January 11, 2017

The Death Star

Last Sunday treated us to a picture-perfect Santa Monica day.

We were there helping investor-relations folks at the NIRI Fundamentals conference understand the stock market.

Of it, you probably won’t say to your CFO, “I bet you have no idea how our stock trades.” But it’s bad news if you’re asked by the CFO and have no answer.

So let’s talk about the Death Star. That’s what the industry bemusedly calls today’s trading environment.  The stock market is not at the corner of Broad and Wall or in the heart of Times Square.  It’s in New Jersey on banks of computers at several massive colocation facilities connected by superfast telecommunications infrastructure.

DeathStar

The Death Star (courtesy IEX, T Rowe Price)

The three big exchange groups today each operate four stock markets on those giant computer arrays. Suppose Nordstrom ran four stores in the mall rather than one. We’d think: “Why don’t they put the stuff in one place so customers can easily find it?”

Good question. We’ll answer it in a moment.

BATS Global Inc. is the largest stock exchange in the US now by market-share with its four platforms. Yet it lists only its own shares and exchange-traded funds. ETF trading is good business.

At two of them, traders are paid to buy shares, and at the other two they’re paid to sell (fees differ). This paying traders to buy or sell is called Maker-Taker/Taker-Maker.  Now, the Chicago Board Options Exchange is buying BATS Global.

The Nasdaq also pays traders one place to sell and pays them another place to buy. The Nasdaq is the largest options-market operator. Now the Nasdaq and the CBOE will both run large options/equities trading complexes with fees and credits that encourage traders to do opposite things in different spots, which is arbitrage.

The NYSE is owned by Intercontinental Exchange, and equity trading and listing are fragments of a global revenue colossus in derivatives helping financial players manage risk. ICE is also a huge technology and data purveyor.

By operating multiple platforms, the exchanges can set the best bid or offer, the market’s singular entry point, more often.  Each market then has unique data to sell to brokers and other exchanges, which in turn are required by rule to prove they’re giving customers the best prices – which means they have to buy the data.

There’s your answer. Exchanges operate multiple markets because they make money by changing the prices of everything and encouraging profits on differences. By promoting the arbitrage that vexes you in the IR chair, they sell data and technology.

The only exchange solely offering equity trading and listing that’s not intertwined with derivatives and influenced by trading incentives to set the bid and ask is the newest, IEX.  For our view on IEX and much more, catch the Chicago NIRI chapter’s webcast Friday.

The starting point for understanding any business is recognizing how it makes money.  The Death Star is an inferior capital-raising mechanism (it could be good again with rule-changes issuers should push).  Today, companies like Uber and Facebook grow giant on private equity and use the public market as an exit strategy.

Microsoft and Intel were like reality TV for stocks, taking everyday investors on the long and exciting process of growing in public for all to see and own. We can quibble over causality for this divergence. Our systems monitor the Death Star. It favors trading.

When you understand the Death Star, you arrive at this sort of answer for the CFO: “Since investors and traders can only trade at the best price, our price is most times set by the fastest machines. The big exchanges pay them to set the price so they have price-setting data to sell. They also encourage customers to engage in arbitrage.

“Occasionally active investors shoulder through the arbitrage.  Waves of asset-allocation flows can dominate.  A lot of the time derivatives lead because everybody is focused on managing risk, and in that process short-term divergences develop, which can be traded for profit. And this is why you need an IR professional more than ever.  Somebody has got to understand the Death Star.”

It’s easier to say, “I’m not sure but our story is central.”  It’s just not true most times.

Every IR gal or guy faces this moment of truth: Do I mail in the pat answer, or do I assail the battlements of convention and learn about the Death Star?

You can change your stars, as the Heath Ledger movie A Knight’s Tale asserts. Consistent metrics resonate with executives. If last week Active money led and Sentiment was Neutral, 5.0/10.0, and short volume was down, driving gains, they’ll want to know how those metrics changed this week. Measure and report.

They’ll look to you for the next episode of Star Wars, so to speak. That beats watching the stock or getting sent by them on wild goose chases for answers.  Embrace the change.

Speaking of change, we plan to launch in coming weeks daily sector reports highlighting key metrics – Sentiment, Key Behavior, Short Volume, etc. – for the eleven big industry classifications so you can see what’s happening in your group and how you compare.

There’s much more, so stay tuned! And don’t fear the Death Star.

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