March 25, 2015

Compensation Model

What do you get paid to do?

That’s the question the SEC may soon pose to high-frequency traders, according to a story from Bloomberg yesterday.

“The maker-taker compensation model is very much in the core of what our market structure review folks are looking at,” said SEC Chair Mary Jo White.

If you’re the CFO or investor-relations officer for a public company, you should want an answer too. Because there’s belief silence from public companies about market structure indicates agreement.

Suppose I said, “In one minute, describe your business, its key drivers and how you differentiate yourself for investors.”  I bet most of you could.

What if I asked, “How do your shares trade and where, who trades them, and how are they priced?”

“I don’t even know what ‘maker-taker’ means,” you might mumble.

It’s convention in IR to ignore the stock but that ethos has led a generation of investor-relations professionals to think they don’t need to know how the stock market functions.

“I don’t want my executives watching the stock,” you say.  “If we run a good business, the rest will take care of itself.”

The largest institutional investors in the US equity market, Blackrock and Vanguard, are asset allocators. They’re not Benjamin Graham, the intelligent investor. They track benchmarks because that’s what they’re paid to do.

Active investors are paid to find good businesses, deals, and yet nearly 90% don’t outperform indexes. Stock-pickers are not less intelligent than mathematical models. But they seek outliers in a market that rewards conformity.

Follow me, here. The biggest investors use models, sending trades through the biggest brokers, which are required to meet “best-execution standards,” a wonky way to say “give investors good results,” which is determined by performance-averages across the market – which are being driven by the biggest investors and their brokers.

Thus Blackrock and Vanguard and their brokers perpetuate standards of conformity created by regulators.  Company story becomes secondary to indexes and Exchange-Traded Funds,  investment vehicles dependent on conformity.

Which brings us back to the compensation model. Exchanges under the rule-structure get to set market prices. But they don’t have any of your shares. Ever thought of that?  Investors hold your shares in brokerage accounts primarily, but the exchanges created by brokers are now owned by shareholders. Not brokers. So if exchanges are supposed to set the price in products they don’t have…how can they do it?

Enter the maker-taker compensation model. Exchanges pay brokers to buy or sell your shares in order to set a “displayed” price for them. Generally if traders “make” shares, or sell them on an exchange, they’re paid for it, and if they “take” shares, or buy them, they’re charged (there are exceptions).

Your listing exchange is paying somebody to set the price in your shares, so it can earn revenues from selling this price-setting data back to the biggest brokers, which are required to meet “best execution” standards – which can only be determined from the price-setting data captured by the exchanges. And Blackrock and Vanguard peg that benchmark.

Do you see?  This is what Michael Lewis a year ago in Flash Boys was decrying.  You think rational money is pricing your shares. The SEC, which created this structure, wants to scrutinize who’s setting prices. That should give us all pause. Regulators either don’t comprehend what they’ve done, or worse, they do.

Why care? Because our profession cannot quantify what it’s paying for, and knowing is the premise of commerce.

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