February 22, 2011

Flash Crash Panel Proposes More Market Constraints

Among the eight panelists pondering how to forestall another Flash Crash, my favorite quote comes from Columbia professor and Nobel winner in Economic Sciences Joseph Stiglitz, who said in a 2008 paper: “Dollars are a depreciating asset.”

Potent statement. I invite you to consider its ramifications some other time, however. Let’s discuss what the Flash Crash Panel’s recommendations mean to the IR chair. They will affect how your stock trades.

We read all fourteen ideas. They range from charging traders for excessively posting orders and cancelling them, to setting limits on the permitted up/down movement of stocks and imposing circuit breakers for all securities save the most thinly traded. The panel clearly aimed at addressing investor uncertainty through controlling outcomes. If stocks are constrained to ranges, and algorithms to supervision, incentives are adjusted to encourage this, and fees imposed to stop that, the net result will be less uncertainty, the panelists hope.

The net result will be a market suited only to passive index money. If that’s what you want then you’ll be happy. If you want vital markets, where investors can differentiate your shares from other stocks, then a market built around rigid conformity is not for you.

Some news reports called the panel’s recommendations bold, singling out proposals to charge high-frequency traders for excessive churn. Fine, but beware the cognitive dissonance. I don’t think enough IR professionals understand how stocks trade today. Orders run on machines that constantly track costs and risks. Most orders match up through intermediaries incentivized to show up (not actual buyers and sellers).

The SEC approved the rule-filings from the exchanges that created this “maker/taker” market and its fee structure on which HFT feeds. Essentially, the panel is proposing that they now be charged for furnishing too much liquidity. The unintended consequence of this action might be likened to airports built before security lines that suddenly have inserted into their concourses an inflexible security process.

Further, the Flash Crash Panel in making these recommendations does not really know what caused the Flash Crash. How well do corrective measures predicated on presumption usually work? Of the eight panelists, seven are academics or regulators.

The other is the erstwhile CEO of Vanguard, which favors high-frequency trading. The market’s high-speed low-spread structure is a boon to passive money that turns on constant tweaks and shuffles. It lowers commissions and creates incremental profit opportunity from discretionary liquidity, which can be run on machines to generate trading rebates. But index funds do not form capital. They index it.

How about regulators? What are they paid to do? What do you think they will recommend?

As to the professors on this panel, they are incredibly bright folks. But academics are not investors or public companies, the parties that our markets were meant to match. When I was a kid on the cattle ranch of my youth, we regularly trucked steers and culled cows to the sale yards in Weiser, Idaho. Had our beef auction market been run by regulators and academics, we would not have used it. We’d have sold cattle straight to buyers.

That’s what’s happened in equity markets, where natural liquidity is sold broker-to-broker or in dark pools. And the panel has a number of recommendations for further limiting natural liquidity from meeting up unopposed, forcing it back to the trading conformity of our artificial structure.

So the Flash Crash Panel’s recommendations will be great so long as you want most of your holders to be passive indexes and speculative arbitragers. Neither of these listens much to corporate messages. What participants thrive in a controlled, mathematical, parameter-driven environment largely devoid of human thought and intervention? Machines. What will we have more of now? Machine orders.

Lesson: Public companies ought to weigh in. I hate to be blunt, but without public companies’ voices in the decision-making process, those formulating responses to market risks are doing everything wrong.

The solution to our market woes really begins with the first statement: dollars are a depreciating asset. Then, structure must encourage vibrant nonconformity. Risk diminishes through decentralization, not concentration.

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