March 27, 2013

Hired ETF Guns

I dare you.

Ever say that as a kid? “I’ll give you a dollar if you—” (fill in the blank)

Last week the SEC approved a plan by the NASDAQ for sponsors of ETFs trading less than a million shares daily – 93% of ETFs – to pay $50,000-$100,000 annually to market participants if they dare to trade any of these ETFs more aggressively.

We opposed this plan because it allocates dues and fees specifically, not equitably as the Exchange Act requires, and it promotes statistical arbitrage – trading securities for spreads. That’s harmful to buy-and-hold investors and the issuers who seek them out.

The NASDAQ argued – successfully – that stimulating trading in weak ETFs unattractive to automated market-makers will shrink spreads, boost volumes and benefit investors.

Yesterday at TABB Forum, a news site for the trading community hosted by influential consultancy the TABB Group, Stephen Bain from RBC Capital Markets wrote a piece called “The Hidden Cost of Tighter Spreads.” RBC studied trading before and after spreads between the best prices to buy or sell tightened through decimalization and automated market-making.

Bain wrote: “Our initial analysis documents a marked increase in short-term price gyrations for individual stocks, which have effectively doubled from pre-2000 levels to present. This finding represents a significant increased cost for investors – entirely contrary to claims that lower execution costs now prevail.”

We arrived at similar conclusions. The average US stock has Total Intramonth Volatility (TIV) of roughly 40%, calculated by subtracting the low price from the high price each day, dividing by closing price, then tallying those over 20 trading days.

Adding back distortion caused by continuous small price-changes suggests that stocks with 40% TIV could be sacrificing 21% of market-capitalization – a cost paid by investors and public companies (in higher equity costs of capital) to intermediaries with no economic incentive save to change the price.

Now the SEC has approved economic incentives for doing nothing more than changing the price of some 1,340 low-volume ETFs in order to tighten spreads – which RBC has shown costs investors more money.

That’s not the worst part. ETFs are not units of ownership. ETFs are derivatives of derivatives. Every ETF tracks an index, which in turn is a collective measure of performance across a set of underlying equities.

If BlackRock launches the SuperIRO 2X Leveraged ETF, it can make Morgan Stanley an Authorized Participant to manufacture or destroy ETF units to flex with demand. Then BlackRock promotes the ETF through, say, sales agreements with E*TRADE or Fidelity.

If Fidelity and E*TRADE find demand, Morgan Stanley uses its custodial power – lots of accounts holding shares of many stocks – to create ETF units by assembling shares of this and that according to the SEC-approved prospectus for the SuperIRO 2X Leveraged ETF (and it’s paid to do so). If demand drops, Morgan Stanley “destroys” ETF units and returns the shares of this and that to the proper accounts.

Do you see the moral hazard the SEC endorsed? Rather than promoting the product, BlackRock can now pay Morgan Stanley to stimulate trading – cheaper but not as informative for investors. And it’s shadow demand – in fact, ETFs can substitute cash and derivatives for shares of components. That’s inflation, not additional real liquidity.

The reason only 7% of ETFs trade well is because there’s one ETF for every three public companies. Over-supply. Creating artificial demand isn’t a remedy. It’s a distortion.

Plus, BlackRock and Morgan Stanley can exploit demand for components comprising the SuperIRO 2x Leveraged ETF. This daring-do is good for whom? Investors? ETFs are derivatives. ETFs do not create investment capital. It seems apparent that the parties benefiting here are ETF sponsors and authorized participants. And the SEC. The agency depends for funding on Section 31 fees predicated on market dollar-volume, which keeps declining but may rise with these incentives.

Alas, the incentive model is en vogue. That’s the “maker-taker” model. Even the Federal Reserve uses it, manufacturing cash to buy Treasuries from too-big-to-fail banks that submit bids to buy US debt. The same too-big-to-fail banks are six of the top ten liquidity providers in US equity trading driving some 65% of volume, our data indicate.

These things make us scratch our heads. Why would anyone want a market that can’t stand on its own? You don’t know when that kind of market will fall apart.

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