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.