May 6, 2015

25 Basis Points

Whether public companies are winning in the stock market comes down to basis points.

The Buttonwood Agreement formulating the US public equity market in 1792 affirmed in two terse sentences that its parties would charge a quarter-point commission.

Last weekend Jason Zweig wrote about “May Day” for the Wall Street Journal. On May 1, 1975, under pressure from the SEC and Justice Department antitrust lawyers, and seeing a path to reducing market-fragmentation and competition from low-cost platforms like Instinet, the NYSE ended fixed commissions. Many brokers saw doomsday looming and called it “Mayday.”

As Mr. Zweig says, assertions of industry demise proved both exaggerated and misplaced. Volumes boomed, advertising about stock-trading exploded, Charles Schwab created the greatest Everyman brokerage in the history of the profession and here in 2015 the notion that set costs for trading was ever a good one are scorned.

It was called “deregulation” since the rule inked by quill pen May 17, 1792 stating “We the Subscribers, Brokers for the Purchase and Sale of the Public Stock, do hereby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever, any kind of Public Stock, at a less rate than one quarter percent Commission on the Specie value of and that we will give preference to each other in our Negotiations” was rescinded.

Under deregulation has come tens of thousands of pages of rules ranging from exchange order-types that hide shares even though exchanges are markets where shares are displayed, to the structural opus magnum Regulation National Market System decreeing trading at the best national price and dividing consequent data revenue.

When you dine out, what’s a fair tip?  If somebody handles bags for you at the hotel, what do you give them?  In 1792, brokers thought 25 basis points an acceptable fee for finding a buyer for a seller, and vice versa.

In January last year we described how T Rowe Price tracked its big brokers’ trades and discovered that to buy 2.5 million shares they placed orders for 750 million, a success rate of about 30 basis points.

The NYSE fee schedule says it costs 27 basis points ($0.27) to buy 100 shares. What’s more the NYSE will pay 22 basis points, or 22 cents, to those selling shares. An online broker could bill $8 per trade and earn $2.20 more selling it to the exchange.

The Nasdaq charges the full regulatory cap of $0.30 per 100 hundred shares (30 basis points) and actually pays more for shares than it charges ($0.31/100) to brokers in the top “liquidity tier,” meaning those supplying big volumes to them.

It gets much more complicated. But I can boil it down for you, public companies.  When you look at your trading volume, over half of it is generated by intermediaries. Imagine if half the cost of everything you bought or sold was the tip, the commission.

Good middle men are unobtrusive.  Karen and I had the best meal of our lives at a Michelin-starred restaurant in Paris and the waiters were like perfect, skilled ghosts, feathering silently around conversation to make and take table service.

Back to stocks, you say, “This is volume, not money.” If your shares trade at $50 apiece, two million shares daily, your dollar-flow is $100 million. When brokers rather than real buyers and sellers are responsible for half of it, the market for your shares is far smaller than you think.

The point of “deregulation” was eliminating that fixed, 25-basis-point excise. It appears everybody is still charging it but in complex fashion. Plus, now brokers are half the market’s volume. They’re setting the prices. Imagine your waiters sat down and ate half your meal but said you owed them no tip. A good deal?

In the past the middle men charging a quarter-point to buyers and sellers were the marketing machine for capital-formation. When Mayday happened, 100 investment banks went broke, half what everybody thought.  We don’t have a single investment bank today (even Goldman Sachs is a Fed-regulated commercial bank), and just 30 brokers intermediate 90% of volume and the sellside keeps shrinking. Why write research if nobody expects an exchange of value for commissions?

In 2000, there were nearly 8,000 public companies. Today, about 3,750 populate the US National Market System, even if the SEC itself tries to claim 6,000 (that’s counting exchange-traded products). The largest capital-flow line item the past ten years is corporate buybacks at $7 trillion, more than incoming investment dollars.

Is this good?  By my way of thinking we’re better off with a one-sentence rule, 25 basis points, a market without intermediary inflation that’s attractive to investment capital, more public companies, more IR jobs.  Or is it just me?

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