Tagged: Reg NMS

Caveat Short Emptor

What’s 218 pages and heavily footnoted? 

No, not an Act of Congress. Federal laws are ten times longer or treated as unserious.

It’s the new SEC proposed short-sale rule.

Illustration 129811007 © | Dreamstime.com

I admit, I was excited. As the sort who read Tolstoy’s War and Peace in high school and in college relished French symbolism and theological exegesis – finding meaning in dense and inscrutable texts – what could be more compelling than an SEC rule proposal?

Well. Hm.

Under the Gensler regime, the SEC has engaged in hyperventilating levels of rulemaking while suppressing discourse. Between Feb 9-Mar 21, 2022, the SEC issued six MAJOR rule proposals.

How the hell can we read them – even me – let alone respond substantively?

Politburos do that.

We want fair markets. I support short-sale disclosure. 

But not at the expense of discussion or at the cost of permitting the SEC to regulate matters over which it has no authority.

Contrary to popular belief at the SEC, it’s not omniscient in our financial pursuits. It exists to reduce the risk of fraud in public equity and fixed-income markets.

It could be argued the Constitution enumerates no such federal authority at all. Whatever the case, if a power enlarges like a prostate, it’s probably cancerous.

Cough, cough.

Back to the short-sale rule. Dodd-Frank legislation after the Financial Crisis – crises always diminish liberty (and seem to thus compound) – directed the SEC to implement short-sale reporting, so investors and public companies would know who’s doing it.

The Fact Sheet for Rule 13f(2), as it’s called, says the principal purpose is to “aid the Commission in reconstructing significant market events and identifying potentially abusive trading practices, including short squeezes.”

Are short squeezes abusive?  I thought the purpose of the Exchange Act that created the SEC was to promote transparent and equitable markets.  Did you know that the compulsory disclosures public companies are making today under forms 10Q and 10K date to 1933 and 1934? You think the market functions anything like it did then?

If you do, you haven’t read Regulation National Market System. I have. I read the Federalist Papers for fun, to hear the mellifluous wonder of the English language.

For those struggling with math, it was 88 years ago. Not the Federalist Papers, the Exchange Act of 1934. Automobiles and electricity weren’t ubiquitous on the fruited plain yet then, let alone cell phones, algorithms, and electronic markets.

Now the SEC is regulating to give itself information, not to give the public information.

Again, I’m for transparency. The proposal says: 

Form SHO would require that institutional money managers file on the Commission’s EDGAR system, on a monthly basis, certain short sale related data, some of which would be aggregated and made public. Certain data, including the identities of such managers and individual short positions, would remain confidential.

Wait, what?

The SEC would get a bunch of data, and the rest of us would see anonymous aggregated meaningless stuff. 

Got that?

Yes, the rule proposes that investment managers report short positions greater than $10 million, or average shorting of 2.5% of outstanding shares monthly.  BUT, not by fund.

It’s anonymous data.

So really, PUBLIC COMPANIES get penalized. Everybody would know which stocks are getting the hell pummeled out of them – but not by who.

What does that promote? Mob behavior.

You have to read what the SEC says. For that matter, you should read what the exchanges say when they file to implement regulations.  It may not be what you think.

And while the SEC will collect more data, the biggest source of shorting in the stock market, the market-making exemption from Reg SHO Rule 203(b)(2), is undaunted.

Yes, brokers will have to report “buy to cover” orders or class them as exempt under the provision above.  What would you do as a broker? Report them or class them exempt?

Let me explain. Brokers will continue to be permitted to short stock without locating it, because the SEC thinks the principal purpose of the stock market is to form PRICES, not CAPITAL.

But they will promote an artifice called “short-sale reporting.”

I’m offended by that. The SEC should be mandating 13F reporting monthly for long and short positions. That the Commission instead wants short positions without names each month and long positions by name 45 days after the end of the quarter is sententious.

Quast, what does that mean? Pompous moralizing.

We don’t have legislative authority to mandate monthly long-reporting, the SEC will say. Hypocrites. The SEC just issued climate-disclosure rules with no legislative authority.

The SEC has forgotten its purpose: Free, fair and transparent markets.

Instead, it’s after power, political agendas. Not truth. By the way, see comments here (and I LOVE Patrick Hammond’s). Let’s add to them.

We should reject that impulse, even if it means waiting longer for a rethinking of 88-year-old disclosure standards.

Extended Chaos

See this photo?  Winter Carnival in Steamboat Springs. The Old West. Sort of. People ride shovels on snow down main street behind horses.

Courtesy Karen Quast. 2022 Steamboat Winter Carnival.

Now. What the hell is happening in extended-hours trading? Could be a shovel ride.

You might’ve forgotten with the pace of news and markets, but during Q4 2021 earnings, SNAP lost 24% of its value by market-close, then soared 62% in the hour and a half after.

Facebook – Meta Platforms (strange to brand as something nonexistent) – lost $235 billion of market cap after the market closed.

Amazon was down 8% at the close, then rose 18% afterward.  Market cap, $1.5T.

What’s going on?

Let me tell you a story. Settle in.

Once there was a buttonwood tree in New York City and stockbrokers would gather to trade there. In 1792 the brokers formed the NYSE.  To trade securities listed at the NYSE, you had to be a member.

Time passed. It worked. In 1929, the stock market blew up.

The government flexed. The Constitution authorizes no intervention in securities markets, but people were economically panicked.  Congress passed the Securities Acts of 1933 and 1934, taking control. Stuff got complicated.

In 1975, with inflation soaring and a war in Asia ending badly (déjà vu), Congress decided the stock market was a vital national interest and should be a System.

They passed the National Market System amendments to the Securities Acts after finding that new data technology could mean more efficient and effective market operations.

So Congress, pursuing the nebulous “public interest,” decided it must decree fair competition among brokers, exchanges, and other markets.

And they said opportunity should exist for trades to execute without the middleman, the broker-dealer or exchange – rejecting the buttonwood model.

With me still? 

I’m explaining how we ended up with extended-hours trading, and why it bucks like a bronc. We’re not there yet. 

In 1971, the National Association of Securities Dealers launched an automated quotation system. That became the Nasdaq.

In the 1990s, computerized trading systems outside the stock markets – as Congress envisaged – sprang up. No broker-dealers. No middlemen (save the software).

They demolished stock markets, taking more than half of all trading.

They were firms like Island, Brut, Archipelago, Instinet (the oldest, from 1969). They weren’t stock exchanges, weren’t brokers.  They were software companies matching buyers and sellers.

Ingenious, frankly. The exchanges cried foul.

The SEC intervened with a set of rules forcing these so-called Electronic Communications Networks (ECNs) to become broker-dealers.

And extended-hours trading began.

Why?

Because exchanges had to display ECN prices, and ECNs had to become brokers. So exchanges would win the price business, and ECNs would win the size business.

By the way, the exchanges bought the ECNs and incorporated the technology. The Nasdaq runs on vestiges of Brut and Island, the NYSE on Arca – Archipelago.  Instinet is owned by Nomura.

In 2005, the SEC fulfilled the vision of Congress from 1975, imposing Regulation National Market System – Reg NMS. That’s the rule running the stock market today, with its 17 exchanges and about 34 “dark pools,” which are ATS’s.  Latter-day ECNs.

Reg NMS links all markets, removes the differences in listing one place versus another, shares all prices and all data, and mandates trading at the best systemwide price.

But rules preceding Reg NMS for ATS’s didn’t proscribe extended-hours trading.

The irony? Congress wanted to cut out the middleman, the broker and exchange, and instead ALL trading is intermediated. It might be the craziest thing in human history outside emergency powers.

Plus, the rise of Passive Investment means vast sums need reference prices – a set price each day – to comply with the Investment Company Act of 1940 (another rule).  So exchanges persist with a 4p ET close.

But Exchange Traded Funds (ETFs) match off-market in blocks – and the parties running those trades are the same operating dark pools (ATS’s), behind most derivatives.

And there you have it.  Exchanges create prices for “40 Act” funds at 4p ET. And broker-dealers trade stuff other times, getting ever bigger.  Gyrating prices when the Stock Market is closed.

It’s now at times the tail wagging the dog.  It’s incongruous if the aim of the legislation behind Reg NMS is a free, fair, regulated, orderly, connected market.

That’s your answer.

Stocks gallop after the market closes because rules have fostered an arbitrage trade between market hours, and after-hours. The reason for extended-hours chaos is rules bifurcating the stock market into prices for thee but not for me.

The fix? I think it’s wrong for a “market system” to own the price of anything.  Stores for stocks should be no different than grocery stores – stocking what they wish and offering prices and supply.

How do we change it? Fix government powers. The SEC owns the market. Not us.

No Excuses

There’s no excuse. 

It’s 2022.  Not 1934, when Benjamin Graham wrote Security Analysis.

Back then, the timeless notion of buying profitable companies with undervalued growth opportunity took firm shape. But its interpretation would have to be shaped by the Securities Acts of 1933 and 1934, which birthed the SEC and part of the market’s structure that prevails still.

In 2022, the stock market has been operating under Regulation National Market System for 15 years.  Anybody in the stock market – investor, trader, public company – who doesn’t know what Reg NMS is and does is without excuse.

And any company reporting financial results during options expirations is without excuse. Like NFLX. Shareholders should rightly be upset.  There is no excuse for a public company to be ignorant of market form and function in 2022.

Monthly options expirations. Illustration 23855600 © John Takai | Dreamstime.com

Isn’t that a bit harsh, Tim?  No excuse? 

It’s been 15 years. We’ve watched meme stocks. Surges and collapses in prices. No connection to reality.  And we’re here to help you. You need not go through an NFLX experience.

Here’s some perspective. In 1995, well before Reg NMS when Yahoo!’s earnings call was an event attracting tens of thousands of retail investors as CEO Tim Koogle, who called himself “the adult supervision,” discussed financial performance, you didn’t need to worry about the options calendar. Options trading was a blip on the equity radar.

The goal then was to show you could close the books fast.  Koogle and team reported Q4 outcomes within ten days of year-end.  Remember that?

Today, the daily notional trading value in options is greater than the dollar-volume of stocks.  The latter is $600 billion. 

Derivatives comprise close to 20% of all market-capitalization. Derivatives are a right but not an obligation to do something in the future.

Suppose, public companies, that 20% of your sales at any given moment were a bet – a possibility but not a certainty.  You’d have to account for that when setting internal and external expectations for results. Right?  That’s very material.

And that’s the stock market.  If 20% of your value depends on something that might not happen, should you take that into account?  And are you irresponsible if you don’t?

I don’t know this stuff, you say.  Well, learn it! It’s a primary part of the investor-relations job in 2022. The calendar is here, and here, and here and here. It’s public information.

And we can help you measure and understand behaviors and see what the money is doing BEFORE you report results, before expirations.

Options expire all the time, but the RHYTHM of the stock market moves with monthly expirations.

Weeklies are too short a timeframe for indexes and Exchange Traded Funds that use them for substitutes, too unstable for the market-makers driving colossal trading volumes to keep ETFs aligned with underlying stocks – while profiting on directional options plays.

In 1995, most of the market’s volume tied back to the 90% of institutional assets that were actively managed.  For NFLX, between Dec 1, 2021 and Jan 24, 2022, Active money averaged 9%of daily volume.

Eighteen percent of volume tied to derivatives, which expired last week as NFLX reported financial results.  And 55% of NFLX trading volume is driven by machines that exploit price-changes and want to own nothing.

Fast Trading.  High Frequency Trading. Whatever you want to call it.  Firms that are exempt from having to locate shares to short, under Reg SHO Rule 203(b)(2).

Investor Relations Officers, it’s your job to know the market’s risks and advise your executive team and board on how best to maximize shareholder value and minimize risks to shareholder interests.

Shareholders should, can and will expect it of you, public companies. You shepherd money, time and resources belonging to other people.

MSFT is reporting on the RIGHT side of expirations. Same with IBM.  Doesn’t mean stocks aren’t volatile with new options. But they haven’t time-decayed yet. Bets are much more expensive.

Yesterday was Counterparty Tuesday when banks squared the books on wins and losses related to last week’s January derivatives and the new February derivatives that traded Monday and prompted one of the epic 21st century trading days.

Don’t report results in the middle of that.

Oh, we have an internal calendar from the General Counsel. Well, tell the GC to change it!  Stop acting like it’s the 1990s.  It’s not.

Your priority, your job, your responsibility, is to be an informed participant in 21st century American public equity markets.  To your credit, IR community, a meaningful part has adapted, changed behaviors, learned how the market works.

If you’re ready to drag your executive team into the 21st century, tell them there’s no excuse.  It’s time to change behavior, reduce risks for shareholders. Come join the market structure family.

The Big Story

Here we go again. 

Twitter fans of Fast Trading are claiming these firms help markets and especially the little guy. Now, before you check out, what’s the Big Market Story of 2021?

Retail trading. Right?  Meme stocks. The rise of the Reddit Mob.

Illustration 209856483 © Hafakot | Dreamstime.com

Editorial Note: And the rise of the #EDGEMob, the success of our trading decision-support platform, Market Structure EDGE, winner of the 2021 Benzinga Global Fintech Award for Best Day Trading Software.  EDGE helps retail traders win by seeing Supply and Demand, the very thing Fast Traders obfuscate daily.

Okay, back to our story.

Fast Trading is computerized speculation.  What most call “market-making.” In the sense that these firms buy stuff wholesale – orders from retail traders – and sell it retail (in the stock market and often back to retail traders via dark pools in bits), that’s true.

But it’s not market-making like Goldman Sachs providing research coverage on hundreds of stocks and committing to buy and sell them.

Fast Traders don’t have customers, don’t write research, don’t most times even commit to both buying and selling. They aim to own nothing at day’s end.  They profit on how prices change. Ironically, they create volatility to vacuum it away through tiny spreads.

Money for nothing.

So, these people on Twitter were saying Citadel and Jane Street and Two Sigma and G1X (unit of Susquehanna that buys retail flow) have better execution-quality than stock-exchange IEX.

That’s like saying sprinters have faster 100-meter times than marathoners.  Well, no kidding. They’re doing different things.  IEX is trying to increase trade-size so we can buy something meaningful. Fast Traders are after the opposite. Tiny spreads, tiny trades.

If you’re getting a headache, let me bring it all around.

“Execution Quality” is part of Reg NMS, the regulatory structure of the stock market. It’s benchmarked by thin gaps between prices, in effect. That is, a spread of a penny is no good. A spread of a tenth of a penny, awesome.

Yet Reg NMS prohibits quoting prices in increments of less than a penny, so there’s an element of irony here.  Quote sub-penny? Illegal. Trade sub-penny? The goal!

At any rate, the SEC determined that it could validate how great the market it had created worked by metering whether brokers executed trades near the best overall prices.

Well, that seems good.

Except the best price is determined by the brokers who are being measured on delivering best prices. That’s like saying, “Whoever you see in the mirror gets to judge you.”

I’m talkin’ ‘bout the man in the mirror. He’s gonna have to change his—sorry, digression. Thank you, Michael Jackson, for that awesome song.

Why use data from firms with no customers – Fast Traders serve none in the sense that Goldman Sachs or IEX do – to determine if there is market quality?

And would someone explain who benefits from a narrow spread?  Anyone? Anyone?

The parties buying and selling stuff but not wanting to own it.  That’s who.

The stock market is supposed to help investors, who want to own stuff.  Yet the rules give kudos to trading firms exploiting retail money, clouding supply and demand, and owning nothing.

That’s how retail money chased herds of buffalo off cliffs in AMC, GME and others. Market regulation crowns highwaymen champions for “narrowing the spread” while meanwhile no one knows what the hell is going on.

Well, we do.  We’re not confused at all.

But what reached a climax in 2021 besides retail trading was confusion. Public companies, do you know why your stock went up or down? Investors and traders, did the market make sense to you?

Stocks fell. Pandemic fears. Stocks zoomed. Fears were easing. Wash, rinse, repeat.

We found it entertaining, as we watched Supply and Demand and saw the market move largely in synchrony with that beat.

Low spreads don’t help public companies or traders. They help regulators justify market structure, market operators make money selling data, Fast Traders make money buying low and selling high in tenths of pennies.

All while saying the market exists for investors and public companies.

Good one, that.

Will it change in 2022?  No.

So, will you?

Traders, if you don’t know Supply and Demand, you’re kidding yourself.

And public companies, I’m not sure what else to say that I haven’t said in 17 years. We can be the people who answer an ever quieter phone, the setters of dwindling meetings as money goes quantitative, data goes quantitative.

Or we can understand Supply and Demand in the stock market.  Ask, and we’ll show you.

Two choices in 2022. Happy New Year! 

Something Wicked

When I was a kid I read Ray Bradbury’s novel, Something Wicked this Way Comes, which plays on our latent fear of caricature. It takes the entertaining thing, a traveling carnival, and turns it into 1962-style horror.

Not 2021-style of course. There’s decorum. It stars a couple 13-year-olds after all.

The stock market also plays on our latent fear of caricature.  It’s a carnival at times.  Clowns abound.  As I said last week, companies can blow away expectations and stocks fall 20%.  That’s a horror show.

Courtesy The Guardian

Devilish winds have been teasing the corners of the tent for a time.  We told our Insights Reports recipients Monday about some of those.

The Consolidated Tape Association, responsible for the data used by retail brokers and internet websites like Yahoo! Finance and many others last week lost two hours of market data.  Gone.  Poof.

Fortunately, about 24 hours later they were able to restore from a backup.  But suppose you were using GPS navigation and for two hours Google lost all the maps.

So that was one sideshow, one little shop of horrors.  I don’t recall it happening before.

Twice last week and six times this year so far, exchanges have “declared self-help” against other markets.

It’s something you should understand, investor-relations professionals and traders.  It’s a provision under Regulation National Market System that permits stock exchanges to stop routing trades to a market that’s behaving anomalously, becoming a clown show.

Rules require all “marketable” trades — those wanting to be the best bid to buy or offer to sell — to be automated so they can zip over to wherever the best price resides. And exchanges must accept trades from other exchanges. No exceptions.  It’s like being forced to share your prices, customers, and even your office space with your competitors.

The regulators call this “promoting competition.” Sounds to me like a carnival.

But I digress. Exchanges must by law be connected at high-speed, unless declaring self-help.

An aside, I’ll grant you it’s a strange name for a regulatory term.  Self-help?  Couldn’t they have come up with something else?  Why not Regulatory Reroute? Data Detour?

Anyway, last week the trouble occurred in options markets.  First the BOX options market went down. It’s primarily owned by TMX Group, which runs the Toronto Stock Exchange.

Then last Friday CBOE — Chicago Board Options Exchange, it used to be called — failed and the NYSE American and Arca options markets and the Nasdaq options markets (the Nasdaq is the largest options-market operator) declared self-help. They stopped routing trades there until the issue was fixed.

Now maybe it’s no big deal.  But think about the effect on the algorithms designed to be everywhere at once.  Could it introduce pricing anomalies?

I don’t know.  But Monday the Nasdaq split the proverbial crotch of its jeans and yesterday the so-called “Value Trade” blew a gasket.

I’m not saying they’re related. The market is a complex ecosystem and becoming more so. Errors aren’t necessarily indicative of systemic trouble but they do reflect increasing volumes of data (we get it; we’re in the data business and it happens to us sometimes).

And we’d already been watching wickedness setting up in our index of short-term supply and demand, the ten-point Broad Market Sentiment gauge.  It’s been mired between 5.8-6.1 for two weeks.

When supply and demand are stuck in the straddle, things start, to borrow a line from a great Band of Horses song, splitting at the seams and now the whole thing’s tumbling down.

And here’s a last one:  Exchange Traded Funds (ETFs) have been more volatile than the underlying stocks for five straight weeks, during which time stocks had risen about 5% through last Friday. Since we’ve been measuring that data, it’s never happened before.

Doesn’t mean it’s a signal. It’s just another traveling freak show. Clowns and carnivals. ETFs are elastic and meant to absorb volatility. Stocks are generally of fixed supply while the supply of ETFs fluctuates constantly.  You’d expect stocks most times to thus move more, not less.

I think this feature, and the trouble in options markets, speaks to the mounting concentration of money in SUBSTITUTES for stocks.  It’s like mortgage-backed securities — substitutes for mortgages.  Not saying the same trouble looms.  We’re merely observing the possibility that something wicked this way is coming.

Our exact line Monday at five o’clock a.m. Mountain Time was: “There’s a lot of chaos in the data.”

Son of a gun.

I don’t know if we’re about to see a disaster amongst the trapezes, so to speak, a Flying Wallendas event under the Big Top of our high-flying equity market.  The data tell me the probability still lies some weeks out, because the data show us historically what’s happened when Sentiment hits stasis like it’s done.

But. Something is lurking there in the shadows, shuffling and grunting.

And none of us should be caught out. We have data to keep you ahead of wickedness, public companies and traders. Don’t get stuck at the carnival.

Reg Nemesis II

In the Colorado mountains at Steamboat Springs, the pixie dust florescence of greening aspen leaves paints spring onto the high country.

In the bowels of equity markets there gurgles an emergent leviathan (maybe I should choose different imagery – but we’ll talk about what stinks and what doesn’t in this…movement).  The Securities Exchange Commission (SEC) in January asked stock exchanges to rethink Reg NMS.

Everybody who trades stocks, every investor-relations officer for a public company, should know some key facts about this regulation.

Yes. Of course it’s a pain in the butt (I need a new motif).  Who wants to read regulations?

Reg NMS is Regulation National Market System. In one of our all-time most frequented posts, called Reg Nemesis, we described the effects this law has had on the stock market.

We also explained in our recent NIRI webcast on market structure that its four components regulate stock data, stock quotes, stock prices, and access to all three.

Now the SEC wants to modernize it. I think that’s not a stinker at all. Rules should reflect how the market works, and Reg NMS hatched in the contemporary minds of members of Congress in 1975.

Then, amid caroming inflation and screaming currency volatility of the post-gold, bell-bottomed pandemic-haired hippie era, the legislative halls of Columbia echoed with calls to protect the vital “system” of our stock market.

So Congress added the 11A national market system amendments to the Securities Act.  And thirty years later, the SEC got around to regulating Congress’s will upon free markets, and in 524 sweepingly droll pages that one cannot help but read in the same soporific nasal tone as Ben Stein in Ferris Bueller’s Day Off, the stock market became the national market system.

You cannot bear imagining the cacophony with which the stock exchanges met this plan, back then.  There was shrieking and gnashing of legal teeth, the rending of garments and the donning of sack cloth. Ashes were poured on heads. Hieratic beseeching, a great priestly tumult, roared over capital markets.  It was like a pandemic.

Reg NMS was approved in 2005, about four years after the drumbeat began, and implemented in 2007.

Thirteen years on now, nobody loves Reg NMS like stock exchanges love Reg NMS. They’ve even sued the SEC to stop the regulator from questioning its own rules.

As Dave Barry, one of my favorite humorists (if your car is making a knocking noise, turn the radio up) of all time, used to say, “We are not making this up.”

So the SEC basically said, to quote Jerry Stiller (RIP, Ben Stiller’s dad), “Do you want a piece of me!!!!????”

And they’ve instructed exchanges and other market participants to help redraw Reg NMS.  And somehow the sequel is even longer than the original, at 595 pages.

And once again, even though the Securities Act of 1933 and 1934 as amended (oh so very many times amended) specifically includes issuers as constituents not to be discriminated against, we’re omitted from this re-imagining.

That’s a major reason to me why more than 55% of all trading volume currently comes from firms that don’t know what you do or who you are, public companies. They care only that your price profitably changes in fractions of seconds at your investors’ expense.

But I digress.

The Festivus for the rest of us that’s thus far been as elusive as holiday aluminum poles and feats of strength is a market that really works for our profession.

What would that be?  For one, a market that produced more IR jobs rather than fewer (we continue to lose more stocks each year than we gain and there are less than half what there were when I started in this profession in 1995).

And a market where stock pickers favoring your story have the same chance to make money as ETF market-makers and Fast Traders (so blissfully optimistic you want to start humming Fred Rogers, and, were we not socially distanced, hugging your neighbor).

Hey, maybe this is our chance. We can form opinions, speak up.  We’ll have that opportunity as this process, likely to take years as it did the first time around, unfolds.

So, what’s the SEC wanting to put in Nemesis II?  It wants competition for consolidated market data.  The Securities Information Processor (SIP) is a monopoly run by one firm (currently the Nasdaq).  It’s the official source of price and quote information – but it’s slower than all the proprietary data feeds. So everybody sells access even though the law says access must be uniform.

That needs fixing and the SEC is right.

And they want to redefine a “round lot” to reflect an Amazon market. Right now, stocks quote in 100-share increments.  The problem is AMZN, BKNG, GOOG and other stocks trade for well more than $1,000.  The average trade-size in these is about 30 shares.

In fact, almost 60% of trades now are for less than 100 shares, so stocks are trading at prices differing from quotes. It merits analysis, we agree. But do we further “yellow pencil” the market? Should we force all stocks to be $25-50? Is the round lot dead?

I haven’t finished reading all 595 pages yet. We’ll have more to say. We need rules that reflect reality. But we also need simple, comprehensible markets that work for all of us, and not just for speedy machines and stock exchanges.

Maybe we should all yell at them, “Do you want a piece of me!!!!????”

Epiphany

DoubleLine’s famed Jeff Gundlach says we’ll take out March lows in stocks because the market is dysfunctional.

Karen and I have money at DoubleLine through managed accounts with advisors.  Mr. Gundlach is a smart man. Maybe it’s splitting hairs if I say the stock market isn’t dysfunctional but reflecting its inherent structural risks.

We know as much as anyone including Mr. Gundlach about market mechanics. And I still learn new stuff daily.  Matter of fact, I had an epiphany over the weekend. I compared market behaviors during the Great 2020 Market Correction.

Wow is that something to see.  We might host a webcast and share it.  If you’re interested, let us know.

Over the past decade, the effort to produce returns with lower risk has spread virally in the US stock market.  Call it alpha if you like, getting more than you’re risking.  Hedge funds say it’s risk-adjusted return.

The aim is to protect, or insure, everything against risk, as we everyday people do. We protect our homes, cars, lives, appliances, even our entertainment expenditures, against risk by paying someone to replace them (save for our lives, where beneficiaries win at our loss).

Stock traders try to offset the cost of insurance by profitably transacting in insured assets. That’s the holy grail.  No flesh wounds, no farts in our general direction (for you Monty Python fans).

It works this way. Suppose your favorite stock trades for $20 and you’re a thousand shares long – you own 1,000 shares. For protection, you buy 20 puts, each for 50 shares. You’re now long and short a thousand shares.

If the stock rises, the value of your puts shrinks but you’re up. If the stock declines, your long position diminishes but your puts are worth more.  Say the stock rises to $23. The value of your puts declines, making you effectively long 1,300 shares, short 700.

To generate alpha (I’m simplifying, leaving out how options may decrease in value near expiration, the insurance-renewal date, so to speak), you need to offset the cost of insurance. With a good model built on intraday volatility, you can trade the underlying stock for 20 days, buying high and selling low, going long or short, to mitigate costs.

Everybody wins. Your counterparty who sold you the puts makes money.  You make money trading your favorite stock. You have no fear of risk. And because more money keeps coming into stocks via 401ks and so on, even the losers get lucky (thank you Tom Petty, rest in peace, for that one).

One big reason this strategy works is the rules.  Regulation National Market System requires all stocks to trade at a single daily average price in effect. Calculating averages in a generally rising market is so easy even the losers can do it.

Now, what would jack this model all to hell?

A virus (frankly the virus is an excuse but time fails me for that thesis today).

Understand this:  About 80% of all market volume was using this technique. Quants did it. Active hedge funds. Fast Traders. Exchange-Traded Funds (ETF) market-makers.

Big volatility doesn’t kill this strategy. It slaughters the parties selling insurance. Observers are missing this crucial point. Most active money didn’t sell this bear turn.  We can see it.  Again, a story for later via webcast if you’re interested.

What died in the great 2020 Coronavirus Correction was the insurance business.

Casualties litter the field. The biggest bond ETFs on the planet swung wildly in price. Big banks like Dutch giant ABN Amro took major hits. Twenty-six ETFs backed by derivatives failed. The list of ETFs ceasing the creation of new units keeps growing and it’s spilling into mainstream instruments. Going long or short ETFs is a fave hedge now.

The Chicago Mercantile Exchange auctioned the assets of a major high-speed trader that sold insurance, Ronin Capital (around since 2006. If its balance sheet and leverage can be believed, it may have imputed a loss of $500 billion to markets.

Just one firm. How many others, vastly bigger, might be at risk?

Forget stock-losses. Think about how funds mitigate volatility. How they generate alpha. We’ve been saying for years that if the market tips over, what’s at risk is whatever has been extended through derivatives. ETFs are derivatives. That’s 60% of volume.

And now key market-makers for stocks, bonds, ETFs, derivatives, commodities, currencies, are tied up helping the Federal Reserve. Including Blackrock. They can’t be all things to all people at once.

The market isn’t dysfunctional.  It’s just designed to function in ways that don’t work if insurance fails. And yes, I guess that that’s dysfunctional. That was my epiphany.

I’ll conclude with an observation. We shouldn’t shut down our economy. Sweden didn’t. This is their curve. Using a population multiplier, their curve is 27% better than ours – without shutting down the economy, schools, restaurants. We are the land of the free, the home of the brave. Not the land of those home, devoid of the brave. I think it’s time to put property rights, inalienable rights, above the government’s presumption of statist power.

Many Tiny Trades

All 20 biggest points-losses for Dow Jones Industrials (DJIA) stocks in history have occurred under Regulation National Market System.

And 18 occurred from 2018-2020. Fifteen of the 20 biggest points-gains are in the last two years too, with all save one, in Mar 2000, under Reg NMS (2007-present).

It’s more remarkable against the backdrop of the Great Depression of the 1930s when the DJIA traded below 100, even below 50, versus around 20,700 now and small moves would be giant percentage jumps. Indeed, fifteen of the twenty biggest percentage gains occurred between 1929-1939. But four are under Reg NMS including yesterday’s 11.4% jump, 4th biggest all-time.

Just six of the biggest points-losses are under Reg NMS (we wrote this about the rule). But ranked second is Mar 16, 2020. And 19 of the 20 most volatile days on record – biggest intraday moves – were in the last two years, and all are under Reg NMS.

Statistically, these concentrated volatility records are anomalous and say what’s extant now in markets promotes volatility.  Our market is stuffed full of many tiny trades.

Volume the past five days has averaged 9.9 million shares per mean S&P 500 component, up 135% from the 200-day average.  But intraday volatility is up nearly 400%, trade-size measured in dollars is down 30%.

That’s why we’re setting volatility records. The definition of volatility is unstable prices.

I’m delighted as I’m sure CVX is that the big energy company led DJIA gainers yesterday, rising 22%.  But stocks shouldn’t post an excellent annual return in a day.

CVX liquidity metrics (volume is not liquidity!) show the same deterioration we see in the S&P 500, with intraday volatility up 400%, trade-size down 47%, daily trades up over 240% to 196,000 daily versus long-run average of about 57,000.

Doing way more of the same thing in tiny pieces means intermediaries get paid at the expense of investors.

Every stock by law must trade between the best national visible (at exchanges) bid to buy and offer to sell.  When volatility rises, big investors lose ability to buy and sell efficiently, because prices are constantly changing.

Regulators and exchanges have tried to deal with extraordinary volatility by halting trading.  We’ve tracked more than 7,500 individual trading halts in stocks since Mar 9 – twelve trading days.  Marketwide circuit breakers have repeatedly tripped.

Volatility has only worsened.

In financial crises, we inject liquidity to stabilize prices.  We can do the same in stocks by suspending the so-called “Trade Through Rule” requiring that stocks trade at a single best price, if the market is more than 5% volatile.

Trade size would jump, permitting big investors to move big money, returning confidence and stability to prices. We’ve proposed it three times to the SEC now.

Investors and public companies need to understand if the market is working. Let’s define “working.” The simplest measure is liquidity, which is not volume but dollars per trade, the amount one can buy or sell before price changes.  By that measure, the market has failed utterly during this tumult.

Let’s insist on a market capable of burstable bandwidth, so to speak, to handle surges.  Suspending Rule 611 of Reg NMS during stress is a logical strategy for the next time.

Let’s finish today by channeling the biblical apostles, who came to Jesus asking what would be the sign of the end of the age?  Here, we want to know what the sign is that market tumult is over.

At the extremities, no model can predict outcomes.  But given the nature of the market today and the behaviors dominating it, the rules governing it, we can inform ourselves.

This market crisis commenced Feb 24, the Monday when new marketwide derivatives traded for March expiration.  In the preceding week, demand for derivatives declined 5% at the same time Market Structure Sentiment topped.

We had no idea how violent the correction would be. But these signals are telling and contextual. They mean derivatives play an enormous role.

We had massive trouble with stocks right through the entire March cycle, which concluded Mar 20 with quad-witching.  Monday, new derivatives for April expiration began trading.

It’s a new clock, a reset to the timer.

You longtime clients know we watch Counterparty Tuesday, the day in the cycle when banks square the ledger around new and expired derivatives. That was yesterday.

That the market surged means supply undershot demand. And last week Risk Mgmt rose by 5% and was the top behavior – trades tied to derivatives, insurance, leverage. Shorting fell to the lowest sustained level in years. Market Structure Sentiment bottomed.

It’s a near-term nadir. The risk is that volatility keeps the market obsessed with changing the prices, which is arbitrage. Exchange Traded Funds depend on arbitrage (and led the surge in CVX).  Fast Traders do too. Bets on derivatives do.

The tumult ends in my view when big arbitragers quit, letting investment behavior briefly prevail.  We’ll see it. We haven’t yet.  The market may rise fast and fall suddenly again.

Clashing Titans

While Karen and I consumed Arctic Char in Iceland, stock exchanges sued the SEC.

Talk about a big fish story.

The NYSE, Nasdaq and CBOE, representing about 57% of trading volume over a combined twelve platforms, asked a federal court to halt the SEC’s plan to test changes to trading fees and credits via a Transaction Fee Pilot program set to begin late in 2019.

It’s the more curious because investors transacting in markets generally support the planned study. Reading through hundreds of comment letters (including our own, offered in support), we tallied around $24 trillion of assets backing the test.

What’s got the exchanges in such a tizzy about a probationary effort – not an actual rule-change, mind you – that they’ve lawyered up?

The answer lies in the four key tenets of Regulation National Market System, a sort of current Magna Carta for stock-trading in the USA.  Every investor-relations professional and investor should know baseline facts about it.

In 1975 when the USA was mired in screaming inflation, a plunging dollar loosed from its gold moorings in 1971, an oil crisis, and failure in Vietnam, the US Congress decided to throw a fence around stock markets as a vital strategic interest.

So they passed the National Market System amendments to the Exchange Act of 1934, now part of the leviathan United States Code, 15 USC, Section 78c.

Oh boy.

The wheels of regulation mire in swampy muck, so it was thirty years later when the SEC finally got around to fulfilling the vision (no longer needed, in my view) Congress saw in 1975.  Enter Reg NMS.

The regulation has four pillars.  First, exchanges must ensure that stocks trade only at a single national best price (the Order Protection Rule). Second, the SEC – and this is the essence of the Fee Pilot – capped (the SEC said “harmonized”) what exchanges could charge so nobody would be priced out of access (The Access Rule) to stock quotes. It also required a spread between the bid to buy and offer to sell. No locked (same bid, offer) or crossed (higher bid than offer) markets.

Third, the law prohibited stock-quotes (unless under $1 in value) in increments of less than one penny (in effect, guaranteeing speculative traders a profit, because while quotes are in pennies, trades are often in far smaller increments at variations of midpoints) so every stock would have a bid and offer separated by at least a penny.

Finally, the law changed how revenue from data (Market Data Rules) would be allocated.

Reg NMS was implemented in 2007.

I think a legal case could have been made that both decimalization and Reg NMS six years later were unconstitutional. Nowhere does our governing charter give Congress the power to set prices and commandeer property not for public use.

Yet it did so by forcing exchanges to share what before had been proprietary intellectual property – data – and setting what they could charge for services. So how ironic is it that now exchanges are suing to keep this structure?

Not ironic at all when you realize that big exchange groups (the newest entrant IEX is not suing, supports the fee pilot, and didn’t build business on data and technology services) have exploded in size, profits, revenues and influence under Reg NMS.

Humans are an intelligent species. We adapt. The exchanges discovered that they could pay traders to set the bid and offer, and sell the data generated in that process – and then sell all kinds of services for using that data effectively.  Genius!

The pilot plan threatens this construct.

You’ll read that the concern is brokers routing trades for payments instead of where it’s best. That’s to me a red herring.

We oppose prices set by participants wanting to own nothing. They distort fair value, supply, demand, and borrowing. If you use our analytics, you know it’s 44% of trading volume directly, and over 70% indirectly (we calculate that 94% of SPY volume is arbitrage).

If half the volume is intermediation, the market is a mess.

The stock market is supposed to match investors and public companies. Reg NMS derailed the market’s central purpose. That’s my opinion. Predicated on data. I run a technology firm that for the entirety of the Reg NMS regime has measured the collapse of rational thought and capital-formation consequent to this regulation.

The stock market today is a great place to trade stuff. Exchange Traded Funds have prospered because they’re by law dependent on arbitrage, profiting on different prices for the same things. The regulatory structure requires different prices for the same things.

Let’s summarize what’s occurring. The exchanges have invested billions of dollars to make money under Reg NMS. And they’ve succeeded.

The SEC now realizes that Reg NMS hurts the root purpose of equity capital markets and it wants to test ways to roll back rules promoting short-term trading.

The exchanges are opposed because short-term trading is the very cornerstone of profitable data and technology services.

I don’t fault them.  But come on, guys. The SEC has finally seen how the market has devolved into a laser light show of speculation and fleeting intermediary profiteering that has pushed meaningful capital-formation into private equity.

That in turn defrauds mom and pop investors of the Intel Effect (I don’t have to explain it), and my profession, investor relations, of a thriving job market.

Could we run this test, please, and see what happens, exchanges?

Rules and Money

There are two pillars to market intelligence: The Rules, and The Money.

By market intelligence, I mean information about what’s pricing a stock. So, translating, information about what’s pricing a stock must derive from the rules that govern stock-trading, and how money conforms to those rules.

Wouldn’t that be supply and demand?  Would that it were! There are instead four big rules for stocks now, tenets of Regulation National Market System about which every investor and investor-relations officer should have a basic grasp.

“Quast,” you say. “This sounds about as exciting as cleaning a tennis court with a tooth brush. In Houston. In the summer.”

It can be very exciting, but the point isn’t excitement.  If you don’t know the rules (always expect your market intelligence provider to know the rules for stocks), your conclusions will be wrong.  You’ll be guessing.

For instance, if you report strong results and your stock jumps on a series of rapid trades, can a human being do that?  Refer to the rules. What do they require?  That all marketable trades – an order to buy or sell stock – be automated.

No manual stock order can be marketable. Manual orders are nonmarketable, meaning prices for the stock must come to them instead. Picture a block of cheese and a grater passing by it and shaving some off.

The rule creating this reality in stocks is the Order Protection Rule, or the Trade-Through Rule. Same thing. It says traders cannot trade at $21.00 if the same stock is available for $20.99 somewhere else. To ensure compliance, regulators have mandated that orders wanting to be the best bid to buy or offer to sell must be automated.

And the bid to buy will always be lower than the offer to sell. Stocks may only trade at them, or between them.  There can only be one best price (though it may exist in several places).

Now start thinking about what money will do in response.  Orders will be broken into pieces. Sure enough, trade size has come down by factors, and block trades (we wrote about it) are a tiny part of the market.

Big Commandment #2 for stocks is the Access Rule. It goes hand-in-glove with the first rule because it’s really what turned the stock market into a data network.

The Access Rule says all market centers including stock markets like the five platforms operated by the NYSE, the three owned by the Nasdaq, the four owned by CBOE, the newest entrant IEX, and the 32 broker markets that match stock trades must be connected so they can fluidly share prices and customers.

It also capped what exchanges could charge for trades at $0.30/100 shares – paid by brokers trading in the stock market for themselves or customers (the SEC Fee Pilot Program aims to examine if these fees, and their inverse, incentive payments, cause brokers to execute trades in ways they would not otherwise choose).

The third big rule outlaws Sub-Penny Pricing, or quoting in increments so small they add no economic value.  You may still see your stock trading at $21.9999 because of certain exceptions for matching at midpoints of quotes.

Reg NMS lastly imposed new Market Data Rules. Since everyone is sharing prices and customers on this network called the stock market, plans had to be refined for pooling data-revenue (prohibiting sub-penny trading was meant to prevent a proliferation of tiny meaningless prices).

Yet, data is a byproduct of prices. There are hundreds of millions of dollars of revenue governed by the Consolidated Tape Association, which divides proceeds according to how various platforms and brokers quote and trade in accordance with best prices. Outside the CTA, there may be billions of dollars now in proprietary data feeds.

These rules drive how money behaves. The fastest machines will price your stock to start the day no matter where you trade, because they have the quickest bids and offers. But their purpose is to profit on changing prices, not to own stocks.

Passive investment dominating the market is aided by rules. What lies between the bid and the offer? The average price. Those tracking benchmarks like index mutual and exchanged-traded funds get a boost toward their objective.  Prices become uniform (our data show very tight Poisson distribution in the stock market – which helps securities tracking benchmarks).

And because stock prices are highly unstable – average intraday spread in the Russell 1000 the past five trading days is 2.6%, and the typical stock trades over 16,000 times daily in 167-share increments – investors turn to substitutes like derivatives. Even Warren Buffett who once famously skewered them as instruments of mass financial destruction has large derivatives positions.

Let’s finish where we started. Why doesn’t supply and demand drive stock prices? Because rules governing trades don’t let supply and demand manifest naturally. The greatest proportion of trades are now driven by machines wanting to own nothing, the opposite of a market animated by supply and demand.

When you look at your stock or stocks in your portfolio, remind yourself: What’s driving them up and down are rules, and money racing around a course in compliance with those rules.  Some part is rational. A bunch of it isn’t.  We all – investors and public companies – can and should know what’s going on. The first rule, after all, is to be informed.

Welcome to the 21st century stock market.