January 19, 2010

Risk and Naked Access

Hope you enjoyed MLK Weekend! We were on bikes for the first time in Twenty Ten as temperatures tickled the high 50s Saturday and Sunday on Colorado’s Front Range.

TRAVEL UPDATE: I’m in Kansas City today joining Joe Ratterman, CEO of BATS, and Jeff Albright, head of equity trading at Waddell & Reed, for a NIRI panel on how stocks trade. Thursday Jan 21, I’ll be at the NYC NIRI meeting with Professor Bob Schwartz of Baruch College, Jim Ross from NYSE Euronext, and Donald Bollerman of Nasdaq OMX to “demystify the markets.” See Events & Articles at modernir.com for more, and join us.

Last Friday, money moved from equities to derivatives as options expired. News perhaps influenced the shift, but on the whole, trading was a sum of reactions. These shifting sands haven’t changed much since June last year. Despite the reasons why not, we hoped for more rational enthusiasm in the New Year. Instead it’s more of the same. Money isn’t acting, it’s reacting. Market behavior is determined by other market behavior. There’s no goal to outcomes, except to adapt.

That part isn’t surprising. Capitalism is the profitable adaptation to change. Now, around the globe, the mortgage markets, the banking industry, a large portion of the automotive business, the insurance markets in substantial part, a growing portion of the health care sector, the breadth and scope of risk management, and the chief medium of exchange, the dollar, are defined by something other than profitable adaptation. What’s left is tick-by-tick trading. No wonder that’s what we’ve got.

Speaking of trading, Mary Shapiro said last week that the SEC may soon prohibit “naked access,” a somewhat voyeuristic term for renting out your courtside box seat at the equity market. It’s better termed sponsored access, because you’re using somebody else’s seat.

Shares today move at bionic speed. That renders ponderous trading moot at most times. It consigns small floor brokers and old-fashioned one-customer-at-a-time orders to the backwaters and eddies. So imagine you were on Main Street and all the big-box retailers in the suburbs emptied the town of customers. Then somebody came and said, “I’m going to run eighteen-wheelers down Main Street. I just need your store as a loading dock.” That’s sponsored access.

Sure, some sneaky forces use it. But the SEC is yet again regulating to capillaries to the harm of arteries. An example: KeyBanc Capital Markets, a full-service broker-dealer and money manager offering research and underwriting but no algorithmic trading, in October began using SunGard Assent for sponsored access, algorithmic trading and access to dark pools. Keybanc can’t compete on the trading floor. Assent gives them the access, speed, risk-management and trade-optimization tools they lack.

Assent itself is a product of market evolution. Assent was formerly Andover Brokerage, a provider of trading systems under the HammerTrade brand. We used to consider their volume proprietary day trading.

The SEC and others, including Goldman Sachs, think sponsored access might increase risks. If we have lots of it and the markets have behaved well, where’s the evidence? We have seen data that suggest to the contrary how sponsored access may have crucially forestalled a global equity retreat October 1-2 of last year. Risk-management, we observe, is often a primary purpose for sponsored access – not its biggest shortcoming. Sponsored access provides a means to move large liquidity fast and within market rules. This is essential to offsetting slippage in other asset classes when you’re managing risk.

Perhaps an exception will be granted for the Keybanc form of sponsored access. Yet, that’s the root problem at all levels – at least in the USA. We are about uniformity. That’s what “created equal” means. Our form of government is supposed to reflect uniform justice. Instead, it’s a gigantic collection of exceptions.

I’m moved to reference Section 15A-6 of the SEC Act. It’s for broker associations like FINRA, but the principle applies:

“The rules…are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information…to REMOVE IMPEDIMENTS TO AND PERFECT THE MECHANISM OF A FREE AND OPEN MARKET…to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers…or to regulate by virtue of any authority conferred by this title matters not related to the purposes of this title…”

Perhaps the SEC should return to basics. The best way is not to do, but to undo.  IR professionals and the business of forming capital and fostering creative, productive enterprises would benefit. Investors would again find equity markets a place to leave money for the long term with an expectation of a return.

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