Tagged: Citadel

Mission SEC

Gamestop wasn’t our fault. 

That’s the conclusion of the Securities Exchange Commission in a 45-page report.  I’m reminded of Gulliver.

Not tiny people with tiny ropes tying down the giant SEC while it slept.  Satire. That the SEC exonerated itself comes as no surprise. Ask the Department of Flooding if it had anything to do with the failure of anti-flooding systems and the answer will be: Nope.

I’ve got just one beef with the SEC in this report, and read on, and you’ll see.  I commend the SEC for saying things like: To understand what transpired in January 2021, it is necessary to understand the market structure within which the events occurred.

We use the phrase “market structure” all the time.  Here, the SEC did.  Coincidence?

Illustration 94594512 / Markets © Idey | Dreamstime.com

Who is the SEC’s audience?  The public, yes. But I’m a market-structure expert. That memo is for market participants, not neophytes. Those who depend on the public equity markets. Such as public companies – who should possess the capacity to understand it (like alert reader Jay D. in New York City did!).

You do it right, public companies.  File your regulatory filings. Tell your superlative story. Meet financial targets, issue your ESG reports, hold your DEI teach-ins, put “sustainable” in everything.

Then your stock soars 500% and you don’t know why. Sure, up 500% is awesome but not knowing why is a condition that should never exist in a free, fair and open market.

Or worse, your stock plunges from $40 to $10 in a day, at the open, even though not a single stockholder sold.  That happened to AVIR yesterday. Sure, bad news on the Covid-19 front. And I can’t say no holder sold.

But isn’t the market supposed to prevent dramatic, reactionary moves in prices? We have a systemwide network of volatility girders instituted by the SEC to prevent midday panic.

Did you know your stock can trade when no holder buys or sells?  We’ll come to that at the end.  It’s how the $50 trillion construct of the US stock market clings together. And why Gamestop happened.

Let’s get to what the SEC said is necessary to understand. I’ll trim it because the memo is 45 pages long – terse for a government missive but I need 800 words for this column.

The SEC says retail trades proceed from a retail broker to somebody else for execution, report to the consolidated tape, and pass on for clearing, which can take up to three days.  Meanwhile in the options market there are a million securities, vastly more than total stocks, where the prices come from brokers and trades settle in two days or less.

How can derivatives change owners before the underlying asset?  Good question.  Unanswered.

And on page 11 of the memo is a painfully discursive paragraph on what traders may do with retail orders.  I’m condensing in Cliff’s Notes fashion: Market-makers may choose to trade with money that’s less sophisticated and avoid what’s more sophisticated, to reduce the risk of loss. And apparently it’s possible to easily segment these orders.

Got that?  I’ll dumb it down one step more, and this is my beef: The SEC is fully aware that some have a huge advantage over others.  Yet the SEC says to begin Section 2.2 that its mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Well, how can that be true if some know what others don’t? People have gone to jail for years because they bought and traded on what others don’t know. Here it appears to be happening willy-nilly.

Because the SEC needs an unfair market. The one we have won’t work if it’s fair. There is no other conclusion.

What about Payment for Order Flow, where retail brokers like Robinhood and Schwab sell trades to “wholesale” buyers like Citadel Securities and Two Sigma?

Wholesalers buy things only because they can sell what they buy at a profit.  Period.

The SEC knows it. The SEC knows some have better information than others.  And the SEC knows it exempts firms like Citadel from the short-locate rules under Reg SHO Rule 203(b)(2).

Because the mission of the SEC is to preserve the market. Which can’t hum continuously. Unless it’s gamed. So the SEC pays whomever it must with favors to see that it hums.

Sounds like politics.

As to how Gamestop happened and why no buyers or sellers are needed, see my Meme Stocks presentation.

Traders, you can’t beat the market if you don’t know how it works.  Public companies, we’re wasting time and money doing things that don’t matter.

The starting point is making sure our CEOs and boards know how the market works. We can help you begin this new mission.

Reg Efdy and Thee

The Securities and Exchange Commission is in danger of becoming the Dept of Silly Walks.

Let me explain why I’m calling the SEC Monty Python. And it matters to you, public companies and investors.

Speaking of disclosure: I’m on the NIRI National Ethics Council, and we’re debating this matter.  What I’m saying here is, as usual, my own view.

So back in the go-go late 1990s, “sellside” analysts like Henr

Courtesy Monty Python’s Flying Circus, 1970.

y Blodget and Mary Meeker were the superstars of research. Public companies could be seen groveling at sellside thrones.

And simultaneously, sometimes tens of thousands of retail investors would join a new-fangled communication tool public companies were using, the earnings-call webcast.

And insider-trading was the hottest of buttons for regulators.  They were concerned companies were telling sellside analysts and big institutional investors things before the little guys would hear them.  The disturbing spectacle of the Big Guys getting an edge over the Little Guys.

Nothing smokes the cigar of regulators faster than that.

So in August 2000, the SEC passed Regulation Fair Disclosure requiring public companies not to tell some people stuff that could alter valuation or stock-performance without telling everybody else.

In enacting the rule, the SEC said:  

As reflected in recent publicized reports, many issuers are disclosing important nonpublic information, such as advance warnings of earnings results, to securities analysts or selected institutional investors or both, before making full disclosure of the same information to the general public. Where this has happened, those who were privy to the information beforehand were able to make a profit or avoid a loss at the expense of those kept in the dark.

Step forward to 2021.  The SEC last week brought a Reg FD enforcement against members of the investor-relations team at AT&T for supposed material nonpublic disclosures to analysts and big investors five years ago.

AT&T is contesting these findings in a tartly worded missive.

So now we get to the Ministry of Silly Walks and how it’s dragging its gangly limbs about in comic fashion.  First, if it takes you five years to figure out enforcement is needed, you’ve already made a mockery of the process.

Now, consider the stock market in 2000.  Almost 90% of investment assets were actively managed – overseen by people finding what would set one company apart from another and lead to better investment returns.  And 80% of volume was Active. And market intermediaries like Citadel Securities barely existed.

And in 2000, stocks were not decimalized.  Markets were not connected electronically and forced to share prices and customers and stock-listings so that everything trades everywhere, all the time.

In 2021, about 65% of investment assets are now passively managed using models.  Over $5 trillion in the US alone resides in Exchange Traded Funds (ETFs), stock substitutes backed by cash and securities that trade in place of actual stocks.

And trading machines using lightning-quick techniques from collocating servers right next to the exchanges’ to microwaves and fiberoptics drive over 50% of volume.

And guess where selective disclosures and informational advantages reside now?  You got it.  ETFs.  And Fast Traders.  ETFs know which direction the supply and demand for shares is moving, and they transact off-market with a handful of Authorized Participants in giant blocks called Creation Units.

Imagine if big investors gathered with big companies and traded information in smoky backrooms.  It would at minimum violate Reg FD.  It would no doubt prompt outrage.

So, why is it okay for ETFs and their brokers to do this at the rate of $500 billion per month?  It’s an insurmountable advantage harming non-ETF fund managers.

Second, Fast Traders buy retail stock orders so us little guys can trade for free and in fractional shares.  But Fast Traders can see the limit-order pipeline. Nobody else can.  That’s material nonpublic information, and it permits them to profit at others’ expense.

Why is it okay for the quickest firms to have a first look?  Notice how the operators of big traders own sports teams and $100 million houses?  There’s a reason.  It’s called Informational Advantage.

Third, as I’ve said repeatedly, automated market-makers, a fancy name for parties between buyers and sellers, can short shares without locating them, and they don’t have to square books for more than 30 days.  As we described, it’s how GME went up 1,000%.

Finally, next week indexes and ETFs will have to rebalance, and a raft of options and futures expire. And about ten big banks handle all that stuff – and know which direction it’s going.

A handful have a massive advantage over everybody else – the very thing regulations are meant to prevent. Sure, we get free trading, cheap ETFs and the appearance of liquidity.

But it’s not a fair market – and that’s why this AT&T case is silly.  It’s cognitively dissonant and hypocritical to permit rampant market exploitation while culling a five-year old file from the last regime to score political points.

Reg FD is a quaint relic from a time that no longer exists.  Maybe the SEC should regulate to how the market works now?

Onward and Upward

The market is always forward-looking, said the pundit.

courtesy Cnet.

We were driving back from Steamboat to Denver and listening to satellite radio.  It was noon coming through Kremmling in Grand County and the temperature was five degrees Fahrenheit, 50 degrees chillier than Denver.

And I thought, “Do these people pay attention?”

I like traditions.  Thanksgiving.  Anniversaries.  Hieratic observances that remind us there are bigger things than ourselves.  Skiing before the riff-raff gets to the slopes.  Reading Federalist 41 periodically and then looking at our government and laughing.

But clinging to traditions like sell in May and go away and the market is always forward-looking while ignoring the geological upheaval in market form and function the past 15 years is inexcusable.

How can you say the market is always forward-looking when Citadel Securities is its largest volume-driver and its investment horizon is a day or less?  Over 52% of all trading volume has an investment horizon of a day or less. It’s machines changing prices and profiting by sitting in the middle.

If you wonder if that pays, have a look at the stuff Ken Griffin owns.  And Doug Cifu. And Vinnie Viola.  Ed Bosarge (that’s quite entertaining, no offense to this innovative high-frequency trader).

The market cannot be forward-looking if the majority of its volume is living in the moment. The market then lives in the moment.

Do you follow?

It’s not just wrong to cast the market as a forward-looking.  It’s dangerous.  Take Transports, a classic subdivision of the stock market long used as a barometer of commerce. They’re trading at all-time highs. The thinking is a strong Transports group predicts economic prosperity.  After all, it’s the machinery and apparatus of the movement of goods.

And how about retail stocks?  I was just saying to the folks at EDGE, the decision-support platform built on market structure that we founded to help mom and pop traders out-think the machines, that retailers looked best.

That’s not because we examined all the data on spending patterns in the USA or concluded that folks would plow their latest Covid cash from the government into garments and furniture.  No, it’s math. The short volume trend was down, and the ramp in Sentiment was the best of any sector or industry.

Son of a gun.  Look at Overstock, Wayfair, pick your component.

But supposing that it’s anything other than math is supposing amiss.  You can no more look at the market and draw a reliable economic conclusion than you can look at a forked stick and hope it leads you to water.

Unless you’ve been touched by the spirit, I suppose.

You get the point.

Transports?  Sure, the stay-at-home pandemic culture enriched distribution channels like trucking and rails.  AMZN isn’t a component of the Dow Jones Transportation Index (DJT).  But a bunch of airlines and a rental-car company are.

You can try like all the pundits to come up with a rational reason for why the future is brighter than ever for Transports. And you can always find one.

That doesn’t make it so.  The reason Transports are up is because they’re volatile. You can make a crap ton – to use an elegant Latin term – trading volatility in the moment.

Speaking of volatile, so is the outlook for Activism in 2021.  It may be INTC is a harbinger of things to come.

If you want to know what that data looks like and how you can see it coming in your own trading, I’ll show you at the NIRI Twin Cities program this Thursday at 11a CT. I’m moderating a discussion on the data, the preparation and the battle – and why 2021 might bring the Viking raiders back ambuscading our ranks.

Back to the present.  I’ve said it before. There are facts apparent to any observer about the stock market.  More assets are passive now than Active.  Citadel Securities dominates.  Options trading is at records.  Volatile is a plague. Short volume is nearly half the total.

When is our profession, the investor-relations discipline, going to adapt? Are these facts part of your regular communication to your boards and executive teams?  If not, why not? If you’re ready, we’ve got the orbit, the data, the tools and the structure to help you keep your relevance in a right-now market. Have for 16 straight, unrelenting years.

The world moves on. We must too. We can’t be the last people on the planet to catch up.  Now if you’ll excuse me, there are three planets upward in the sky I want to see (Jupiter, Saturn, Mercury, this week),  moving onward, like time and the stock market.

Boxed Yellow Pencils

“How do you think about ESG?” said my friend Moriah Shilton at a San Francisco NIRI summit some weeks back with hedge fund Citadel.

Silence. The four panelists shifted around.  A couple whispered to each other. Finally, somebody offered with a throat-clearing cough, “It doesn’t factor into our portfolio decisions.”

For those not fluent in Investor Relations (IR) Speak, ESG is “Environmental, Social, Governance.”  NIRI is the National Investor Relations Institute, professional association for the liaison between public companies and Wall Street.

ESG dominates the contemporary IR educational platform. NIRI has made a policy statement on ESG. There are at least two ESG sessions here at the NIRI Senior Round Table meeting (and NIRI national board meeting) this week in Santa Barbara.

The ESG heat isn’t coming from stock-picking investors, the “long-only” audience of public companies spending billions annually on communication through compliance-driven reports like 10Ks, 10Qs, press releases and proxies and via proactive outreach aimed at increasing share-ownership.

Nor is it, apparently, coming from hedge funds like Citadel, the other key audience – and I’d argue now the vital IR constituency because of its capacity to compete with the Great Passive Investment Wave – for public companies.

In fact, the Citadel team later said, “We vote with management on proxy matters, or we vote with our feet by selling shares.”

It’s passive money that’s obsessed with ESG. Passive investment to us is any form of capital allocation for a day or more (by contrast Fast Trading is an investment horizon of a day or less) driven by rules. That’s index investing, Exchange Traded Funds, or any variety of quantitative investment, from global macro to statistical arbitrage.

True, passives may oppose a proxy measure that doesn’t comport with an ESG platform. They will, however, continue owning the stock. Index funds pegged to a benchmark like the S&P 500 are required to own the securities comprising the benchmark.

It’s cognitively dissonant to own things you oppose.

But aren’t they trying to promote practices that make companies better stewards for stakeholders?

From my first exposure to it, good business has been sound financial management, the right people, products, markets, capital structure, the advancement of the best interests of your customers, employees, communities. These are essential strands of business DNA.

In fact, turning those into a checklist promotes the possibility that mediocre firms are treated the same as stellar ones by virtue of filling out a form.  Rules breed uniformity.

Nowhere is that more apparent than in the stock market, where rules push prices toward a mean. Track the midpoint – as Passive money does – and returns become superior by pegging the average.

The investor-relations profession, the pursuit of excellence, Warren-Buffett-style investment strategies, are about unique differentiation.  What makes a company better, superior?

Rules-based investing makes things the same. Passive money has boomed because shares of companies are increasingly products defined by shared criteria, like ESG. The more of that there is, the greater the probability the market will become homogeneous.

Without dismissing its merits, I’m perplexed by why public companies and stock-picking investors would promote shared criteria like ESG (why not differentiate with ESG if you’re so moved?).  We don’t want the stock market to become a bunch of yellow pencils in a box.

I think a form of guilt has gripped the passive-investment colossus like what manifests among the Silicon Valley nouveau riche who ofttimes with minimal effort realize vast wealth, and then feel compelled to browbeat the rest about the “greater good.”

How one favors the greater good should be individually chosen, not directed by rules.

So from atop vast heaps of assets gained through doing nothing more than tracking a benchmark, Massive Passives are compelled to berate the market over purpose.

If that purpose is an ESG checklist, the purpose is a dictated set of rules.  The very thing passive investment promotes.  Ironic, right? By subtly suggesting moral superiority, passive investment advances its own self-interest: rules-based investing.

Rather than mindlessly embracing ESG as good for all, a sentient species capable of staggering creativity and achievement through the individual pursuit of happiness that inures to the benefit of the masses owes itself moments of objective reflection.

And the question to ponder is whether a uniform ESG blanket tossed over the capital markets furthers the pursuit of the excellence the IR profession and stock-pickers seek.

The Fortress

Happy birthday to Karen Quast! My beloved treasure, the delight of my soul, turns an elegant calendar page today. It’s my greatest privilege to share life with her.

Not only because she tolerates my market-structure screeds.

Speaking of which, I’m discussing market structure today at noon ET with Joe Saluzzi of Themis Trading and Mett Kinak from T Rowe Price. In an hour you’ll mint a goldmine of knowledge.  Don’t miss it.

A citadel by definition is a fortress.  I think of the one in Salzburg, Austria, the Hohensalzburg castle perched on the Salzach, “Salt River” in German, for when salt mined in Austria moved by barge.  We rode bikes there and loved the citadel.

It’s a good name for a hedge fund, is Citadel. We were in San Francisco last week and joined investor-relations colleagues for candid interaction with Citadel. IR pros, hedge funds are stock-picking investors capable of competing in today’s market.

Blasphemy?  Alchemy?  I’ve gone daft?

No, it’s market structure. Exchange Traded Funds (ETFs) have proliferated at the expense of what we call in the IR profession “long-only” investors, conventional Active managers buying stocks but not shorting them.

Since 2007 when Regulation National Market System transformed the stock market into a sea of changing stock-prices around averages, assets have fled Active funds for Passive ones.  ETF assets since 2009 have quadrupled, an unmatched modern asset-class boom.

Underperformance has fueled the flight from the core IR audience of “long-onlys.” Returns minus management fees for pricey stock-pickers trails tracking a benchmark. So funds like SPY, the ETF mirroring the S&P 500 from State Street, win assets.

Why would a mindless model beat smart stock-pickers versed in financial results? As we’ve written, famous long-only manager Ron Baron said if you back out 15 stocks from the 2,500 he’s owned since the early 80s, his returns are pedestrian. Average.

That’s 1%. Smart stock-pickers can still win by finding them.

But. Why are 99% of stocks average? Data show no such uniformity in financial results. We come to why IR must embrace hedge funds in the 21st century.

Long-onlys are “40 Act” pooled investments with custodial assets spent on a thesis meant to beat the market.  Most of these funds must be fully invested. That is, 90% of the money raised from shareholders must be spent.  To buy, they most times must first sell.

Well, these funds have seen TRILLIONS OF DOLLARS the past decade leave for ETFs and indexes (and bonds, and target-date mixed funds). Most are net sellers, not buyers.

Let’s not blindly chase competitively disadvantaged and vanishing assets. That confuses busy with productive. And “action” isn’t getting more of the shrinking stock-picking pie.

First, understand WHY ETFs are winning:

  • ETFs don’t hold custodial assets for shareholders. No customer accounts, no costs associated with caring for customers like stock-pickers support.
  • They don’t pay commissions on trades. ETFs are created and redeemed in large off-market blocks (averaging $26 million a pop, as we explained).
  • They don’t pay taxes.  ETFs are created and redeemed tax-free through in-kind exchanges.
  • ETFs avoid the volatility characterizing the stock market, which averages about 3% daily in the Russell 3000, by creating and redeeming ETFs off-market.
  • And fifth, to me the biggest, stock-market rules force trades toward average prices. All stocks must trade between the best bid to buy and offer to sell. The average.

So.  Stocks are moved by rule toward their average prices. Some few buck it.  Stock-pickers must find that 1%. Money tracking benchmarks picks the 99% that are average. Who’s got the probability advantage?

Now add in the other four factors. Who wins?  ETFs. Boom! Drop the mic.

Except dropping the mic defies market rules prohibiting discrimination against any constituency – such as stock-pickers and issuers.

SEC, are you listening? Unless you want all stocks to become ETF collateral, and all prices to reflect short-term flipping, and all money to own substitutes for stocks, you should stop. What. You. Are. Doing.

Back to Citadel. The Fortress. They admit they’re market neutral – 50% long and short. They use leverage, yes. Real economic reach isn’t $32 billion. It’s $90 billion.

But they’re stock-pickers, with better genes. Every analyst is covering 25-55 stocks, each modeled meticulously by smart people. Whether long or short they meter every business in the portfolio. Even analysts have buy-sell authority (don’t poo-poo the analysts!). And they’re nimble. Dry powder. Agile in shifting market sand.

They can compete with the superiority modern market structure unfairly affords ETFs.

So. Understand market structure. Build relationships with hedge funds. This is the future for our profession. It’s not long-onlys, folks. They’re bleeding on the wall of the fortress. And don’t miss today’s panel.

Behind the Trade

We were in King Soopers and they were out of lemons.

For those of you elsewhere in the country and world, King Soopers is a Kroger-run grocery chain and I’m sure you’re thinking as I did when I first saw one, “Who names a store King Soopers?”

I bet you’re also thinking, how do you run out of lemons? Answer: deliveries hadn’t arrived. We take for granted that stuff will be on the shelves. Having lived a year in Sri Lanka in college, where oftentimes there wasn’t anything on the shelf because no shipments had come, I grasp limited liquidity.

When stocks rise in price, we figure there must be more buyers than sellers. When they decline, the opposite must be true. You laugh, yes. But how do shares get on shelves in the first place?

A long time ago, there were just a couple stores, like the New York Stock Exchange, owned by the firms who stocked the shelves – literally. Brokers had books of business comprised of owners of shares. In 1792 under a buttonwood tree in lower downtown New York City one May day, 24 brokers agreed to confederate, recognizing that pooling business would create a marketplace. The NYSE was born (next week it becomes a subsidiary of derivatives market The ICE). (more…)