First Things First

If you’re in a tree sawing off a branch, note which side of it you’re standing on.

The guy studying the branch was Brad Katsuyama, CEO at dark pool IEX, which has designs on exchange-hood. He was speaking along with others before that folksy and fashionable Washington DC club, the Senate Permanent Subcommittee on Investigations (you get a titular sense our republic is engaged in perpetual sleuthing – and how do you conclude a hunt when its sponsor is permanent?).

Katsuyama, who called markets “rigged” in Michael Lewis’s Flash Boys, said yesterday, “IEX was created within the current regulatory framework.”

Translation: “We invested big bucks finding a solution that helps investors and complies with rules and we won’t cut off our noses to spite high-speed faces.”

Wait a minute. Doesn’t IEX hate the current framework? For those who’ve not read Flash Boys yet, I won’t spoil it. Ronan Ryan, who earns his own “problem” chapter, entertained a big NIRI National breakout session last week. Karen (beloved spouse and ModernIR COO) thought it was the best one ever at NIRI. Even with the f-bombs.

I’m not knocking IEX! Love ‘em. But a point has been missed. In order to facilitate what should naturally occur – buyers finding sellers – IEX had to perform unnatural acts. Let me rephrase. There are rules governing stock orders. To comply, IEX created the Magic Shoe Box, a 38-mile fiberoptic hampster wheel to neutralize fast-trading’s version of location, location, location.

Why is some crazy Rube Goldberg contraption necessary to structure a market so it appeals to real investors? Today’s equity market defies Occam’s Razor, which at risk of offending you experts on philosophy I’ll dumb down to “simplest is best.” For proof, the outfit heralded with restoring fairness must perform technological gymnastics to achieve it.

Having committed effort to solving a problem that only exists through synthetic warping-by-market-rule, IEX now is in a quandary. It can’t call for an end to something for which it just found a solution.

We here at ModernIR have long decried how arbitrage prices stocks. The role of the consolidated tape in prices, how data revenues are shared among market centers, and what makes data and circuits at exchanges valuable cements that reality. This foundation now underpins the US stock market with its ETFs, its 44% short volume daily, and its tens of trillions of dollars annually.

It may be an SOB. But to paraphrase political leaders of past generations describing distasteful foreign dictators who were allies: it’s our SOB.

The Senate hearing spotlighted “maker-taker,” about which we’ve written much and often. It describes incentives paid to traders to bring their orders to markets. The NYSE is on the record calling for its end.

We remain uncertain if the new owners of the NYSE understand how the market works. Remove incentives at the NYSE, and why would anyone do business there? It’s a marketplace lacking any native orders. It imports 100% of its goods, with rebates.

“Quast has gone round the bend,” you say. “He’s for HFT.”

Not at all! But first things first. Before we outlaw maker-taker (happy to explain what this means – just send me a note), we had better disconnect markets from each other, and remove the requirement that trades match between the best bid and offer. If we don’t, we will have a stunning disaster. Public companies should care about that.

And if the SEC is unprepared to loosen its grip so the market may function as a free one should, where buyers and sellers match at prices within the natural limits of supply and demand, then we best get used to the SOB we’ve got.

Either way, IROs, do you measure markets the way they work now? Monitor behavioral market-shares, short-volume and dynamic fair value. If you’re tracking ownership and moving averages, you’re missing most of what’s actually occurring.