Tagged: Jane Street

Fab Problem

The world relies on one semiconductor company. 

How did an economic ecosystem let itself get boxed in like that?  About the same way it happened in the stock market.  There’s a lesson for public companies and investors.

Yang Jie and colleagues at The Wall Street Journal June 19 wrote a thorough treatise (subscription required) on the extraordinary rise of TSMC, as it’s known, under founder and Texas Instruments veteran Morris Chang.

Courtesy Dreamstime.com

And how 92% of the world’s most sophisticated chips depend on it. And nearly 60% of all chips, including all the ones for iPhones, the chips for cars, for PCs, for a vast array of devices operating on microcircuitry.

The company is a juggernaut and Morris Chang, 89 and now retired, is a genius.  But a different term comes to mind for participants in the semiconductor industry who let themselves become so perilously dependent.

And what about the consumers of the products?  Was no one aware that the boulevard ferrying technological essentials had a sign on it saying “not a through road?”

There was a failure of hindsight and foresight, a fixation on discrete objectives at the expense of broad comprehension of its mechanics and structure. Seems to me, anyway.

What’s this got to do with the stock market?

There’s a similar lack of imagination over the past 15 years among public companies participating in it.  Finra says it regulates about 3,400 brokers.  But 30 of them execute nearly all trading volume, data we’ve observed ourselves as the leader in Market Structure Analytics for public companies.

If you want to know how the stock market works, join ModernIR June 24 to learn how the Great Meme Stock Craze of 2021 happened – and can happen to you. 

Back to the point, it’s far worse than 30. About ten firms handle nearly all customer orders, and another ten set most of the prices but have no clients and aim to own nothing.

And $500 billion daily dances delicately through that machinery.

It happened the way it did for TSMC.  Once, there were many designers and fabricators.  Then designers discovered they could cut costs and burdens by leaving the fab business, outsourcing it to TSMC.

It made sense operationally. It’s a lot cheaper not building and running factories.  The WSJ article says a single fab may cost $20 billion to build.

And by the time you finish, maybe the technology has moved on, and now what?  TSMC will spend $100 billion the next three years staying current.  Hard to compete with that.

The same thing happened in the stock market, though for somewhat different reasons.  Among the thousands of broker-dealers buying and selling securities for investors, the great majority got out of the fab business, so to speak.

They don’t clear their own trades. They don’t even execute their own trades. They’re introducing brokers.  They sell to customers but outsource trading and account services.

It’s an operational decision. You can’t make money owning the infrastructure.  But the reason is market rules created by Congress and regulators.  First, stocks were decimalized. Brokers counted on the spread between buying and selling for profits.  Poof, gone. There went the fabs.

Then regulators in 2007 implemented the 1975 Congressional vision of a “national market system” connecting all markets electronically and setting in motion a rigorous rules matrix on handling trades. It forced most firms to send their trades to a handful capable of making the equivalent of a $20 billion investment in chip fabrication.

And intermediary profits didn’t vanish. Oh no, they’re larger than ever. But where big spreads between stocks in the past supported sellside research and deep arrays of stock-trading by firms with customers, now tiny spreads accrue colossally to a handful of firms you’ve barely heard of.

Read the Front Month Newsletter piece called Jane Street and the Arbitrage Royal Family.  Sounds like a vocal group from the 1960s. If Gladys Knight ran a market-making firm, she’d call it PipTrading LLC.

Jane Street is killing it. Arbitragers. Should that not raise eyebrows?

The Stock Market has the very same supply-chain issue that besets chips.  We only learned about Chip Trouble through the 2020 Pandemic. We shut down the global supply chain.  Now it can’t get back to level.

Supply-chain flaws will show in the stock market when a fab fails, the supply chain stalls. I’m not worried about it. You should be!  Public companies. Investors.  You’ve let parties with no vested interest in the market – regulators – hang it on a fragile wire.  Like the kind etched by Extreme Ultraviolet Lithography.

Look that one up.

Will we ask for a report on the stock-market supply chain before it’s our undoing?  Or is it TSMC all over again?

Wholesale Profits

CNBC’s Brian Sullivan invited me to discuss shrinking market liquidity last Friday. Riveting, huh!

Well, it is to me! Unraveling the mystery of the market has turned out to be a breathtaking quest. I had another aha! moment this weekend.

Jane Street, a big Exchange Traded Funds (ETF) Authorized Participant, commissioned a study by Risk.net on ETF liquidity.  As a reminder, APs, as they’re called, are essential to the ETF supply chain.  They’re independent contractors hired by ETF sponsors such as State Street to create and redeem ETF shares in exchange for collateral like stocks and cash.

Without them, ETFs can’t function. In fact, they’re the reason why ETFs have been blanket-exempted from the Investment Company Act of 1940 under SEC Rule 6c-11, recently approved.

Exempted from what? The law that all pooled investments be redeemable for a portion of the underlying assets. There is no underlying pool of assets for ETFs, as we’ve explained before.

If you’re thinking, “Oh, for Pete’s sake, Quast, can you move on?” stay with me. If we don’t understand how ETFs are affecting equities and what risks they present, it’s our own darned fault.  So, let’s learn together.

As I was saying, ETFs don’t pool assets. Instead, firms like Jane Street gather up baskets of stocks and trade them straight across at a set price to ETF sponsors, which in turn “authorize” APs, thus the term, to create an equal value of ETF shares wholesale in large blocks and sell them retail in small trades.

I explained to Brian Sullivan how the math of the stock market shows a collapse in stock-liquidity. That is, the amount of stock one can buy before the price changes is down to about 135 shares (per trade) in the S&P 500. Nearly half of trades are less than 100 shares.

Block trades have vanished. The Nasdaq’s data show blocks are about 0.06% of all trades – less than a tenth of a percent. Blocks are defined as trades of $200,000 in value and up. And with lots of high-priced stocks, a block isn’t what it was. For BRK.A, it’s 1.5 shares.  In AMZN, around 130 shares.

Yet somehow, trade-sizes in the ETF wholesale market have become gigantic. Risk.net says 52% of trades are $26 million or more.  A quarter of all ETF trades are over $100 million. Four percent are over $1 billion!

And almost $3 TRILLION of ETF shares have been created and redeemed so far in 2019.

Guess what the #1 ETF liquidity criterion is?  According to the Risk.net study, 31% of respondents said liquidity in the underlying stocks. Another 25% said the bid-offer ETF spread.

Well, if stock liquidity is in free-fall, how can ETF liquidity dependent on underlying stocks be so awesome that investors are doing billion-dollar trades with ETF APs?

We’re led to believe APs are going around buying up a billion dollars of stock in the market and turning around and trading it (tax-free, commission-free) to ETF sponsors.

For that to be true, it’s got to profitable to buy all the products retail and sell them wholesale. So to speak. My dad joked that the reason cattle-ranching was a lousy business is because you buy your services retail and sell the products wholesale.

Yet the biggest, booming business in the equity markets globally is ETFs.

We recently studied a stock repurchase program for a small-cap Tech-sector company.  It trades about 300,000 shares a day. When the buyback was consuming about 30,000 shares daily, behaviors heaved violently and Fast Traders front-ran the trades, creating inflation and deflation.

That’s less than a million dollars of stock per day.  And it was too much. Cutting the buyback down to about 10,000 shares ended the front-running.

I don’t believe billions in stocks can be gobbled up daily by ETF APs without disrupting prices. Indeed, starting in September we observed a spiking breakdown in the cohesion of ETF prices and underlying stock-prices and a surge in spreads (not at the tick level but over five-day periods).

But let’s say it’s possible. Or that big passive investors are trading stocks for ETF shares, back and forth, to profit on divergence. In either case it means a great deal of the market’s volume is about capturing the spreads between ETFs and underlying stocks – exactly the complaint we’ve made to the SEC.

Because that’s not investment.

And it’s driving stock-pickers out of business (WSJ subscription required) with its insurmountable competitive lead over long-term risk-taking on growth enterprises, which once was the heart of the market.

The alternative is worse, which is that ETF APs are borrowing stock or substituting cash and equivalents. We could examine the 13Fs for APs, if we knew who they were. A look at Jane Street’s shows its biggest positions are puts and calls.  Are they hedging? Or substituting derivatives for stocks?

Public companies and Active investors deserve answers to these questions. Market regulation prohibits discriminating against us – and this feels a lot like discrimination.

Meanwhile, your best defense is a good offense:  Market Structure Analytics. We have them. Ask us to see yours.  We see everything, including massive ETF create/redeem patterns.