Tagged: access fee pilot

Electric Market Toothbrush

We were in Portugal and our electric toothbrush went haywire.

It would randomly turn on in the night, and no amount of pressing the button would silence it. We abandoned it in Evora in the shadow of 2,000-year-old Roman aqueducts that still work.

The point isn’t the ephemeral nature of manufactured products (Amazon assured we’d have a replacement waiting, so the modern era works!). But two recent events show how the stock market is built for the short-term – and may run of its own accord.

First, the Wall Street Journal reported Sep 21 that a judge is permitting a class action suit from customers to proceed against TD Ameritrade alleging the big discount broker with 11 million customers breached its “best execution” obligation.

For you investor-relations professionals who’ve heard about the Fee Pilot Program proposed by the SEC, this gets to the heart of it. For you investors, it illustrates how market structure is trumping investment motivation.

Let me explain.  The suit claims TD Ameritrade put its own interest above that of its customers because it routed customer trade-executions to high-speed traders for payment, earning $320 million. TD Ameritrade had net income of about $870 million in 2017 – so selling orders was over 35% of the bottom line.

There’s no law against it, and rules encourage it by forcing trading to occur between the national best bid to buy or offer to sell. Prices constantly change as machines move bids and offers, breaking trades into small pieces to profit on intermediating them.

Retail brokerages sell orders to high-speed firms to avoid these marketplace challenges (of note, the WSJ said Fidelity stopped selling its orders in 2015, an exception in the group). That fast traders paid $320 million for orders suggests they can sell them for more – money that should have gone to the customers rather than the intermediaries.

One could argue spreads are so low that what difference does it make?  What’s a few pennies on a hundred-share order?

The problem is that fees for orders change behavior. High-speed firms aren’t investors. They profit by changing prices. That’s arbitrage, and it becomes both means and end.

What’s the definition of volatility?  Unstable – changing – prices. Rules create economic incentives to change prices. Intraday volatility marketwide is 2.3%, far higher than what the VIX based on implied volatility suggests. Arbitrage is the opposite of long-term investment. Why would we want rules that encourage it?

This is why we support the proposed SEC study that would include eliminating fees in one group (an astute IR guy observed to me in Washington DC last week that every stock should spend time in each of the buckets so there is no discrimination). We don’t want arbitrage pricing the market we all depend on as a gauge of fair value.

Which leads to the second item. The ETFMG Alternative Harvest ETF, a pot fund amusingly tickered “MJ” (last dance with Mary Jane, one more time to kill the pain, sang Tom Petty), made headlines for sharp divergence from its intraday indicative value.

ETFs are required to report net asset value every 15 seconds. Traders can arbitrage – here it comes again – ETF shares as they cross above or below NAV.

(Programming note: I’ll be at the Connecticut/Westchester Chapter Oct 3 talking about the impact of ETFs on markets and your stock, and we’re sponsoring the NIRI Chicago Chapter this Friday the 28th so stop by and say hi!)

The SEC is now proposing to eliminate that requirement so ETFs would price once a day like actual pooled investments such as index mutual funds.  Here’s the kicker: The SEC in first permitting ETFs to trade exempted them from the “redeemable security” mandate in the Investment Company Act of 1940.

That is, all pooled investments must exchange investors’ shares for a proportionate part of the pool of assets when asked. ETFs are exempted from that provision. They are not redeemable. The SEC approved them because creators said the “arbitrage mechanism” would make them in effect redeemable because they would have the same value as an index.

What if the arbitrage incentive diminishes?

To me, the problem today for investors and public companies is the market’s staggering dependency on arbitrage. High-speed traders and Passive money, the latter mostly ETF market-making, are 80% of market volume. The two behaviors at issue in these situations. The math on SPY, the world’s largest ETF, suggests arbitrage is an astonishing 94% of its trading volume when compared to gross share-issuance.

It’s like an electric toothbrush you can’t shut off. What you thought was an instrument designed to serve a purpose can no longer be controlled.  It’s creditable that the SEC is investigating how its rules may be running the toothbrush – and courts could put a spotlight on a market priced by the fastest orders.

We don’t need to go back to Roman aqueducts (though they still work). We can and should recognize that the market has gotten awfully far removed from its intended purpose.

Big Pillow Fight

I hope you enjoyed summer vacation from the Market Structure Map!

We skipped last week while immersed in NIRI National, the investor-relations profession’s annual bash, this year at the Wynn in Las Vegas, where at the ModernIR booth these passersby in feathers joined us for a photo (and Sammy Davis, Jr., whom I’d mistakenly thought had expired some time ago).

Speaking of feathers, a “big league” (bigly?) pillow fight has erupted over the SEC’s proposed Access Fee Pilot Program – we’ll explain – and the exchanges are stuffing the digital airwaves with nasal-clogging goose down over it.  How to blow the air clear?

Before we answer, you may be thinking, “Tim, didn’t you write about this June 6?” Yes. But I’ve had relentless questions about what the exchanges are saying.

The IR industry’s biggest annual event last week had nothing on market structure. Never has there been a session at NIRI National called “How Stocks Trade Under Reg NMS.”  You can earn an Investor Relations Charter designation, our version of the CFA, without knowing how stocks trade, because the body of knowledge omits market structure.

As one IR officer said to me, “It’s become acceptable today to not know how our stock trades, and that ought not be.”

No wonder our profession has officially taken a neutral position on something the listing stock exchanges generally oppose, and investors support – this latter lot the audience for IR, and ostensibly the buyers and sellers exchanges are knotting in matrimony.

Do you see?  We’re told the stock market matches investors with investments. Yet exchanges and investors have opposing views, and public companies, the investments of the market, are neutral. What could be more bizarre?

Well, okay. There are beings walking the hallways of casinos on the strip more bizarre than that. But follow me here.

As we explained last week, this trading study is intended to assess how fees and incentives affect the way stock-prices are set and how trades are circulated around the data network that our stock market has become today.

In 2004, when the current market structure was still being debated, the NYSE’s then CEO said trading incentives should be prohibited. The Nasdaq thought requiring a national best price would lead to “flickering quotes” and “quote shredding,” terms that describe unstable prices resulting purely from effort to set the price.

Step forward.  The exchanges are paying some $3 billion of combined (that includes amounts from CBOE, operator of four erstwhile BATS equity markets) incentives aimed at setting prices, and we have flickering and shredded quotes all over the market as evidenced by the SEC’s own data (Midas) on ratios of quotes to trades.

And both exchanges want these conditions to persist because both make money selling data – which is the byproduct of a whole bunch of prices.

This is the key point: Exchanges pay traders to set prices. Picture a table with marbles on it.  Exchanges are positioned at the corners. Consider incentives called trading rebates a weight that exchanges can lean on the corners to cause marbles to roll toward them.  The more rolling marbles, the more data revenue they capture.  So you see why exchanges want those payments to continue – and why they are pressing issuers hard for support.

Investors are the marbles. The incentives cause marbles to roll AWAY from each other, the opposite of what investors want. They want orders with big size and stable prices, a big marble pool.

The problem for issuers is that prices are set to create data revenues, not to match investors.  The culprit is a market that behaves like a flat table with marbles on it, when a market ought to encourage the formation of a big pool of marbles.

That the SEC wants to examine an aspect of this structure is itself encouraging, however.

Regulation National Market System, the Consolidated Tape Association Plan, and exchange order types coalesce to create the market we have now. We understand them.  Do your trusted sources of market information explain these things to you?  You cannot interpret the market without first understanding the rules that govern its function.

I don’t blame our friends at the exchanges for clinging to current structure. They have their own revenue streams in mind. Human beings are self-interested, the cornerstone of international relations from the beginning of time. But you should not count on unbiased information about your trading to come from trading intermediaries.

You can count on unbiased analytics from ModernIR, because we are the IR profession’s market structure experts.  If you want to see how your stock trades, ask us.

Paid Access

A day ski pass to Vail will now set you back $160-$190. It’s rich but I’m glad the SEC isn’t studying skiing access fees. It is however about to consider trading access fees and you should know, public companies and investors. These are the gears of the market.

We all probably suppose stock exchanges make money by owning turf and controlling access. Right? Pete Seibert, Earl Eaton and their Denver investors had a similar ski vision when in 1962 they bought a hunk of Colorado mountain down from the pass through which Charles Vail had run Highway 6. Control turf, charge for access.

In stock trading it started that way too. The Buttonwood Agreement by 24 brokers in 1792 that became the NYSE was carving out turf. Brokers agreed to give each other first look at customer orders and to charge a minimum commission.

This became the stock-exchange model. To trade at one, you had to have access, like a ski pass. Floor firms were called two-dollar brokers, the minimum commission. If you wanted to offer customers more services – say, beer at Fraunces Tavern with a stock trade – you could charge more. But not less.  No undercutting on price.

In the ski business, Nederland, Loveland, Wolf Creek and other ski slopes along the continental divide will undercut, letting you in for half Vail’s cost – but Vail wraps world-class value-adds around its access fees, like Mountain Standard and The Sebastian.

Suppose all the ski resorts could charge only a maximum rate for passes and were forced to send their customers to any mountain having a better price.  It would be inconvenient for travelers arriving in Vail via I-70 to learn that, no, the best ski price is now at Purgatory in Durango, five hours by car.

And it would be like today’s stock market (save for speed). The three big exchange groups, plus the newest entrant IEX, and tiny Chicago Stock Exchange, comprising currently 12 separate market centers, can charge a maximum price of $0.30/100 shares for access to trade. And still they all undercut on price.

That’s because rules require trades to match between the marketwide Best Bid or Offer (BBO) – the best price. As Vail would do in our imaginary scenario, exchanges must continually send their customers to another exchange with the best price.

How to set the best price? You can only cut price so much.  More people will still go to Vail because it’s close to Denver on the Interstate, than to Purgatory, halfway between Montrose, CO and Farmington, NM off highway 550.

Now suppose Purgatory paid to chopper you in from Vail. It might not move you out of The Sebastian, but you’d again have the stock exchanges today. While access fees are capped (and undercut), exchanges can pay traders to bring orders to them.

That’s called a rebate. Exchanges pay brokers incentives to set prices because if they can’t attract the BBO part of the time, they don’t match trades, don’t capture market share, can’t generate valuable data to sell to brokers (Only IEX is eschewing rebates).

The problem for investors and companies is that trades motivated by rebates are like shill bids at art auctions (which by the way are prohibited). They set the best price for everybody else yet the shill bidder doesn’t want to own the painting – or the shares. That’s high-frequency trading. It’s 40% of market volume on average and can be 60%.

Bloomberg reported yesterday the SEC is planning to study access fees through a pilot trading program next year. We’re encouraged that it may include a group of securities with no rebates. But the initial framework begun in 2016 under Mary Jo White aimed to lower access fees, and the study right now contains those plans.

Why? Exchanges are already lowering them. How about setting a floor on access fees so exchanges can make a decent return matching trades and don’t have to engage in surreptitious incentive programs to compete? I got the idea from the Buttonwood Agreement and 200 years of history.

Say all exchanges charge baseline access fees. If this exchange or that wants to wrap more value around fees – better data or more technology or beer – they can charge more.

Whatever happens, we hope (and I asked Chairman Clayton by email) the SEC makes an issuer committee part of the process. Without your shares, public companies, there’s no market. We should have a say. That’s why we have to know how it works!