March 28, 2012

Did You Carry the One?

Suppose the chairperson of the national central bank strode from the organization’s Gothic façade on Maiden Lane and said, “Job growth is likely temporary, and folks are going to have to borrow money and buy stuff just to keep the economy running like a used Yugo.”

How would you expect stocks to react? Exactly. They would soar, as they did Monday March 26.

Speaking of bizarro-world, if you missed the BATS Exchange IPO drama Friday, you must have been on a monastic sojourn in the hinterlands. It showed several things. You can run a great business. You can raise money from investors. You can be quality folks who are nice to boot, as our friends at BATS are.

But if somebody forgets to carry the one in that mathematical equation for the opening auction, the incredible shrinkage occurring in the dollar can immediately translate to your shares, speeded up to nanoseconds.

Humor aside, we were asked by various members of the media (and quoted by the WSJ Saturday for the lead article on page one) and many clients about BATS. Should you worry about trading markets because the IPO for a technology-driven stock exchange failed?

Not for that reason. BATS will be fine. They will be back, and soon. Mark it.

But something should concern you. We’ll come to it in a moment.

First, here’s what happened at BATS. Exchanges want to host listings for the profitable auction business at the start and close of trading days. Auctions among other things facilitate rebalances for the massively clogged trend-trading, asset-allocation, ETF and index-mutual-fund complexes, which have exploding in scope but must feed off the same number of nationally traded public companies as existed in 1980.

The bulk of trading profit for exchanges resides in auctions. They charge the same fee for making or taking shares during auctions, instead of rebating half their revenues to attract trades (in order to capture revenue off the consolidated tape) as they do the rest of the day. Plus, they earn about $0.10/100 shares for orders routing out to other markets after a partial fill in the auction.

At BATS, the auction hiccupped. All those “intermarket sweep orders” lined up to get a volume-weighted price in BATS shares and then rush off to another market center to profit on spreads or fill more orders got only 100 shares and then electronically stampeded off the cliff at the Nasdaq where nobody was waiting to take the other side of trades.

Which brings us to what should bother you.

Markets run on math. Calculations can only identify conditions for which they have been programmed. Human beings cannot under existing rules intervene with force and authority to demonstrate the difference between value and growth. Market rules emphatically ordain that the only quotes to be recognized by machines are other automated, machine quotes.

Regulators have decided that their fellow, equal, human beings are incapable of handling bad things and making decisions for themselves, so all markets are connected by law. Thus, any un-carried one in an algorithm over here will infect markets over there, for our own safety. So we have what in the Cold War was called Mutually Assured Destruction, which was also for our safety.

Circuit breakers and connected markets designed to protect humans from their own nature will be their undoing at some unforgettable point. Maybe a Friday.

Or public companies could speak up and insist that markets be disconnected from each other to diffuse risk and that the National Best Bid or Offer be scrapped because everybody ignores it anyway. Those two steps would tamp down the nuclear threat in our markets.

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