Tagged: NYSE

The Death Star

Last Sunday treated us to a picture-perfect Santa Monica day.

We were there helping investor-relations folks at the NIRI Fundamentals conference understand the stock market.

Of it, you probably won’t say to your CFO, “I bet you have no idea how our stock trades.” But it’s bad news if you’re asked by the CFO and have no answer.

So let’s talk about the Death Star. That’s what the industry bemusedly calls today’s trading environment.  The stock market is not at the corner of Broad and Wall or in the heart of Times Square.  It’s in New Jersey on banks of computers at several massive colocation facilities connected by superfast telecommunications infrastructure.

DeathStar

The Death Star (courtesy IEX, T Rowe Price)

The three big exchange groups today each operate four stock markets on those giant computer arrays. Suppose Nordstrom ran four stores in the mall rather than one. We’d think: “Why don’t they put the stuff in one place so customers can easily find it?”

Good question. We’ll answer it in a moment.

BATS Global Inc. is the largest stock exchange in the US now by market-share with its four platforms. Yet it lists only its own shares and exchange-traded funds. ETF trading is good business.

At two of them, traders are paid to buy shares, and at the other two they’re paid to sell (fees differ). This paying traders to buy or sell is called Maker-Taker/Taker-Maker.  Now, the Chicago Board Options Exchange is buying BATS Global.

The Nasdaq also pays traders one place to sell and pays them another place to buy. The Nasdaq is the largest options-market operator. Now the Nasdaq and the CBOE will both run large options/equities trading complexes with fees and credits that encourage traders to do opposite things in different spots, which is arbitrage.

The NYSE is owned by Intercontinental Exchange, and equity trading and listing are fragments of a global revenue colossus in derivatives helping financial players manage risk. ICE is also a huge technology and data purveyor.

By operating multiple platforms, the exchanges can set the best bid or offer, the market’s singular entry point, more often.  Each market then has unique data to sell to brokers and other exchanges, which in turn are required by rule to prove they’re giving customers the best prices – which means they have to buy the data.

There’s your answer. Exchanges operate multiple markets because they make money by changing the prices of everything and encouraging profits on differences. By promoting the arbitrage that vexes you in the IR chair, they sell data and technology.

The only exchange solely offering equity trading and listing that’s not intertwined with derivatives and influenced by trading incentives to set the bid and ask is the newest, IEX.  For our view on IEX and much more, catch the Chicago NIRI chapter’s webcast Friday.

The starting point for understanding any business is recognizing how it makes money.  The Death Star is an inferior capital-raising mechanism (it could be good again with rule-changes issuers should push).  Today, companies like Uber and Facebook grow giant on private equity and use the public market as an exit strategy.

Microsoft and Intel were like reality TV for stocks, taking everyday investors on the long and exciting process of growing in public for all to see and own. We can quibble over causality for this divergence. Our systems monitor the Death Star. It favors trading.

When you understand the Death Star, you arrive at this sort of answer for the CFO: “Since investors and traders can only trade at the best price, our price is most times set by the fastest machines. The big exchanges pay them to set the price so they have price-setting data to sell. They also encourage customers to engage in arbitrage.

“Occasionally active investors shoulder through the arbitrage.  Waves of asset-allocation flows can dominate.  A lot of the time derivatives lead because everybody is focused on managing risk, and in that process short-term divergences develop, which can be traded for profit. And this is why you need an IR professional more than ever.  Somebody has got to understand the Death Star.”

It’s easier to say, “I’m not sure but our story is central.”  It’s just not true most times.

Every IR gal or guy faces this moment of truth: Do I mail in the pat answer, or do I assail the battlements of convention and learn about the Death Star?

You can change your stars, as the Heath Ledger movie A Knight’s Tale asserts. Consistent metrics resonate with executives. If last week Active money led and Sentiment was Neutral, 5.0/10.0, and short volume was down, driving gains, they’ll want to know how those metrics changed this week. Measure and report.

They’ll look to you for the next episode of Star Wars, so to speak. That beats watching the stock or getting sent by them on wild goose chases for answers.  Embrace the change.

Speaking of change, we plan to launch in coming weeks daily sector reports highlighting key metrics – Sentiment, Key Behavior, Short Volume, etc. – for the eleven big industry classifications so you can see what’s happening in your group and how you compare.

There’s much more, so stay tuned! And don’t fear the Death Star.

Busily Productive

“We try not to confuse busy with productive.”

Thus spake the head of investor-relations for an Israeli tech company years ago, and as we wrap the 2016 NIRI National Conference here in June-gloomy but ever awesome San Diego, I recall it anew.

IR for those of you who don’t know is the job that sits at the confluence of the inflow of capital to companies with shares trading publicly and the outflow of information to the buyers and sellers of shares. With investing gaining popularity in the 1960s, companies organized the effort of courting the former and formalizing the latter, and IR was born.

Attracting investors and communicating effectively will remain a bedrock of our profession until the second-to-last public company is consumed by the one giant firm owning everything and in turn owned by one exchange-traded fund leviathan (let’s hope that future never arrives!).

Most IR spending goes to telling the story and targeting investors, the historical yin and yang of IR.  But how are your shares priced?  Do you know?  Is our profession confusing busy with productive?

Let’s review. IR targets investors suited to the story.  We track corporate peers to find areas needing improvement and ways in which we outperform.  I did this too as a telecom IRO (investor relations officer). Your investment thesis defines unique exceptionalism.

Yet trades are measured by averages, indexes and ETFs hew to the mean, and high-speed traders setting prices want to own nothing.  While you’re trying to rise above, all the algorithms are bending your price back to the middle. It’s one reason why indexes beats stock-pickers: Market structure punishes outliers while active money seeks them.

The only NIRI session I was able to attend this year (we’re busying seeing customers, colleagues and friends during the conference) was a tense paneled polemic (moderated adroitly by one of our profession’s scions, Prudential’s Theresa Molloy) with IEX, hero of Flash Boys with a June 17 SEC deadline on its exchange application, and incumbents the NYSE and the Nasdaq.

Without offense to our market-structure friends at the exchanges, it’s stunning how the legacy firms lobby to preserve speed. Here’s what I mean. When the NYSE and the Nasdaq savage IEX for suggesting that slowing prices down by 350 microseconds is unfair, they are bleating a truth: Their dominance depends on privileges for fast traders.

I’ll reiterate how the market works:  Exchanges don’t aggregate supply and demand, they fracture buying and selling by running multiple markets rather than one. Suppose Nordstrom at the mall split into three stores located at either end and in the middle, with different products in each.  It would inconvenience shoppers, who would have to buy clothes one place and then troop to the far end for shoes. But if Nordstrom was selling data on customer patterns in the mall, it would be a great strategy.

Exchanges pay fast traders to set prices.  Prices are data.  Exchanges make billions selling data.  When IEX says it won’t influence the movement of money by paying for prices but instead will match buyers and sellers fairly and charge them both the same price – which none of the other exchanges do – the truth should be obvious to everyone.

It’s this:  Exchanges are deliberately spreading buyers and sellers apart to sell data. Fast traders are paid by exchanges to create great clouds of tiny trades reflecting narrowly separated prices – the exact opposite of the efficiency of size.

Exchanges sell that price data back to brokers, which are required to give best prices to customers, which they can only demonstrate by buying price data and making sure they match trades at averages of these prices, which means the prices are going to be average, which means the entire market is defined by fast traders and averages.  No wonder Blackrock is enormous. The structure serves it better than stock-pickers – IR’s audience.

This is a racket.  You IR folks are running your executives around the globe at great cost telling the story, targeting investors, tracking ownership-change. Yet the market is built on artificial prices intended to generate data revenue. Structure trumps story.

Stop confusing busy with productive.  Again, telling the story will never go away. But learn what sets your price.

We’ve solved that problem for you.  We announced our Market Structure Analytics Best Practices Guide last Friday, and our new Tableau-powered Market Structure Report.  Five Best Practices. Six Key Metrics. Do these and you’ll be a better IR practitioner in the 21st century – and maybe we’ll cease to be gamed when CEOs understand the market. Five Best Practices (drop me a note for our Guide):

Knowledge. Make it your mission to know how the stock market works.

Measurement.  Measure the market according to how it works, not using some metric created in the 1980s. We have six metrics. That’s all you need to know what matters.

Communication.  Proactively inform your management team about how the six metrics change over time so they stop believing things about the market that aren’t true.

A Good Offense.  Use metrics to drive relationships on the buyside. More meetings confuses busy with productive; develop a better follow-up plan.

A Good Defense.  Since markets don’t work anymore, Activism – a disruption of market structure – is perhaps the most popular active value thesis now.  Activists have had 35 years to learn how to hide from Surveillance.  They don’t know how starkly Market Structure Analytics capture their movements.

Let’s stop being pawns. Without public companies the market does not exist. That’s serious leverage.  Maybe it’s time to starting using it.

Pricing Models

The 1,200 NYSE stocks supported by Barclays were the last redoubt of the old market-making guard.

Yesterday, New York City-based Global Trading Systems (GTS) said it will buy the Designated Market Maker (DMM) unit from Barclays at the NYSE. GTS joins KCG Holdings, IMC Financial Markets and Virtu Financial Inc. (which may have to call itself VFI to keep acronym pace) as the quad core making markets and setting prices for NYSE stocks trading at the home exchange.

Barclays likely exited the DMM business because it couldn’t compete. For one, banks are under regulatory pressure to quit trading for their own accounts. Second, rules on the floor prohibit DMMs from using customer orders to price the market. Barclays has customers. The rest were free from the task of sorting those from proprietary trades.

GTS is a high-frequency trading (HFT) firm like its floor brethren. KCG alone has an agency brokerage business with customers, but it’s the progeny of a marriage between Knight Securities and seminal HFT firm GETCO (the Global Electronic Trading Co., the first curiously anonymous massive volume-maker to grab our attention ten years ago).

DMMs pay roughly $0.03 per hundred shares to buy stock, and earn about $0.30 a hundred to sell it. It works poorly for a conventional broker-dealer like Barclays matching buyers and sellers, or crossing the transaction. Proprietary traders find it a money-minting model.

Lest you Nasdaq companies feel special, you’re no different. Prices at the Nasdaq are set by incentives and dominated by HFT too.  Real buyers and sellers rarely price shares – a fact we establish with Rational Price, our fair-value measure, which changes infrequently.

Virtu and IMC Financial Markets, like GTS, say they’re automated market-makers, an innocuous term implying a robotic form of erstwhile human effort. But GTS isn’t matching buyers and sellers.

In its own words: “Today HFT makes up approximately 51% of trades in U.S. equities, and technology-driven innovations continue to transform the investment and financial sectors in profoundly positive ways. At GTS, our advanced algorithms and ultra-fast computers execute thousands of transactions in fractions of a second.  This automation provides liquidity in all the markets we trade and enables our trading venues to provide lower transaction costs.  GTS is proud to be one of the industry innovators contributing to the evolution of the modern market.”

You see? Not a word about match-making. GTS hopes to convince us that its brilliant technology is profoundly positive when in fact it’s exploiting our ignorance.

Various markets for thousands of years have experienced arbitrage – capturing spreads that develop because of inefficiencies in pricing, supply, demand and information. Take theater tickets. Scalpers arbitrage supply and information asymmetries. They are intermediating intermediation. What if we were all forced to buy tickets from scalpers – somebody wanting to profit from owning nothing? Scalpers should be a small part of a market, not 51%.

There are four primary problems with a market priced by HFT:

Risk. If regulators think proprietary trading is risky, why then is 100% of the DMM model proprietary trading?  Why are regulators propagating rules that fashion a market inhospitable to firms taking companies public and supporting them with research and true market-making (carrying inventory, serving customers)?  Following the August 24 trading debacle, JP Morgan changed DMMs from KCG to Barclays because, rightly or wrongly, it lost confidence.

Volatility.  HFT claims to smooth volatility with rapid-fire transactions. That’s muddying the definition. Volatility means “tending to vary often.” Things vary often when they’re broken into fragments and bounced around. That’s intraday volatility, or the spread between high and low daily prices. Tally yours for a month. For AAPL over 20 trading days ended Jan 25, it’s 55.8% – or in dollars, $56.39. That’s the sum of spreads between highs and lows. The Fed shoots for a 2% annual inflation target (wrong but a separate story). AAPL changes more than that each day.

HFT isn’t intermediation but arbitrage. Intermediating by definition is fostering agreement or reconciliation. It involves a vested interest in outcomes. Customers are a tacit requirement. HFT firms have no customers and care not about direction. They create fleeting price-changes for profit.  That’s not market-making.

HFT distorts supply, demand and price. Deduct half your volume because it’s HFT (and over 48% of volume is borrowed so add that to the risk equation). But it set prices and created impressions of supply and demand.  These firms commit little capital, manage no investment portfolios and execute no trades for investors. They’ve devised proprietary pricing models that find short-term inefficiencies (fractions of seconds at once in equities, currencies, commodities and derivatives). They obscure the truth in effect, and in a crisis of magnitude, discovering that most of the prices and half the volume are arbitrage could have devastating consequences for multiple asset classes simultaneously.

Solutions? In Swiftian spirit, there’s the Berkshire-Hathaway Option.  If every US-listed company would reverse-split its shares to $200,000 each, the cost would force arbitragers out. Our serene market would lack arbitrage and intermediation and trade about 1.5 million shares daily. Of course traders, brokers and exchanges, even the regulators (the SEC budget depends wholly now on Section 31 trading fees), would go broke.

Moral of the story? If intermediaries are half our market, it’s a poor one. That should make us mad (why doesn’t it?). It matters not what altruistic oratory streams from the community of high-speed traders. Calling arbitrage market-making will not magically make it so, nor will a better deal materialize from a multitude of middle men.

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 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.

Derivation

One thing you learn not to say is “well it can’t go any lower.”

So said the investor-relations officer for a big energy company as we talked recently about markets. Last week we were writing after the biggest drubbing for stocks since 2008, and as the strongest rally in oil since war – Gulf One, when Saddam, Kuwait and Stormin’ Norman Schwarzkopf were center stage – commenced a quarter-century ago.

If you’re going to spend money in this market as so many public companies do, it’s best to know the derivation of its vicissitudes. Not China, the Fed, oil supplies, jobs data. Those are inputs. What determines outcomes in markets is structure. Think otherwise? Play a game by your own rules and see how others react. Rules govern behavior.

Morningstar said in July that the S&P 500 in the first quarter of 2015 spent more on buybacks ($238 billion) than it earned in profits ($228 billion), an anomaly last seen in latter 2008 when companies were losing money but still plowed $100 billion into stock. They’re buying what they know – their businesses. Why then if the market summarizes business-value do companies struggle to understand it?

The answer is they’re unclear on the rules governing it.  Take the NYSE’s Rule 48, invoked for extreme volatility, about which there’s been chatter at CNBC and elsewhere. It permits the NYSE to suspend ahead of what may be a turbulent day the usual requirement that Designated Market Makers – KCG Holdings, Barclays, IMC Financial Markets and Virtu – approve and post prices before trading starts. I’d translate invocation of the rule as: “Look, do whatever you need to.”

The DMMs may be permitted to do whatever they need to when among other things foreign markets are volatile or unusual activity afflicts the futures market. It would be the latter that triggered yesterday’s use of Rule 48, we’d guess, the fourth time now in two weeks.  So right away the exchange is telling us factors beyond the summary of business-value here in America impact our stocks. Doesn’t matter where you do business.

Rule 48 was created in December 2007 as the mortgage derivatives debacle was picking up steam and as Bear Stearns labored into its final weeks of life. It’s been amended repeatedly, last on August 13 this year by NYSE rule-filing deleting a requirement for DMMs to get exchange approval before initiating trades more than 10% different in price from the last one.

DMMs are proprietary traders – yes, even Barclays here. They’re paid to make markets and so they’re prohibited from filling customer orders for an exchange rebate. But they can “reach across” the market to buy the NYSE’s best offer or sell to its best bid (how that’s different from proprietary trading in dark pools is unclear).

The Nasdaq doesn’t have DMMs but it pays high-speed traders to set prices too. Before markets open, prices are disseminating via proprietary exchange feeds to help fast traders line up and create stable positions. The NYSE says “DMM units have increased their utilization of technology to reduce risk exposure by using algorithms to adjust prices quickly in response to market dynamics.”

Consider these facts against a volatility backdrop, and here’s what you must know:

  • Prices in US markets at the open and throughout the day are often set by fast traders who aren’t investors in your shares but aiming to profit by setting prices.
  • The biggest fast traders are global like IMC and Virtu, the latter saying it’s “embedded” in 200 global markets.
  • Fast traders connect markets globally by trading everything at once – equities, options, futures, currencies (all the stuff transacting on exchanges).
  • They’re arbitragers at root, profiting on spreads.

Here’s the capstone. The average US equity trade-size (if you don’t know yours, you should) is less than two futures contracts. In a global interconnected market, the capacity of high-speed traders to move equity prices using futures is astronomical. 

It’s ultimately about the root of all prices: Money. Currency-volatility. You saw it again this week.

A closing word on markets: The ModernIR 10-Point Behavioral Index at Aug 28 was 1.8. We’ve never registered an official reading below 2.0. A bottom likely looms though September expirations could be ugly again. And we won’t say it can’t go lower.

Follow the Line

Money is better than poverty, if only for financial reasons.

So wrote Woody Allen for himself as Broadway Danny Rose in the eponymous 1984 film. I’m not sure what Allen meant then as I was a high-school sophomore wearing a mini-mullet. But there’s an application to IR.

Last week I had an intense exchange with an investor-relations officer new to the chair and moved over from the sellside after losing his job in research to advancing asset-allocation investment (This is Blackrock to Betterment, the translation of business strategies into squares on a Rubik’s Cube. These investors buy no research with commissions and listen to no earnings calls but track governance, meaning the biggest investors now are tuned more to rhetorical position than financial condition – I leave risk/reward ramifications to you).

Cognitive dissonance by definition is an inherent contradiction between evidence and conclusion. In Steamboat Springs it’s easy to match evidence to conclusion when watching the weather. If storms approaching from the south cross over Catamount Lake, you’re going to get showers on Mount Werner, the ski hill. Simple. No cognitive dissonance. You can see what’s happening.

But it struck me listening to this new IRO that he’d not drawn a line between his emigration from brokerage to corporate belfry. It reminded me of that lyric by Jacob Dylan, son of Bob and troubadour with the Wallflowers, who refrained plaintively how the same black line that was drawn on you was drawn on me and has drawn me in. Despite the origin of his demise on Wall Street, this IRO was certain active investors were pricing his shares. “Indexers don’t set prices,” he insisted. “They track active money.”

This view defies what we just saw from the NYSE where his shares are listed. When the exchange stopped trading for nearly half the day July 8, it was to make sure the closing cross – the ending auction setting prices for indexes and ETFs – would go off properly. The world’s greatest equity market sacrificed most of the trading day to one chronological exigency. And that’s because the most vital endeavor is tracking benchmarks – pegging the index. Getting the data right.

Follow the drawn line between diminishing sellside influence and the shift of equity research analysts to the IR chair and how the market functions. It’s drawn us all in to a 6th Avenue Heartache in a way, because what moved markets before doesn’t now, and if you suppose so, I refer you back to the definition of cognitive dissonance.

But it’s not sad! It just changes IR Best Practices – things we should all be doing. Our profession’s requisites must include comprehension of how prices are set so that the information you provide to management is accurate. Five rules:

Number One, high-frequency trading is a product of incentives paid by exchanges to fast traders to create valuable pricing data that exchanges can sell back to brokers. This is the No. 1 price-setting force (only half of intermediation is fast trading; the rest is from brokers working orders for customers).

Number Two, the buyside and sellside have spent billions over the past decade to disguise whether they’re buying or selling, so translating “block trades” into “long-only investing” doesn’t follow the money.

Number Three, the greatest force in the equity universe today is not love but asset-allocation. Blackrock and Vanguard. And they do price your shares routinely.

Number Four, more than 50% of your volume is the middle men (fast traders, brokers disguising orders) not actual investment. Factor that into your thinking.

And Number Five, there is little to no “long only” money anymore. Everybody uses a smartphone, and everybody hedges. Derivatives are a colossal factor because they represent risk-transfer and leverage and often (as yesterday in equities) price the underlying asset.

Connect the dots. Follow the money. Think. Okay, so money is no elixir and as Woody Allen said, it may be superior to poverty for financial reasons only (smile). But in the IR chair (and in politics) you should always follow it, because it’s the line of truth.

Defend Yourselves

You need to defend yourselves as public companies.

This clarion lesson comes from last week’s trading halt at the NYSE though we think the exchange handled the outage correctly. Humans want pictures of perfection like Saturday’s Balloon Rodeo in Steamboat Springs. But don’t expect serendipity in securities markets. Your equity is the backbone of your balance sheet, basis for incentives, currency for investments. Know how it trades.

The root of the NYSE’s July 8 200-minute trading penalty box is the Flash Crash, a May 6, 2010 plunge and recovery in equities that spanned about a thousand Dow Jones Industrials points in twenty minutes.  During that maelstrom, trades executed at stale prices because timestamps on orders didn’t keep pace with market activity.

Now five years later, the exchanges are aiming for a July 27 deadline on two updates to timestamps mandated by Finra and the SEC. The new timestamps will calibrate to 100 microseconds are less, with one coming from orders occurring at exchanges, and the other timestamp for ones flowing through broker-operated dark pools relying on proprietary data feeds.  The thinking here is better timestamping will improve market-function and offer better future forensics. For instance, was there separation between exchange and dark-pool prices as occurred in the Flash Crash?

You don’t have to know this in the IR chair. But what if the CEO or CFO asks? It’s the market for your shares. There’s a great deal more to it than your story, a point made stark in a moment.

The NYSE claimed it had been testing timestamps and made a mistake in a deployment. Why test new code when the Chinese market is imploding, Greece is teetering on the Eurobrink and volatility is exploding in US equities – all of it interconnected through indicative value-disseminations for global indexes and ETFs that depend on timestamps?

Be that as it may, the NYSE handled the problem appropriately by stopping trading, cancelling orders and focusing on getting operations fixed in time for the closing auction. That in itself points to the larger lesson, which we’ll articulate in a moment. We heard lots of talking heads say “our fragmented market is a plus in crises because people could continue trading.”

The outage in fact demonstrated the opposite. We measured in NYSE data that day an 18% reduction in Fast Trading generally for NYSE issues, and commensurately higher investment behavior. In other words, with trading halted for half the day, speculators were less able to interfere with real investors’ moves.

By extension, we can infer with data support that much of what occurs intraday is effort by arbitragers to spread prices among securities that must track benchmarks – market indexes – by the time trading concludes.

Guess who supports that effort? The exchanges.  I’m not castigating here. But if you’re depending on information from an exchange (or its partner) to understand your trading, you had better darned well know how the exchange operates.  When the Nasdaq charges traders to buy shares at its primary market and pays them to sell at the BSX platform, it’s helping traders multiply prices and spreads. Do you see? Paying traders to engage in opposite actions incentivizes arbitrage. All exchanges pay traders for activity that’s got nothing to do with investment.

I’ll rephrase:  The exchanges fragment markets purposely in order to sell data and create transactional opportunities. It would be akin to your real estate agent encouraging others to bid against you as you’re trying to buy a house.

The NYSE’s trading halt proved that a fragmented market harms investors and helps arbitragers, because when it was closed for three hours there was less fragmentation and more investment – but lower volume. Volume often confuses busy with productive.

Don’t track volume without also metering what sets your price! Yet that’s not the Big Lesson for public companies.  No, it’s that the single most important pricing event of the day is the closing auction. And the audience depending most on it is the one tracking benchmarks (not taking risks like active stock-pickers).  Blackrock and Vanguard – the Asset Allocators collectively and by extension.

The number one force in your market is tracking broad measures, not weighing your earnings. This money is perpetually owning and yet constantly trading to match index-movement. You must quantify the price-setting actions of this colossal demographic group. If you don’t, the intelligence you’re offering management about what’s driving your price is almost certain to be incorrect.

Defend yourselves with an objective view.  It’s part of the job. Counting on exchanges is yesterday’s way.

Future Former

As Christmas Eve arrives in the US, market-structure circles are abuzz on tidings from Intercontinental Exchange (ICE), parent of the NYSE, about bold market reform. Is it the birth of opportunity or a winter fable?

In case you missed it, word broke last week that ICE has proposed in a letter to the SEC a plan for fundamentally reforming the stock market. The missive wasn’t offered publicly but reporters have described the contents.

The plan aims to slash what are called access fees – charges paid by traders to purchase shares at the NYSE – from the current capped regulatory rate of 30 cents per hundred to five cents if brokers agree to send the bulk of orders to the exchanges.

The proposal would also ban the “maker-taker” model under which traders earn credits to offer shares for sale at the exchange. There are other elements too, including exceptions for block transactions and retail orders and ostensibly greater insight into data feeds.

Public companies have yet again been omitted from the planning. Why is there a pathological proclivity on the part of exchange operators and regulators to leave out the businesses paying hundreds of millions of dollars in listing fees and without whom there would be no stocks, indexes, ETFs, options or futures?

Getting past that annoying fact, there’s a lot to like because we’ve seen it before.  We call the proposal “Back to Buttonwood.” The NYSE is a product of a two-sentence compact in 1792 inked under a New York City buttonwood tree by which brokers agreed to give each other preference and to charge a minimum commission. Brokers figured if they pooled orders they’d have more customers, and to make it work they’d agree not to undercut each other on price. (more…)

Legging It

What are the implications?

Posing that question is a great conversation-starter unless you’ve just asked your teenage son about a substance you’ve found in his room that is not (currently in your state) sanctioned by the government, or if your party is on the long end of an election night.

What if stock orders are implied?  The Fear Gauge, the VIX, a derivatives contract from the Chicago Board Options Exchange, gives traders and risk managers the implications of volatility in the S&P 500.  But that’s not what we mean. Let’s keep going.

The stock market has become so complicated that few can describe how it works now. Many investor-relations professionals and public-company executives say “we just ignore the stock,” implying it’s cooler to act like you’re above it all (even though knowing nothing about any other market you’re responsible for would get you canned).

Chuckles aside, the implication is that it needs simplification. Public glare prompted the NYSE to pronounce earlier this year that it would prune its order types (yet it just launched a new one designed to help high-speed traders sell shares at the NYSE).

Aside: I’m speaking today at the NIRI Kansas City chapter about how the market became something nobody recognizes.

If you buy something at Amazon, the order type is the form you complete with your payment instructions and address that causes what you bought to show up on your doorstep.  This works well. (more…)