech as a freight train roars by.  Everybody would look around and wonder what the heck you said.

I found a 2011 Vanguard document that in the fine print on page one says turnover in its mutual funds averages 35% versus 1,800% in its ETFs.

Do you understand? ETFs churn assets 34 more times than your long-term holders. Since 1997 when there were just $7 billion of assets in ETFs, these instruments have grown 41% annually for 18 straight years!  Mutual funds?  Just 5% and in fact for ten straight years money has moved out of active funds to passive ones.  All the growth in mutual funds is in indexes – which don’t follow fundamentals.

Here’s another tidbit: 43% of all US investment assets are now controlled by five firms says the ICI. That’s up 34% since 2000.  The top 25 investment firms control 74% of assets. Uniformity reigns.

Back to healthcare. That sector has been the colossus for years. Our best-performing clients by the metrics we use were in health care. In late August the sector came apart.  Imagine years of accumulation in ETFs and indexes, active investments, and quantitative schemes. Now what will they do?

Run a graph comparing growth in derivatives trading – options, futures and options on futures in multiple asset classes – and overlay US equity trading. The graphs are inversed, with derivatives up 50% since 2009, equity trading down nearly 40%. Translation: What’s growing is derivatives, in step with ETFs. Are you seeing a pattern?

I traded notes with a variety of IR officers yesterday and more than one said the S&P 500 neared a technical inflection point.  They’re reporting what they hear. But who’s following technicals? Not active investors. We should question things more.

Indexes have a statutory responsibility to do what their prospectuses say. They’re not paid to take risk but to manage capital in comportment with a model. They’re not following technicals. ETFs? Unless they’re synthetic, leveraging derivatives, they track indexes, not technicals.

That means the principal followers of technical signals are intermediaries – the money arbitraging price-spreads between indexes, ETFs, individual stocks and sectors. And any asymmetry fostered by news.

Monday Oct 19 the new series of options and futures began trading marketwide. Today VIX measures offering volatility as an asset class expire.  Healthcare between the two collapsed. It’s not fundamental but tied to derivatives. A right to buy at a future price is only valuable if prices rise. Healthcare collapsed at Aug expirations. It folded at Sept expirations. It’s down again with Oct expirations. These investments depended on derivatives rendered worthless.

The point isn’t that so much money is temporary. Plenty buys your fundamentals. But it’s not trading you.  So stop giving traders an advantage by reporting results during options-expirations. You could as well write them a check!

When you play to derivatives timetables, you hurt your holders.  Don’t expect your execs to ask you. They don’t know.  It’s up to you, investor-relations professionals, to help management get it.

Paid to Trade

“You’re giving the exchanges so much business, they should be paying you,” said Richard Keary of Global ETF Advisors in a June 2014 Financial Times article.

He was talking about Exchange Traded Funds, which drive big volumes for markets listing them, much like star athletes or Donald Trump. There’s the adage that the worth of a thing is what someone is willing to pay for it. Turns out ETFs are worth a lot to BATS Global Markets Inc. In 2014, BATS started giving free listings to ETFs with over 400,000 shares of average daily volume.

Now they’ve upped the ante.  Wall Street Journal reporter Bradley Hope in a Sep 30 article described BATS’ plan to pay as much as $400,000 annually for ETF listings. BATS now has 33 ETFs from iShares, ProShares and other sponsors. The gorilla is the NYSE’s Arca unit with over 1,600 listed derivatives.  The Nasdaq has about 180.  But BATS has found a secret sauce. It’s the biggest ETF trading venue by volume.

Exchanges profit on the opening and closing auctions. The exchange with the listing gets to hold the auction for that stock or ETF. During auctions, exchanges charge the same price to buy or sell, 10-15 cents per hundred shares, where the rest of the time they’re paying for liquidity or charging to consume it, about 29 cents each (that’s high-frequency trading at its purest, the exchanges incentivizing them to bring trades that price the whole market, making trading data valuable). Thus all the money is in the auction.

Now, what is money doing today? A great deal of it follows benchmarks like the S&P 500 or the Russell 2000. That’s indexes and ETFs. Both may also have options designed to, as the NYSE’s Arca says in its materials, “gain exposure to the performance of an index, hedge and protect a portfolio against a decline in assets, enhance returns on a portfolio [or] profit from the rise or fall of an ETF by taking advantage of leverage.”

What drives volume? Money with a mission to move daily, especially if it’s big enough to have options (or futures) too. That’s liquid ETFs. Most track underlying indexes. The best way to price benchmarks is in auctions, which offer a midpoint and minimize intermediary arbitrage. These prices often set net-asset-value calculations for indexes.

The Nasdaq is running opening and closing auctions.  BATS does too. Ditto the NYSE.  Arca, the electronic NYSE derivatives market, has three auctions.  In May this year, the SEC approved an NYSE request to hold midday auctions in low-volume stocks.

Auctions aggregate buy and sell interest. Fragmented markets (an oxymoron) do not.  And the most valuable investment vehicles driving this auction revitalization are ETFs. At BATS at least, they’re worth more than the underlying assets, stocks of companies.

If BATS wants ETFs, which are derived from underlying shares, so badly they’re willing to pay, and a market system built on a relentlessly moving best bid or offer is increasingly seeking the singularity of auction prices, what’s driving this market? Well, the uniformity of money tracking benchmarks, and derivatives.

ETFs are derivatives. They don’t listen to earnings calls or meet executives to hear the story. Now let’s think about this.  Nothing exists – ETFs, indexes, options and futures would be valueless chaff – without the 3,800 public companies comprising the US stock market. How is it the things derived from the assets – ETFs – are being paid to list, while the assets, the actual companies driving results and strategies making passive investment possible, are being charged?

And if you’re listed at the Nasdaq you don’t pay the NYSE when your shares trade there.  Ever thought about that?  The problem is public companies aren’t paying attention.  Otherwise they’d be asking why derivatives get paid to trade, and companies pay to trade.

The exchanges will say, “Oh but that would require a rule change.”  Fine. This is why we’ve been saying for ten years that public companies need to understand the market. Then you can start asking the right questions, like what’s setting my price?  And what am I paying the exchange for again?

It begins with comprehending structure.  We track it every day.

The Replicator

In the television and cinematic series Star Trek, the Replicator creates stuff.  Captain Jean-Luc Picard would instruct it to dispense “tea. Earl Grey. Hot.” This YouTube montage is homage.

Speaking of creating stuff, stocks lately saw the longest 2015 rally in step with the weakest jobs report. It came on derivatives, our data show. The OMC song “How Bizarre” says if you want to know the rest, hey, buy the rights. In stocks, the rights to things rather than the things themselves is what drove them. Traders bought rights.

That means somebody else must buy the stocks.  Exercise the right to buy with a call option and the counterparty – we track counterparties – must fulfill it with shares. One risk for markets is that dealers don’t hold supplies of shares, what’s called inventory.

Why? Rules now discourage banks from carrying risk assets like stocks and require instead owning Tier One capital like sovereign debt (how the product of overspending is safer than the rights to profits is unclear) and so banks have stopped making markets in a majority of stocks. Thus, when derivatives are used they must buy, and stocks soar.

The mortgage crisis I hope taught us to watch how markets work. Mortgages were replicated through derivatives as demand for returns on purchased and appreciating homes outstripped underlying supply. When mortgages stopped increasing and houses started to fall in value, mortgage derivatives imploded.

That risk resides now in exchange-traded funds. ETFs often sample rather than replicate indexes. For instance, yesterday a swath of American Depositary Receipts (ADRs) surged because money rushed into an ETF tracking an MSCI global index that excludes US stocks. The index has nearly 1,850 components but the ETF just over 400, or about 21% of the index’s holdings.

What, you say? The ETF doesn’t own all the stocks? Right. There are two kinds of ETFs:  Physical and synthetic.  The former either own shares or sample them, and the latter rely on derivatives to represent the value of stocks. ETFs track indexes four ways:

Full replication. The ETF buys all the stocks in the underlying index, matching comparative weighting. But it may substitute cash for some or all of the stocks.

Sampling. When the tracking index is large (as in our example above) or if the stocks are not available in sufficient quantity, an ETF may construct a representative sample of the index and own only those stocks.

Optimization. Where sampling focuses on picking stocks reflecting the index’s purpose, optimization is a quantitative approach that uses mathematical models to construct correlation in a set of securities that trade like the index whether they reflect industry characteristics or not.

Swap-replication. ETFs pay counterparties for rights to the economic value of underlying indices. No assets actually trade hands.  This is what synthetic ETFs like Direxion and Proshares use (along with futures and options).

It’s worth noting that the great majority of bond ETFs use sampling because fixed-income issues are so vast and illiquid that full replication is a physical impossibility.

Back to equities, as with all derivatives from collateralized debt obligations to floating-rate currencies, problems don’t manifest until the underlying assets stop increasing in value. Those are your shares. The broad market has generally ceased rising and we’ve had a raft of problems in ETFs.

We don’t need to panic. But ETFs are the modern-era mortgage-backed securities. They were designed to make it convenient for everyone to infinitely own a finite asset class: Stocks. That is impossible, and so, sure enough, ETFs are substituting rights for assets.

It didn’t impact us in the IR profession so long as stocks were up. Whether your shares were in an ETF or not, you benefited from the implied demand in the explosion of ETF assets. When ETFs substitute cash, the resulting rise in your share-price isn’t real.

Do you understand? The dollars didn’t buy shares.  And if ETFs are sampling indexes rather than buying them in full, radical volatility can develop between issues held and excluded.

But there’s a bigger risk. As with mortgage-backed securities, ETFs are a multiplier for underlying assets. ETFs that hold stocks don’t trade them per se. Shares of ETFs trade as a promise against its assets. And ETFs lend securities.

ETFs primarily track indexes. You can’t have one without the other. If ETFs investors leave and index investors leave and both stop lending shares to brokers for intermediaries like high-frequency traders, the structure of the market will fundamentally change.

The Fed’s view notwithstanding, markets can and must both rise and fall, and markets dependent on derivatives fall harder. It’s a lesson of history. If we in the IR profession were responsible for the widget market, we’d continually study widget-market form, function, risk and opportunity.

Investor-relations is the equity product manager. We’d better watch the equity-market replicator (and clients, we do, every day).

The Long Slide

Autumn lavished Chicago and Boston in the past week, where we were sponsoring NIRI programs. While nature celebrated the season, stocks did not, continuing a slow bleed.

In Chicago I spoke on the structure of the market today, how the liquidity is one place and the prices are another, and forcing them together gives arbitragers control.

Let me explain. The roots of both the NYSE and the Nasdaq trace to brokers. In 1792, a group of them decided to throw in together, agreeing to charge a minimum commission so as not to undercut each other on price, and to go first to the group when looking for buyers or sellers, creating a marketplace – aggregated customers. It became the NYSE.

In 1971, the National Association of Securities Dealers took a page from The Institutional Network (Instinet today, a dark pool owned by Nomura) and created an automated quotation market for its members to post buy and sell interest.  It became the Nasdaq.

Both exchanges operated one market each for equities. Both markets were comprised of the customers of the brokers belonging to them.  They were bringing buyers and sellers together – that’s the definition of a market.

Today the exchanges are owned by shareholders and the markets they run are not predicated on underlying conglomerated buy and sell interest from customers of brokers.  Rules give these markets, the exchanges, authority to set prices. The liquidity – shares owned by investors and brokers – is outside the market now.

How to get the liquidity over to where prices are? Pay traders to haul it.  If you’re a top-tier maker of Nasdaq volume, meaning your firm is bringing shares for sale to the Nasdaq equaling 1.6% of total volume, you can be paid $0.30 for each hundred shares you offer for sale.  At current volumes, firms in that bracket can make $86,000 daily for doing nothing more than moving shares from one market to another.

But there’s more. Traders earn payments for selling shares at the main Nasdaq market.  They’re conversely paid at the Nasdaq BX, another platform (formerly the Boston Stock Exchange) owned by the exchange, to buy shares, about $0.17 per hundred shares.  So traders can earn money both buying and selling shares.

Why?  To set prices. If all trades must occur between the best national bid to buy and offer to sell, and the exchanges – the NYSE does the same thing, as does BATS Global Markets – can pay traders to set the bid and the offer with small trades, then other trades by rule are drawn there to match, and the data from these trades becomes a valuable commodity to sell back to brokers, who are also required by regulations to buy it in order to know if they’re providing customers the best prices.

This is how stock markets work today. Exchanges pay traders to set prices in order to draw out orders, and then they sell the data generated from these trades, and sell technology services so traders and brokers can access prices and data rapidly.

It’s the opposite of the old market where brokers set minimum commissions and gave preference. Both those are against the law now, and the market is fractured into 50 different pieces – stock exchanges, broker-operated “dark pool” markets – and is really about setting prices and generating data.

Volatility results from one thing: Continually changing prices. Why are prices in flux?  Rules require eleven different markets to pass orders to each other if they don’t have the best price, and these markets are paying traders to constantly change it. All the trades at broker dark pools must match at prices set by exchanges, so they are continuously morphing too.

According to data from S&P Capital IQ reported in USA Today yesterday, 86% of the S&P 500 (430 of 500 issues) is down 10% or more. A quarter are off at least 30%.

Suppose you’re a big money manager like Blackrock and investors have been making redemptions for days or weeks, yet every time you sell some shares, the market shudders because all the prices race away from you, and down.

You try to control it by leaking out, leaking out, because nobody wins if prices implode when you sell.  Months ago we theorized after studying market structure for now over ten years that when the next bear market developed we’d see a long slow slide because there’s no efficient way to move money of size in the current structure (a disastrous design for anyone who gets supply, demand, scarcity and choice – basic economic concepts).

We’re in it.  The only question now is the length of the slope.

Water Down

Why are my shares down when my peers are up?

The answer most times isn’t that you’ve done something poorly that your peers are doing well. That would be true if 100% of the money in the market was sorting differences and was in fact trading you and your peers, and if the liquidity for you and your peers were identical at all times.

What is liquidity? Images of precipitation come to mind, which prompts recollection of that famous quip by whoever said it (Mark Twain gets credit but there’s no proof it was his utterance) that bankers will lend you an umbrella only when it’s sunny and take it back at the first hint of rain.

The Wall Street Journal yesterday carried a story about distressing levels of assets in big bond funds locked in positions that “lack liquidity.” Public companies, your bankers and shareholders have probably complained at some point about your “lack of liquidity.”

What it means is among the most profoundly vital yet most commonly overlooked (and misunderstood) aspects of markets. Things are finite. Public companies spend the great bulk of their investor-relations resources on Telling the Story. Websites, earnings calls, press releases, non-deal road shows, sellside conferences, targeting tools, on it goes.

But do you know how much of the product you’re selling is available to purchase? One definition of liquidity is the capacity of a market to absorb buying or selling without substantially altering a product’s value.

The WSJ’s Jason Zweig yesterday tweeted a great 1936 observation by Hungarian-born German émigré Melchior Palyi, longtime University of Chicago professor of economics: “A liquid structure never liquidates. Only the illiquid one comes under the pressure of liquidation.”

Think about that in terms of your own shares.  A liquid market can absorb the ingress and egress of capital without destroying the value of the supporting assets.

What’s your stock’s liquidity?  It’s not volume. We ran a random set of 11 stocks with market capitalization ranging from $300m-$112 billion. Mean volume for the group was 1.1m shares but varied from 50,000-5.6 million. Leaving out the biggest and smallest in each data set, we had a group with an average market cap of $6 billion, average daily volume of 755,000 shares, and average dollars per trade of $5,639.

That last figure is the true measure of liquidity. How much stock can trade without materially changing the price? In our group, it’s $5,639 worth of shares. So in a market with over $24 trillion of product for sale – US market capitalization – the going rate at any given movement is about the amount you’d spend on a Vespa motor scooter.  Now look at the dollar amount of your shares held by your top ten holders.

The stock market is incapable of handling significant movement of institutional assets. It’s a critically faulty structure if investors were to ever begin to pick up the pace of stock-redemptions. They are trying.  For the 20 trading days end Sept 18, the share of market for indexes and ETFs – Blackrock, Vanguard – is up 120 basis points over the long-run average, and stocks are down measurably.  Now, 1.2% might not seem like much but that’s more than $2 billion daily, sustained over 20 trading days. The S&P 500 is down about 5%.  At that ratio, if 10% of investors in indexes and ETFs wanted to sell, the market could decline 50%.

We’re not trying to make you afraid of water!  But this is the market for the financial product all public companies sell: Shares.  That it’s demonstrably ill-formed for a down market is partly the fault of us in the issuer community, because we’re participants and ought to be fully aware of how it works and when and where it may not, and should demand a structure supporting liquidity, not just trading.

Action items:  Know the dollar-size of your average daily trade (a metric we track), and compare it to the dollar-amount held by your biggest holders.  When your management team needs a risk-assessment, you’ll be ready.