June 21, 2011

Best Execution Makes Your Stock Trade Like the Rest

We’re back from NIRI National!

Orlando sweltered like you’d expect a swamp in central Florida in June might. We heard 1,300 were on hand, up triple digits from last year. There were new faces in the crowd and new vendor names, though big ones were absent too because exhibit costs go up while things like annual reports and total public companies decline.

We were tethered to the booth mostly but I sat in on the session about how equity markets work. Rich Barry from the NYSE, John Adam of Liquidnet, and Brian King at BATS paneled, and well. Our client Moriah Shilton at Tessera moderated like a pro.

The room was packed to standing-room-only. In the two years since I sat in Moriah’s seat on the stage, how markets work and what to do about them continues to populate the thoughts of IR folks, clearly. They streamed to the mics throughout with queries.

Karen and I nudged each other and shook our heads at this one: “How can we understand where our shares trade and for what reason?”

Answers were given but ones that rambled and muddled because, in the main, there are no good answers besides ours – behavioral ones (and our effort to get better data on where trades occur and by which firms). I’m not demeaning the superlative work of the panelists either, who are bright and terrific fellows with vast knowledge.

It’s just a fact that if you don’t look at the market behaviorally – like we do – you won’t know what’s going on. We’re about the central question of the panel: Where your shares trade and for what reason.

One giant reason things are nuts out there is rules. Ever heard of the rule of Best Execution? When the SEC adopted it on January 30, 2001, it was called Rule 11ac1-5; now it’s called Rule 605. It created standards and measures of how brokers execute trades so customers could compare results and see if they were getting proper execution quality.

Of course, these are your traded shares we’re talking about. The SEC was concerned in 2001, when the Nasdaq had about 75% of its market and the NYSE over 83% in NYSE securities, that market fragmentation was depriving folks buying and selling shares of the best deal. It was because market makers were handling lots of volume, and the average public company had 13 market makers.

Stop for a moment. I just tallied the brokers, platforms, and exchanges for a mid-cap stock ($14 billion) with daily volume of 4 million shares. There were 70 different firms printing trades on June 17 at the Nasdaq. But 70% of the volume occurred at exchanges and market centers that don’t disclose the executing brokers. Doing the math, we might estimate that 230 participants were behind trades.

Realize that we’ve gone from 13 to 230 because regulators thought markets were too fragmented. Also, that it was their responsibility to do what buyers and sellers should: determine if they’re getting a good deal, just as you do every day when you buy gas, food, or toiletries (answer: you are getting hosed because the Fed keeps debasing that dollar in your pocket, so it buys less).

Rule 605 requires brokers to stay within standard deviation on trade executions – size, speed, fill rate, proximity to the best bid or offer, and other defined characteristics. These reports must be published monthly. Brokers may be fined for aberrance.

I like analogies. How did executive compensation spiral up to the heavens? Uniform behavior. Everyone complains about CEO pay, but no board wants to be out of step with the market, so pay goes up and up as do the statistics used by those who craft the pay. By contrast, Les Schwab, founder of the eponymous tire stores, earned pay of $32,000 in 2000 at a firm with $1 billion in sales then. Some store managers participating in the firm’s profit-sharing made over $200,000. It’s a private company.

The point is, the more uniform the rules, the more uniform and disconnected from reality becomes the behavior. If all trading activity must behave the same way, what happens to it? It becomes the same. We see it.

Liquidnet, the dark pool (and great friend to IR and the rational buyside) estimates in a June 14, 2011 release with trading statistics that “natural” liquidity in the markets is about 1.9 billion shares. It’s including statistics for microcaps, so if we use microcap volumes and national market volumes of about 15 billion daily shares combined, rational investment is less than 13% of the US market – about where we see it.

A big reason why is that rational money doesn’t want to follow the crowd in most cases. But try to execute trades outside the crowd, and it’s darned difficult and may even earn a fine. Liquidnet has a fraction of the market – about 1%. But a huge part of the block market – sometimes 60-70%.

See the problem? Rules force behaviors into sameness, which diminishes the participation of the money you spend all your time trying to reach.

This problem is reversible. If hundreds of CEOs or CFOs wrote letters to the SEC, say on its still pending dark-pool proposal, that read: “The markets need fewer rules and more freedom so individual thought can distinguish one stock from another,” maybe things would change.

If you’re interested in doing so, drop me a note.

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