July 2, 2014

Setting Prices

Do you remember that movie, The Island?  The people who every day hope they’re selected to go to a tropical paradise are unwitting machinery for others.

I won’t give it away in case you’ve not seen Scarlett Johansson and Ewan McGregor tearing through the sky on some futuristic motorcycle. Things are not what they at first seem. That’s the point.

Which leads us to Nasdaq OMX PSX.  On August 1, the PSX becomes what it calls “a Price Setter Pro Rata algorithm for all symbols, pending SEC approval.” The PSX once was the Pacific Stock Exchange. Now it’s one of the Nasdaq’s three stock markets.

If it’s an exchange, why do they call it an algorithm? Because it’s less a marketplace than a mathematical calculation designed to do something: Set prices. It guarantees traders 40% of an order so long as size meets requisites.

In its marketing materials, the Nasdaq says the PSX is “a Reg NMS protected quote and runs on proven INET technology.” A quote? A price. Under Reg NMS, protected quotes must be automated and cannot be ignored by the market. So the PSX is a price.

INET was a trading system created by the dark-pool Instinet that merged in 2002 with Island, another electronic communications network, or “ECN.” ECNs slaughtered exchanges in the 90s, taking perhaps 65% of all trading at the peak before exchanges bought them and in effect became ECNs. Nasdaq acquired INET in 2005.

Now stay with me here. This story relates directly to you, in the IR chair. There’s a trading firm called Chimera Securities. We see it in about 75% of our Nasdaq client base. It’s a proprietary trader – no customer accounts. It trades equities and options. It provides a platform for hundreds of professional day-traders to execute diverse speculative tactics, and it runs automated strategies to utilize liquidity its traders hold. It’s a member of the Nasdaq OMX PSX, and the Nasdaq OMX PHLX, the latter the Nasdaq’s options platform. Chimera belongs only to these two markets.

So Chimera is using trading schemes to set displayed prices, and it’s likely earning payments from the Nasdaq for furnishing liquidity automatically. Simultaneously, it’s trading options to profit on how its orders price underlying stocks.  That’s arbitrage, which is legal.

The exchange uses Chimera and others like it. If Nasdaq trades set the market price, the data feeds it sells are valuable and the exchange captures revenue from the consolidated tape – the public volume and price data.  Public companies suppose exchanges help them reach investors. It’s the other way around.  Stocks of issuers enable exchanges to set prices, essential to making exchange revenue engines, data and trading services, valuable.

A client with market cap near $50 billion trades over $100 million of stock daily.  For the past 20 days there’s no negative price-setter in its behaviors, and yet price has not moved. How is this possible? One behavior departs and another takes its place. It’s an escalator that reaches a top and repeats. Sisyphus. Arbitrage.

You can target investors till you work fingers to bone, and if market structure driven by money that cares nothing about your story routinely pushes the boulder back down the hill, you’re wasting time, money and effort.

What to do?  Change your measures! Multiples on discounted cash-flows matter to one small market constituency. It’s not reality today. Goals should be realistic. I won’t ever ride in the Tour de France, for example. Once you understand what is realistically possible in a marketplace riven with statistical arbitrage, measure your performance against that goal. That’ll bring simplicity to your IR program. I’m talking about using market structure to help you measure what you can and cannot control.

Your proverbial tropical IR island may lie somewhere. First, understand how your shares are machinery for other purposes. That part is inescapable. And peace of mind and confidence about what’s possible are well within reach.

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