April 18, 2012

The Emperor’s ETF Clothes

If somebody tells you he has a plan to improve your financial condition by borrowing your credit card and buying himself a bunch of stuff with it, be suspicious.

With that setup, we have a story to tell you. In a minute.

First, we said last week: “Overall sentiment is surprisingly good in money behind client shares. Stocks may recover quickly.”

Spot on. It shows how data-analytics help us understand market behavior. But remember our qualifier: “The DXY dollar index shows the same fissures it had last summer when the Euro nearly came undone. This currency crisis is coming back in weeks or months.”

We stand by that. The Infinite Elasticity Theorem posited by central banks is about to snap. It goes like this: “In times of crisis, expand the supply of money until the problem disappears under a pile of paper, because we can’t handle the truth, so we don’t want you to either.”

To our story. The Nasdaq has asked the SEC to approve its Market Quality Program, in which sponsors of thinly traded (under 2m shares daily) Exchange Traded Funds would pay market makers to trade the ETFs. The Nasdaq says these payments will stimulate trading in the ETFs, thus narrowing spreads, making markets efficient, enhancing market confidence and integrity, and boosting volumes in issuer components of the ETFs.

What’s wrong with this reasoning? Here’s a list:

-Paying market makers is illegal (see what our good friends at Themis Trading say). The rule requires amending FINRA rule 5250 prohibiting such payments. Creating exceptions to rules gave us the Tax Code. Do you want your public market to resemble the Tax Code?

 -ETFs are derivatives. Authorized participants create and redeem shares of ETFs. SEC rules allow ETFs to substitute cash and derivatives for components, and authorized participants – large brokers and institutional investors – can create or redeem themselves into and out of ETFs. What an ingenious statistical arbitrage tool! But it’s no help for aligning share prices with multiples of cash flow.

-Who benefits from statistical arbitrage? Exchanges depending for revenue and profits on data and transactions. Their top clients, the high-frequency traders intermediating trading in stocks, indexes, ETFs and the related options and futures that comprise the statistical arbitrage puzzle. Brokers (also big exchange clients). The SEC, which collects a Section 31 fee on each trade.

-The rule’s regulatory justification and functional purpose don’t match. We don’t fault the Nasdaq. It’s a for-profit business. But the Nasdaq filed the rule to compete for transactions in Tape B securities (exchange-traded products) and to drive transactional and data revenue and profits through arbitrage. Saying it does something else is misleading.

And saying something is good for markets does not make it so. In addition to the colossal central-bank currency footprint tromping through equities, the other chief distortion in your capital markets is statistical arbitrage. More is less.

If the stocks of public companies are the credit card, so to speak, that underpins every index and each ETF, then this proposal differs little from lending me your gold card so I can buy myself things because I told you it would be good for you.

That’s ridiculous. Public companies, speak up! Comment on the proposal. You’ve got till roughly May 2 to offer the SEC a letter. This is your market. Not some arbitrage playground.

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