Tagged: SEC

The Winners

There was a country hit 30 years ago called Nobody Wins.

Why drag out a 1993 song by Radney Foster?  Well, it popped into my head reading the SEC’s proposed new regulations for the US stock market.

Oh, but somebody wins here.

Photo 126390367 / Sec © Grey82 | Dreamstime.com

If you missed last week’s first chapter, Origins, read it.  I promised this week to describe who wins in the 1,650 pages of new regulations the SEC thinks the stock market needs.

At Amazon is a book called “How to Play Chess: A Beginner’s Guide to Learning the Chess Game, Pieces, Board, Rules, & Strategies.” It says you’ll master chess. It’s got 498 reviews and gets 4.5 stars. It’s 49 pages.

If you can master chess in 49 pages, you’d think the stock market, which the SEC has opened to 100 million Main Street folks by permitting free trading (no commissions!), must be simple. After all, the SEC wouldn’t just let beginners in. Right?

Regulation National Market System, which regulates the stock market’s quotes, prices data and access (to all three) is 520 pages.  Probably a good idea to know what it says.

After all, the US stock market is home to about $45 trillion of invested assets, over 3,500 public companies, over 2,000 Exchange Traded Funds, hundreds of closed-end funds, scads of preferred and other classes. A combined 10,000 securities.

It’s roughly 70% of total global market-capitalization.  If you’re an investor, this market supports your retirement plans.

But wait, there’s more.

The SEC’s Market Data Infrastructure Plan is 900 pages.  You should probably know what’s in that too. With it, the Clayton SEC regime aimed to end the exchange data monopoly. Exchanges sued and blocked parts of it (not the definitions, though).

The stock market and the exchange business are all about data.

The NYSE is a tiny part of Intercontinental Exchange (NYSE: ICE), which is in the data business.  ICE had $9.2 billion of revenue in 2021, $4.1 billion of income, a 44% margin.

According to ICE’s 2021 10K, 71% of its revenue is data, analytics and network services.  Listings are 13%.

The Nasdaq had 2021 revenue of $3.4 billion after deducting $2.2 billion of rebates paid to traders to set prices, and earned $1.2 billion, a 35% margin.

Here’s the irony. The whole of SEC market regulation is about narrow margins. LOW SPREADS. Remember those two words. 

Nasdaq segment-reporting shows 2021 revenue of $1.1 billion from market data, index-licensing and analytics. 

Do the math. Without that byproduct from operating markets and paying traders to set prices, the Nasdaq made $100 million.

That’s still a lot of money. But it’s a 3% margin, not much different than running a grocery store. Grocery stores are low-margin stock markets matching producers of goods with consumers of them.

The stock market is a grocery store for public companies trying to find investors for their shares.  And this grocery store has margins of 35-44%. 

At whose expense?

The intermediaries using the platform such as Citadel, Virtu (30% margin in 2021), Hudson River Trading, Quantlab, Two Sigma, Infinium, GTS, SIG, Tower Research, IMC, Flow Traders, Optiver, make billions of dollars as middlemen.

Jane Street traded $17 trillion of stock in 2020 and made $8 billion, give or take. It’s got 2,000 employees. Bank of America just reported net income of $7.1 billion. It’s got 220,000 employees.

Anybody seeing a trend? 

The SEC has now proposed 1,650 more pages, bringing the total near 3,000, not counting the thousands more pages of rule-filings emanating from the exchanges every year.

And they’re principally focused on shrinking spreads. A penny is too wide. We need tenths of pennies in quotes now, or the little guy is getting screwed.

We’re told.

By the way, you’ll hear a term over and over and over from regulators and exchanges:  Execution Quality.  It’s supposedly what defines the stock market as “good.”

No, it’s what makes money for intermediaries and ensures what the SEC wants: That somebody keeps posting quotes and trades in this absurdly complicated environment.

When you see the term, know it’s obfuscation.

Let me cut out the intermediating verbiage. The SEC sees that we have a bifurcated market where half the trades, roughly, are occurring off-exchange in dark pools, but the exchanges provide the prices, quotes and small spreads. And the exchanges make scads selling resulting DATA.

The SEC also sees that the data advantage held by the exchanges is unfair, but the exchanges sue when the SEC tries to fix it.  And meanwhile as trading OFF exchange nears 50%, the VALUE of the data the exchanges sell is threatened, and so is the necessary tense alliance between the SEC and exchanges.

So the SEC has, with 1,650 pages, struck a deal. We’ll push more trading and quotes and prices back to you, exchanges, so you get more of the spread. But charge less for trades and ensure that the continuous auction market doesn’t break down.

Execution quality.

The winners are the SEC and the exchanges. 

I can promise you this, investors, traders and public companies, parties for which the stock market exists: Trading in tenths of pennies at stock exchanges is bad.

The smaller the spread, the shorter the investment horizon.

And that’s what these latest 1,650 pages promote. Smaller spreads, tinier trades, more data.  Bigger margins for intermediaries. For the purposes I described.

It’ll be called Execution Quality. It means the middlemen are merchandising you.

And you lose.

Do you care? Does anyone anymore?  You issuers, you are the biggest losers. You’ve lost your audience, your capital-formation mechanism.

And if you let the parties running your market make 40 cents of every dollar, you probably deserve it.

Origins

I counted the times “issuer” appears in the SEC’s four new market-structure proposals.   

Investors and traders (and issuers), should you care?

Without issuers, there’s nothing to trade. These rules could push issuers onto the endangered species list.  You can read and comment

Photo 108381110 / Austin © Sean Pavone | Dreamstime.com

on the proposals here, and you should do both. At minimum, read the fact sheets here.

The word “issuer” never appears beneficially. I’ll explain.

We’re back from Austin TX and marking Karen’s mom’s 80th birthday. Friends and family turned out in droves.  We kids (using the term loosely) served 16 bottles of prosecco, white wine and red wine, plus all the trappings including over 80 Italian cream cupcakes.  The oldsters can party.

In the retirement facility where mom resides is a man named Walter Bradley.  He was a professor for 40 years at Colorado School of Mines, Baylor and Texas A&M. He’s got a PhD in polymer sciences. We talked to him, know who he is.

Turns out, everything is made of chemicals and proteins, inanimate or not.  How these compounds combine is what makes plastics. And humans. 

Walter Bradley is a Christian.  He pioneered a school of scientific thought on the origin of life called Intelligent Design.

Stay with me.  As ever, I’ve got a market-structure lesson. 

Ben Stein made a documentary called “Expelled: No Intelligence Allowed.” Walter Bradley is in it.

Whether you believe in God or don’t, how life happened here is a persistent mystery.  Delve into the science – not the ideologies and philosophies predominating on both sides – and you find convergence of opinion:

Nobody knows for sure.

You’d think the science was settled. There’s evolution with the answers. Ah, but no. Giant, whistling holes. Science can’t obviate God.

Dr. Bradley says the Second Law of Thermodynamics disproves a natural origin to life. The principle, called Entropy (that’s what I’d call my rock band), holds that all things move from a state of order to a state of disorder, like kids’ bedrooms.

Life depends on a precise combination of proteins and chemical reactions, which can only arise from the opposite: Moving from disorder to order. It doesn’t occur in nature.

Nobody in science disputes that, believers and atheists alike.

As Ben Stein’s documentary says, the probability that the right string of proteins combines randomly to foster cellular replication is so monstrously unlikely as to accrue gaggles of zeros.  It’s all the same as impossible.

But it happened.

Which brings us back to the word “issuer.” 

It’s in these SEC documents 24 times by my count.  Just six mean “public companies.”

Three times on page 397 (472 total) of the filing called Disclosure of Order Execution Information – do we need almost 500 pages on that? – we’re told issuers are hurt by “financial frictions.”

Says the SEC: “Financial frictions may have an adverse impact on capital formation. In particular, higher transaction costs may hinder customers’ trading activity that would support efficient adjustment of prices and, as a result, may limit prices’ ability to reflect fundamental values. Less efficient prices may result in some issuers experiencing a cost of capital that is higher than if their prices fully reflected underlying values…”

That’s demonstrably false. Like claiming things naturally move from disorder to order.

Trillions of dollars are raised and deployed in private investments without any stock exchanges or “financial friction.” It proves irrefutably that “fundamental values” do not depend on trading.

But that’s still not the point. 

The market started with issuers. It’s the origin of species, so to speak, for stocks.  There were first, before brokers, which in turn created the exchanges that now compete with them, shares of companies. Without them, there is no stock market.

In a 399-page proposal called The Order Competition Rule, the term “issuers” appears three times in reference to the Securities and Exchange Act’s prohibition on discrimination against issuers and unfair allocation of dues and fees.

Well.

There are three big exchange groups: The NYSE, with 19.4% of volume across five platforms, most of that at the NYSE floor, and NYSE Arca, its derivatives market.

There is the Nasdaq, with 16.9% on three (not one) platforms.

There’s CBOE, with 12.6% at four platforms.

Do the math. A majority of trading happens somewhere else. You companies listed at the NYSE and Nasdaq, over 80% of your trading occurs where you’re not listed. At no cost.

What are you paying for, then? You pay exchanges to trade your stock. But they’re not. 

Issuers, your fees are too high. What are you going to do about it? The SEC is violating the law. Will you defend yourselves?

Trading firms like Citadel are getting rich a tenth of a penny at a time, at your expense. Exchanges are financial behemoths. And there are half the number of public companies there were when the Nasdaq started. Half the investor-relations jobs.

And these 1,600 pages of new rules compound the divide.

Origins matter. The SEC has forgotten that the stock market originated with issuers.  And cannot exist without them.  Issuers, are you going to buy the myth, or the science?

Next time, we’ll talk about who benefits from these new rules – somebody does! – and what they mean to investors and traders.

Right and Wrong

Cheers!

They got it right, and they got it wrong.  I’ll explain in a moment.

Karen and I took two weeks off from the Market Structure Map and disappeared into the white wilderness.  Steamboat Springs, CO logged the biggest pre-January snow season in nearly 40 years.  Over 200 inches.

I snapped this photo at 10,500 feet atop Sunshine Peak before pointing my skis downhill.

Sunshine Peak, Steamboat Springs ski resort. Courtesy Tim Quast

But there were days when the snow fell in such volume that we resorted to the fireplace and binge-watching Yellowstone.  We’re behind the rest of you but catching up.

I grew up on a cattle ranch. Not one like that with a chopper.

But the battle for survival was similar. We weren’t shooting people and bending interpretations of right and wrong. But I was on hand in the so-called Sagebrush Rebellion when guns bristled everywhere.

My dad would say what Kevin Costner’s character did. Ranching is a hard way to make a living because everything is arrayed against you. The government, the activists, the diseases, the weather. You can do right all day long and still get it wrong.

WSJ columnist James Mackintosh also wrote about right and wrong. Not like Yellowstone, no. He said (subscription required) Wall Street nailed earnings but missed the bear market.

Sellside estimates were within $1 of actual earnings. But the market didn’t do what those numbers should have delivered. Right, and wrong.

If earnings won’t tell you what stocks will do, what’s the point?

That question is the existential one for the investor-relations profession.  In the TV show Yellowstone, the existential question for the Duttons is how to beat impossible odds.

So, IR people, is the market for us or against us?

What John Dutton learns is you have to have influence.  There’s more and I don’t want to give it away.

But it’s the ONE THING the IR profession has never realized. We go right on doing the same things leading to the same inevitable outcome, which is that story doesn’t set price.

Why not? Because the stock market’s purpose isn’t to help your story manifest in your share-price. 

As in any market, the purpose is found in the principal activity. It’s still true that cattle ranching reflects its principal activity: raising bovines to supply a grocery market (you don’t have to like it but it’s true).

A Christmas tree farm raises Christmas trees.

The stock market sets prices.

We’ll come to it in a future Market Structure Map, but those 1,600 pages of proposed new SEC rules you’ve heard about?  They contain nothing that helps you, issuers, see your story better reflected in your shares.

No, they have everything to do with setting prices.  And who sets prices? 

Stock exchanges. Fast Traders. That’s who the market serves. 

How and why?  They learned the Yellowstone lesson. They have people everywhere. They lobby for influence.  They shape rules to help themselves.

We never have.  As a profession, we can do everything right and get it wrong.

I’ll let you ponder that.

Now, a word on the market in 2023 since this is the first Market Structure Map of the new year. Turns out 2022 was a top-ten worst for returns since 1926, with the S&P 500 down 19%.

There are only four periods since 1926 when stocks have posted back-to-back declines:  1929-32, 1939-41, 1973-74, and 2000-02. The losses for those periods were about 86%, 21%, 40%, and 46%. All those periods were recessionary.

S&P 500 losses of about 37% during the so-called Great Financial Crisis came all in a year, 2008.

It won’t surprise me if we notch the first back-to-back losing years since 2001-02 on a total-return basis. 

Why? Because stocks had a top-ten bad year on no reason save prices.  What if we get a reason this year?  All those other periods, again, were recessionary.

And here’s the trouble for investors. It’s not just that it takes five, ten, years to get back to level.  You never get back to level.  Stocks go down 40%, but prices of everything you buy go up.

Each time we retrench, governments intervene and expand the supply of money. So you lose 25% or 50% of your savings, but prices never fall 25-50%.  They rise even faster. 

I penned this letter to the WSJ on how the Federal Reserve contributes to this trouble.

The only money avoiding these growing chasms is the short-term money.  The parties setting prices don’t lose.

The stock exchanges don’t write research or provide market-making support.  Fast Traders don’t support customers, research, issuers. They trade their own capital.

It’s a new year. We have a fresh new chance to do something. 

We must first understand how the stock market works. We can’t argue for change without first knowing what’s wrong (we do, and you should have us on your side).

Number two, as a profession, we need to get some political leverage. NIRI, that’s your puzzle to solve in 2023. It’s not just the right thing to do.  It may be our Yellowstone moment.

Closeted

Bill Miller once said, “Seventy percent of stock-pickers are closet indexers.”

 

The image at right is the composition of the daily average volume in SPY, the State Street S&P 500 Exchange Traded Fund (ETF), for the five days ended Aug 24, into index-futures expirations today.

SPY Demographic Volume Composition, 5D Ave Aug 24, 2022

It’s proof of what Mr. Miller said. I’ll explain. 

Miller, former Chief Investment Officer of Legg Mason Capital Management and now head of Miller Value Partners, is a legendary stock-picker.  Closet-indexing is owning what index funds buy to try to mimic performance.

You know what I mean by stock-pickers, right?  It’s bottom-up investors, or as we say in the investor-relations profession, the long-onlys, the investors you talk to.

It’s the money on your earnings calls, showing up on your non-deal roadshows (more jargon from the investor-relations profession), the buy-and-hold folks.

In 1998, using Morningstar data, the four largest investment-management categories were stock-pickers and they controlled 90% of assets under management.

In 2019, comparable Morningstar data showed those four – Active Large Cap Growth, Active Large Blend, Active Large Value, Active Other – were down to 50% of assets.  Data since suggests they’re down to 40% now.

In fact, just one category, Passive Large Cap Blend, now has close to 40% of all assets, the same data suggests.

And it fits other observable facts.  About 95% of market capitalization resides in large-cap funds. It’s a reason why we tell public companies to focus on becoming big.

Size matters. It’s where the money is. 

Were I running a company wanting to IPO, I’d roll up enough assets to value the entity at $5 billion first. We’d be in the thousand biggest stocks in the market –where the cash is.

Why go public and reside where it isn’t?  Common sense. Don’t let bankers fool you!

On Aug 25, the SEC adopted Pay for Performance rules included in Dodd-Frank legislation from a decade ago requiring public companies to tie compensation to total shareholder return, including share-performance.

Public companies should link pay to financial returns. Got no problem with that.  But public companies cannot control how shares are valued, because the great bulk of volume that sets prices isn’t directly motivated by the company’s story.

The two images here paint a stark picture.

In the top image, 19% of SPY volume is from stock-pickers.  SPY is the most actively traded stock by dollar-volume.  It averages over $30 billion daily, about three times what AAPL does.  And it trades about 500,000 times daily, about $50,000 at a time.

But SPY is a proxy for stocks, a substitute. Like all ETFs are.

Now, see the second image here.  It’s volume composition from the same period for the 500 stocks comprising the S&P 500 index that SPY tracks.

S&P 500 Demographic Volume Composition, 5-day average, Aug 24, 2022

Active Investment is 10% of volume in the average S&P 500 stock.

Get it? Active money is 90% higher in SPY than in the stocks it tracks!

And Passive money, which ostensibly indexes the stocks, is just 1% lower daily in SPY.

Meaning? Stock-pickers are closet-indexing not just by following indexes but by substituting SPY for stocks.

Which also means the probability that a public company can directly influence the value of its shares with its story and financial performance is 10%. Or less.

Perhaps far less, since even Passives are buying another passive instrument, SPY, over stocks comprising indexes.

So peg 5-10% of compensation to the stock.

It’s happening because it’s too hard to get in and out of stocks. What’s the SEC doing about that flaw? Nothing. They’re fixated on obsolete, anachronistic disclosures.

And these facts, and these two images, should preface compliance filings by public companies.  Every c-suite and Boardroom should be paying attention.

And why are we spending the same time, and ten times the money, courting stock-pickers if they’re buying SPY?

When I was the IR guy for a telecom, I traveled the fruited plain seeing investors. It’s fun! And back then, most of the money and the market’s volume came from stock-pickers. You could literally call on more investors and create shareholder value.

That market doesn’t exist anymore. Look once more at the images.  Passive Investment is quantitative. Fast Trading is quantitative investment with a horizon of a day or less, suchy as fractions of seconds. It’s 73% of trading in S&P 500 stocks.

Most of the money isn’t influenced by story. You can keep doing what you always have! But the data show it’s unlikely to produce returns.

Let’s be smarter than that! There are myriad ways for IR professionals to make their c-suites and Boards smarter market participants (ask us!).

And if we’re smarter, maybe we can mount a data campaign to get some of these anachronistic disclosure albatrosses off our backs.

The equity market is a machine full of closet-indexers. Let’s use that data not to stay in 1998, but to our advantage, public companies.

Constant Change

The SEC wants to save the little guy. Again. 

A number of you alert readers sent me this story (WSJ registration required but there are similar versions) about the Gensler SEC weighing changes to how trades from retail brokerages are handled.

For those new to market structure, the SEC has a long history of adding complexity to the stock market in the name of helping retail money that ends up instead aiding computerized traders and stock exchanges.

Would that we had less noise and more substance! But we need to first understand the problem. It’s that the stock market is full of tiny trades, and not that retail traders are getting hurt.

Meanwhile, this photo is not of market structure.  Normally in early June – for the bulk of my adult life – I’d be at the NIRI Annual Conference circulating with colleagues.

Photo by Tim and Karen Quast, Jackson Hole, June 2022.

I’d have to count to know for sure, but for most of the past 27 years I’ve been there.  We took a break and this year we’re in Jackson Hole, WY, and other spots in a big loop through WY and MT seeing the west (I’m writing Tuesday night in Billings).

We were in Yellowstone much of Monday covering more than ten miles afoot, riveted by the constancy of change in nature.  Some of it is predictable, like Old Faithful and the Grand Geyser (footage here).

A lot of it isn’t.  And you can’t manage it or direct it.

The point?

Stuff constantly changes.  It’s the most inerrant feature of nature. Change is integral to human nature, which animates the stock market.

Regulators are possessed of that same nature yet want to cast the market like pewter.  Create a model and force every free-moving thing to conform.

It’s most certainly not that SEC chair Gary Gensler is smarter than millions of self-interested participants.  No, regulators want to make a mark, the same as anybody else. 

Pharaohs in Egypt hoped for immortality through pyramids.  Carnegie built libraries.  You can go to Newport and see the edifices of the rich, built to last long beyond the builders.

As ever, I have a point about the stock market. The preceding SEC administration under Jay Clayton revamped the rules, too.

I discussed their final proposed rule, Regulation National Market System II – which I called Reg Nemesis II (see what I wrote about Reg Nemesis I here) – with SEC head of Trading and Markets Brett Redfearn, who described it to the NIRI board at our request.

That rule considered many of the same things Gensler is weighing including redefining the meaning of “round lot,” currently 100 shares regardless of price, to reduce market-fragmentation that harms investors of all kinds.

After all that work, the expended taxpayer resources, the studies and lawsuits and machination, it’s set aside because the new SEC wants to build its own pyramids.   

Okay, Quast, you’ve convinced me everybody wants an ovation. Your point?

The problem is the stock market is stuffed full of tiny trades that devolve purpose from investment to chasing pennies and generating data to sell.

Which in turn is the consequence of rules. I’ve explained before that the SEC’s paramount objective is 100 shares of everything to buy and sell, all the time.

Which is impossible.

I know. I trade.  Trades fragment more at exchanges than in broker-operated markets called dark pools.  Routinely I buy in a chunk in a dark pool and then watch my trades get splintered into 5, 7, 34, 61, shares at exchanges (especially the NYSE).

The exchanges pay traders to set the bid and offer, which snap at my order like piranhas, chopping it into pieces and pricing the market with it.

In Yellowstone, nature takes its course. It’s a marvel, cinematic artistry that takes one’s breath away.  It cannot be and does not need to be directed by humans. We observe it and love it, and it changes.  Some stuff like the Grand Geyser and Old Faithful, follow a clock.  A lot of things don’t.

The same is true of human commerce. The more the few machinate interaction into exceptions and directives and objectives, the less it works.  It should in large part follow its own course, with a clear boardwalk for traipsing through the geysers.

Put another way, rather than merchandising retail trades to build pyramids, we should insist on a single set of standards, no exceptions.  And let the game be played.

There are too many complex rules, too many exceptions.  That’s the real problem.  And so the market lacks the elegance of chance, the beauty of organic and constant change.

Weird

This is weird. 

I’m traveling to an actual business meeting, by aircraft, and I intend to wear a suit.

Illustration 155967106 / Dune © Rolffimages | Dreamstime.com

There are many things in our society that I had considered weird but these two were not among them.  It’s pretty weird seeing Will Smith slap Chris Rock, who took it with aplomb while the Hollywood audience weirdly applauded.

But that’s not what I was thinking about.

Currently among the weirdest – by no means alone – is the divide between what people think is true about the stock market and what actually is. 

Which I suppose makes it somewhat less weird that my suit-wearing face-to-face is with American manufacturing firms in Atlanta at the MAPI conference. That’s the Manufacturers Alliance for Productivity and Innovation.

I’ve been invited to talk about how Passive Investment profoundly shifts the center of gravity for the investor-relations profession, liaison to Wall Street.

Glad to see these companies caring about their stock market.

And it’s not ESG causing the big shift.  Without offense to those advocating the hot ESG zeitgeist gusting globally, it’s yet another way for public companies to do qualitative work turning them into quantitative trading products.

You may not like that characterization. Well, scores are quantitative measures. Score something, and somebody will trade that score against another – exactly the way sports athletes are, or wine-rankings are, or restaurants on Open Table are.

Long-only investment is qualitative, like writing an essay.

Well, get this.  Active Investment is almost 50% higher in SPY, the S&P 500 ETF, than it is on average in stocks actually comprising the S&P 500.

Public companies, it means stock-pickers invest more in SPY than in the fundamentals of individual stocks. That is a statistical and irrefutable fact.

The problem isn’t you. The problem is the market. 

SPY has a 50-day average of 1.2 million trades per day, and over $53 billion of daily dollar flow. TSLA alone comes remotely in range at $25 billion, half SPY’s colossus. AAPL is a distant third at $15 billion.

Public companies continue to do ever more to ostensibly satisfy what investors want.  And they’re buying SPY.

If the SEC persists in implementing regulations with no precedent legislation – which will mark a first in American history – soon you’ll face mandatory climate disclosures.

So, from the Securities Act of 1933 implementing reporting rules for public companies, through 2022, the amount of information issuers are required to disgorge has become a sandstorm right out of the movie Dune. 

And investors are just buying SPY.

That should exercise you, public companies.  You bust your behinds delivering financial results, blowing sums of Congressional proportion populating the fruited plain with data.

And investors just buy a derivative, an ETF with no intrinsic value or story or results.

Years ago we studied the SPY data, measuring creations and redemptions and trading volume in the world’s largest ETF. We found that 96% of it was arbitrage – aligning SPY with the basket of 500 stocks it tracks.

But because the amount of Active Investment is significantly greater in SPY than the average one of those 500 stocks, we know stock-pickers well outside the S&P 500 are simply using it as a proxy for bottom-up investing too.

So, what should we do as a capital-markets constituency? 

The first rule of holes is when you’re in one, stop digging.  If we want to dig something in, how about our heels?  The entire contingent of public companies should rise up and tell regulators to pound sand.

That you will no longer comply with any further disclosures until the SEC makes markets more hospitable to the investors we work our fingers to the bone to court.

Because it’s not working. 

Why?

The SEC has overridden the stated purpose of the law that created it – notwithstanding that Congress had no Constitutional authority to regulate financial markets in the first place because the states never delegated it by amendment to federal government – which is to foster free, fair and unimpeded capital markets.

Instead the SEC decreed that the purpose of the market would be a continuous auction. Creating prices. And so investors are forced to own things with enough prices to permit them to get in and out.

For stupidity, it’s right up there with Will Smith slapping Chris Rock.

But we’ve got ourselves to blame. Public companies have not cared enough about the market to even pay attention to how it works. So we have a market that sets vast numbers of prices but impairs investment.

If you want to know how the stock market works, use our Market Structure Analytics for a year.  See what really happens. Then you can fight back. Maybe you’ll be moved to storm the regulatory Bastille and bring an end to this aristocratic crap.

That would be weirdly and wildly and wonderfully beautiful.

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.

Cliffside

I took a screenshot yesterday at 2:22pm, on Feb 22, 2022. 

Sign from God? Turning point? Hogwash?

Those are better than most proffered reasons for the stock market’s moves.

Lately it’s been delivering pain. Blame goes to Ukraine, where the Gross Domestic Product of about $155 billion is 40% of Apple’s 2021 revenue. Way under Denver’s $200 billion GDP. A tenth of Russia’s.

Illustration 45324873 © Iqoncept | Dreamstime.com

Ukraine is not destabilizing global stocks. Numbers help us understand things.  The numbers don’t add up, without offense, for Ukraine.

So, why are stocks falling? Answering why is like explaining what causes earthquakes: We understand they’re products of mathematical facts insinuated into our dirt.

Well, mathematical facts shape equity markets too, and the construction emanates from the USA and its 40% share of the total global equity market.

Anybody remember the Flash CrashFlash orders?  Books were written. Investigations convened.  Congressional hearings held.  MSM’s good friend Joe Saluzzi was on CBS 60 Minutes describing how the stock market works.

We seem to have forgotten. 

Now the Department of Justice is probing short-selling.  The SEC is investigating block trades.

For God’s sake.

The block market that should be investigated is the off-market one where Exchange Traded Funds are created in huge, swapped block trades of stock without competition, taxes, or commissions. The SEC is fine with that. Approved it.

The short-selling needing investigating is the market-maker exemption from short-locate rules that powers the stock market.  Academic studies claiming clouds of short-selling around big declines lack comprehension of how the stock market works.

The SEC knows how it works. I doubt the DOJ does. 

Everybody wants to find that volatility springs from nefarious intent. Greedy people. Cheats.

No, it’s the rules. The SEC publishes data on cancelled trades – legal spoofing.  That’s the MIDAS system, built for the SEC by a high-frequency trader.

People have gone to jail for what’s a fundamental fact of market function. The truth is, most orders are cancelled.  How can you parse what’s legal or not when the market is stuffed with behaviors that if separated by label or exemption move from illegal to legal?

Something should be wrong, or not.  Don’t lie. Don’t steal. Don’t cheat.  The Ten Commandments are simple.

When you say, “Don’t cheat – unless you’re a market-maker,” your stock market is already a disaster in the making.  People won’t understand why prices go up or down.

Here’s some math.  The average trade-size in the stock market – shares trading hands at a time – is down more than 50% since 2016.  It dropped 10% just in the past 200 days in the S&P 500.

The average S&P 500 stock trades 100 shares at a time, data ModernIR tracks show. That’s exactly the regulatory minimum for quoting a bid or offer.

Meanwhile, the number of trades daily is up more than 20% from a 200-day average of 40,000 trades daily per S&P 500 component to nearly 50,000 in the last five trading days.

Oh, and roughly 48% of all stock volume the last five days was SHORT (vs about 45% 200-day average).

And the DOJ is investigating short-selling.

Combine stocks and ETFs and 90% of trades are cancelled. Over 90% of all short-selling is sanctioned, exempted market-making – firms making stock up out of thin air to keep all those 100-share trades happening.

The DOJ is searching for a private-sector speck while a beam protrudes from the all-seeing government eye.

Do we want a stock market that gives you 100 shares that might not exist? Or a stock market that reflects reality?  People don’t even know.  You can’t have both.  The SEC simply hasn’t explained to anybody this Hobson’s Choice.

The principal stock buyers and sellers embed their computers in every tradable market on the planet, and all the machines share instant information. They’re 50% of volume. That’s why equities rise and fall in relative global uniformity (not perfectly – there are always asymmetries to exploit).

Machines identify breakdowns in supply and demand and magnify them. Stock exchange IEX made famous by Michael Lewis’s book Flash Boys calls it “crumbling quotes.”  The stock market becomes like California cliffsides.  It…dissolves.

Investigations are wasted time.  Constant scrutiny of headlines and fundamentals for meaning behind the market’s moves is mostly pointless.

I’m not saying nothing matters. But the central tendency, the principal answer, is market structure.

I could also say math signals gains next, and also says stocks are down because momentum died in Jun/Jul 2021. Another story.

There’s just one thing wrong with the stock market.  Its singular purpose is the perpetuation of continuous activity.  When activity hiccups, the market crumbles like a California cliffside.

The rest is confusing busy with productive.

And that’s why if you’re a trader or public company in the stock market, and you don’t spend SOME time understanding how it works, you’re on that cliffside.

Mission SEC

Gamestop wasn’t our fault. 

That’s the conclusion of the Securities Exchange Commission in a 45-page report.  I’m reminded of Gulliver.

Not tiny people with tiny ropes tying down the giant SEC while it slept.  Satire. That the SEC exonerated itself comes as no surprise. Ask the Department of Flooding if it had anything to do with the failure of anti-flooding systems and the answer will be: Nope.

I’ve got just one beef with the SEC in this report, and read on, and you’ll see.  I commend the SEC for saying things like: To understand what transpired in January 2021, it is necessary to understand the market structure within which the events occurred.

We use the phrase “market structure” all the time.  Here, the SEC did.  Coincidence?

Illustration 94594512 / Markets © Idey | Dreamstime.com

Who is the SEC’s audience?  The public, yes. But I’m a market-structure expert. That memo is for market participants, not neophytes. Those who depend on the public equity markets. Such as public companies – who should possess the capacity to understand it (like alert reader Jay D. in New York City did!).

You do it right, public companies.  File your regulatory filings. Tell your superlative story. Meet financial targets, issue your ESG reports, hold your DEI teach-ins, put “sustainable” in everything.

Then your stock soars 500% and you don’t know why. Sure, up 500% is awesome but not knowing why is a condition that should never exist in a free, fair and open market.

Or worse, your stock plunges from $40 to $10 in a day, at the open, even though not a single stockholder sold.  That happened to AVIR yesterday. Sure, bad news on the Covid-19 front. And I can’t say no holder sold.

But isn’t the market supposed to prevent dramatic, reactionary moves in prices? We have a systemwide network of volatility girders instituted by the SEC to prevent midday panic.

Did you know your stock can trade when no holder buys or sells?  We’ll come to that at the end.  It’s how the $50 trillion construct of the US stock market clings together. And why Gamestop happened.

Let’s get to what the SEC said is necessary to understand. I’ll trim it because the memo is 45 pages long – terse for a government missive but I need 800 words for this column.

The SEC says retail trades proceed from a retail broker to somebody else for execution, report to the consolidated tape, and pass on for clearing, which can take up to three days.  Meanwhile in the options market there are a million securities, vastly more than total stocks, where the prices come from brokers and trades settle in two days or less.

How can derivatives change owners before the underlying asset?  Good question.  Unanswered.

And on page 11 of the memo is a painfully discursive paragraph on what traders may do with retail orders.  I’m condensing in Cliff’s Notes fashion: Market-makers may choose to trade with money that’s less sophisticated and avoid what’s more sophisticated, to reduce the risk of loss. And apparently it’s possible to easily segment these orders.

Got that?  I’ll dumb it down one step more, and this is my beef: The SEC is fully aware that some have a huge advantage over others.  Yet the SEC says to begin Section 2.2 that its mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Well, how can that be true if some know what others don’t? People have gone to jail for years because they bought and traded on what others don’t know. Here it appears to be happening willy-nilly.

Because the SEC needs an unfair market. The one we have won’t work if it’s fair. There is no other conclusion.

What about Payment for Order Flow, where retail brokers like Robinhood and Schwab sell trades to “wholesale” buyers like Citadel Securities and Two Sigma?

Wholesalers buy things only because they can sell what they buy at a profit.  Period.

The SEC knows it. The SEC knows some have better information than others.  And the SEC knows it exempts firms like Citadel from the short-locate rules under Reg SHO Rule 203(b)(2).

Because the mission of the SEC is to preserve the market. Which can’t hum continuously. Unless it’s gamed. So the SEC pays whomever it must with favors to see that it hums.

Sounds like politics.

As to how Gamestop happened and why no buyers or sellers are needed, see my Meme Stocks presentation.

Traders, you can’t beat the market if you don’t know how it works.  Public companies, we’re wasting time and money doing things that don’t matter.

The starting point is making sure our CEOs and boards know how the market works. We can help you begin this new mission.

Reg Efdy and Thee

The Securities and Exchange Commission is in danger of becoming the Dept of Silly Walks.

Let me explain why I’m calling the SEC Monty Python. And it matters to you, public companies and investors.

Speaking of disclosure: I’m on the NIRI National Ethics Council, and we’re debating this matter.  What I’m saying here is, as usual, my own view.

So back in the go-go late 1990s, “sellside” analysts like Henr

Courtesy Monty Python’s Flying Circus, 1970.

y Blodget and Mary Meeker were the superstars of research. Public companies could be seen groveling at sellside thrones.

And simultaneously, sometimes tens of thousands of retail investors would join a new-fangled communication tool public companies were using, the earnings-call webcast.

And insider-trading was the hottest of buttons for regulators.  They were concerned companies were telling sellside analysts and big institutional investors things before the little guys would hear them.  The disturbing spectacle of the Big Guys getting an edge over the Little Guys.

Nothing smokes the cigar of regulators faster than that.

So in August 2000, the SEC passed Regulation Fair Disclosure requiring public companies not to tell some people stuff that could alter valuation or stock-performance without telling everybody else.

In enacting the rule, the SEC said:  

As reflected in recent publicized reports, many issuers are disclosing important nonpublic information, such as advance warnings of earnings results, to securities analysts or selected institutional investors or both, before making full disclosure of the same information to the general public. Where this has happened, those who were privy to the information beforehand were able to make a profit or avoid a loss at the expense of those kept in the dark.

Step forward to 2021.  The SEC last week brought a Reg FD enforcement against members of the investor-relations team at AT&T for supposed material nonpublic disclosures to analysts and big investors five years ago.

AT&T is contesting these findings in a tartly worded missive.

So now we get to the Ministry of Silly Walks and how it’s dragging its gangly limbs about in comic fashion.  First, if it takes you five years to figure out enforcement is needed, you’ve already made a mockery of the process.

Now, consider the stock market in 2000.  Almost 90% of investment assets were actively managed – overseen by people finding what would set one company apart from another and lead to better investment returns.  And 80% of volume was Active. And market intermediaries like Citadel Securities barely existed.

And in 2000, stocks were not decimalized.  Markets were not connected electronically and forced to share prices and customers and stock-listings so that everything trades everywhere, all the time.

In 2021, about 65% of investment assets are now passively managed using models.  Over $5 trillion in the US alone resides in Exchange Traded Funds (ETFs), stock substitutes backed by cash and securities that trade in place of actual stocks.

And trading machines using lightning-quick techniques from collocating servers right next to the exchanges’ to microwaves and fiberoptics drive over 50% of volume.

And guess where selective disclosures and informational advantages reside now?  You got it.  ETFs.  And Fast Traders.  ETFs know which direction the supply and demand for shares is moving, and they transact off-market with a handful of Authorized Participants in giant blocks called Creation Units.

Imagine if big investors gathered with big companies and traded information in smoky backrooms.  It would at minimum violate Reg FD.  It would no doubt prompt outrage.

So, why is it okay for ETFs and their brokers to do this at the rate of $500 billion per month?  It’s an insurmountable advantage harming non-ETF fund managers.

Second, Fast Traders buy retail stock orders so us little guys can trade for free and in fractional shares.  But Fast Traders can see the limit-order pipeline. Nobody else can.  That’s material nonpublic information, and it permits them to profit at others’ expense.

Why is it okay for the quickest firms to have a first look?  Notice how the operators of big traders own sports teams and $100 million houses?  There’s a reason.  It’s called Informational Advantage.

Third, as I’ve said repeatedly, automated market-makers, a fancy name for parties between buyers and sellers, can short shares without locating them, and they don’t have to square books for more than 30 days.  As we described, it’s how GME went up 1,000%.

Finally, next week indexes and ETFs will have to rebalance, and a raft of options and futures expire. And about ten big banks handle all that stuff – and know which direction it’s going.

A handful have a massive advantage over everybody else – the very thing regulations are meant to prevent. Sure, we get free trading, cheap ETFs and the appearance of liquidity.

But it’s not a fair market – and that’s why this AT&T case is silly.  It’s cognitively dissonant and hypocritical to permit rampant market exploitation while culling a five-year old file from the last regime to score political points.

Reg FD is a quaint relic from a time that no longer exists.  Maybe the SEC should regulate to how the market works now?