February 16, 2022

Extended Chaos

See this photo?  Winter Carnival in Steamboat Springs. The Old West. Sort of. People ride shovels on snow down main street behind horses.

Courtesy Karen Quast. 2022 Steamboat Winter Carnival.

Now. What the hell is happening in extended-hours trading? Could be a shovel ride.

You might’ve forgotten with the pace of news and markets, but during Q4 2021 earnings, SNAP lost 24% of its value by market-close, then soared 62% in the hour and a half after.

Facebook – Meta Platforms (strange to brand as something nonexistent) – lost $235 billion of market cap after the market closed.

Amazon was down 8% at the close, then rose 18% afterward.  Market cap, $1.5T.

What’s going on?

Let me tell you a story. Settle in.

Once there was a buttonwood tree in New York City and stockbrokers would gather to trade there. In 1792 the brokers formed the NYSE.  To trade securities listed at the NYSE, you had to be a member.

Time passed. It worked. In 1929, the stock market blew up.

The government flexed. The Constitution authorizes no intervention in securities markets, but people were economically panicked.  Congress passed the Securities Acts of 1933 and 1934, taking control. Stuff got complicated.

In 1975, with inflation soaring and a war in Asia ending badly (déjà vu), Congress decided the stock market was a vital national interest and should be a System.

They passed the National Market System amendments to the Securities Acts after finding that new data technology could mean more efficient and effective market operations.

So Congress, pursuing the nebulous “public interest,” decided it must decree fair competition among brokers, exchanges, and other markets.

And they said opportunity should exist for trades to execute without the middleman, the broker-dealer or exchange – rejecting the buttonwood model.

With me still? 

I’m explaining how we ended up with extended-hours trading, and why it bucks like a bronc. We’re not there yet. 

In 1971, the National Association of Securities Dealers launched an automated quotation system. That became the Nasdaq.

In the 1990s, computerized trading systems outside the stock markets – as Congress envisaged – sprang up. No broker-dealers. No middlemen (save the software).

They demolished stock markets, taking more than half of all trading.

They were firms like Island, Brut, Archipelago, Instinet (the oldest, from 1969). They weren’t stock exchanges, weren’t brokers.  They were software companies matching buyers and sellers.

Ingenious, frankly. The exchanges cried foul.

The SEC intervened with a set of rules forcing these so-called Electronic Communications Networks (ECNs) to become broker-dealers.

And extended-hours trading began.

Why?

Because exchanges had to display ECN prices, and ECNs had to become brokers. So exchanges would win the price business, and ECNs would win the size business.

By the way, the exchanges bought the ECNs and incorporated the technology. The Nasdaq runs on vestiges of Brut and Island, the NYSE on Arca – Archipelago.  Instinet is owned by Nomura.

In 2005, the SEC fulfilled the vision of Congress from 1975, imposing Regulation National Market System – Reg NMS. That’s the rule running the stock market today, with its 17 exchanges and about 34 “dark pools,” which are ATS’s.  Latter-day ECNs.

Reg NMS links all markets, removes the differences in listing one place versus another, shares all prices and all data, and mandates trading at the best systemwide price.

But rules preceding Reg NMS for ATS’s didn’t proscribe extended-hours trading.

The irony? Congress wanted to cut out the middleman, the broker and exchange, and instead ALL trading is intermediated. It might be the craziest thing in human history outside emergency powers.

Plus, the rise of Passive Investment means vast sums need reference prices – a set price each day – to comply with the Investment Company Act of 1940 (another rule).  So exchanges persist with a 4p ET close.

But Exchange Traded Funds (ETFs) match off-market in blocks – and the parties running those trades are the same operating dark pools (ATS’s), behind most derivatives.

And there you have it.  Exchanges create prices for “40 Act” funds at 4p ET. And broker-dealers trade stuff other times, getting ever bigger.  Gyrating prices when the Stock Market is closed.

It’s now at times the tail wagging the dog.  It’s incongruous if the aim of the legislation behind Reg NMS is a free, fair, regulated, orderly, connected market.

That’s your answer.

Stocks gallop after the market closes because rules have fostered an arbitrage trade between market hours, and after-hours. The reason for extended-hours chaos is rules bifurcating the stock market into prices for thee but not for me.

The fix? I think it’s wrong for a “market system” to own the price of anything.  Stores for stocks should be no different than grocery stores – stocking what they wish and offering prices and supply.

How do we change it? Fix government powers. The SEC owns the market. Not us.

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