September 30, 2015

The Long Slide

Autumn lavished Chicago and Boston in the past week, where we were sponsoring NIRI programs. While nature celebrated the season, stocks did not, continuing a slow bleed.

In Chicago I spoke on the structure of the market today, how the liquidity is one place and the prices are another, and forcing them together gives arbitragers control.

Let me explain. The roots of both the NYSE and the Nasdaq trace to brokers. In 1792, a group of them decided to throw in together, agreeing to charge a minimum commission so as not to undercut each other on price, and to go first to the group when looking for buyers or sellers, creating a marketplace – aggregated customers. It became the NYSE.

In 1971, the National Association of Securities Dealers took a page from The Institutional Network (Instinet today, a dark pool owned by Nomura) and created an automated quotation market for its members to post buy and sell interest.  It became the Nasdaq.

Both exchanges operated one market each for equities. Both markets were comprised of the customers of the brokers belonging to them.  They were bringing buyers and sellers together – that’s the definition of a market.

Today the exchanges are owned by shareholders and the markets they run are not predicated on underlying conglomerated buy and sell interest from customers of brokers.  Rules give these markets, the exchanges, authority to set prices. The liquidity – shares owned by investors and brokers – is outside the market now.

How to get the liquidity over to where prices are? Pay traders to haul it.  If you’re a top-tier maker of Nasdaq volume, meaning your firm is bringing shares for sale to the Nasdaq equaling 1.6% of total volume, you can be paid $0.30 for each hundred shares you offer for sale.  At current volumes, firms in that bracket can make $86,000 daily for doing nothing more than moving shares from one market to another.

But there’s more. Traders earn payments for selling shares at the main Nasdaq market.  They’re conversely paid at the Nasdaq BX, another platform (formerly the Boston Stock Exchange) owned by the exchange, to buy shares, about $0.17 per hundred shares.  So traders can earn money both buying and selling shares.

Why?  To set prices. If all trades must occur between the best national bid to buy and offer to sell, and the exchanges – the NYSE does the same thing, as does BATS Global Markets – can pay traders to set the bid and the offer with small trades, then other trades by rule are drawn there to match, and the data from these trades becomes a valuable commodity to sell back to brokers, who are also required by regulations to buy it in order to know if they’re providing customers the best prices.

This is how stock markets work today. Exchanges pay traders to set prices in order to draw out orders, and then they sell the data generated from these trades, and sell technology services so traders and brokers can access prices and data rapidly.

It’s the opposite of the old market where brokers set minimum commissions and gave preference. Both those are against the law now, and the market is fractured into 50 different pieces – stock exchanges, broker-operated “dark pool” markets – and is really about setting prices and generating data.

Volatility results from one thing: Continually changing prices. Why are prices in flux?  Rules require eleven different markets to pass orders to each other if they don’t have the best price, and these markets are paying traders to constantly change it. All the trades at broker dark pools must match at prices set by exchanges, so they are continuously morphing too.

According to data from S&P Capital IQ reported in USA Today yesterday, 86% of the S&P 500 (430 of 500 issues) is down 10% or more. A quarter are off at least 30%.

Suppose you’re a big money manager like Blackrock and investors have been making redemptions for days or weeks, yet every time you sell some shares, the market shudders because all the prices race away from you, and down.

You try to control it by leaking out, leaking out, because nobody wins if prices implode when you sell.  Months ago we theorized after studying market structure for now over ten years that when the next bear market developed we’d see a long slow slide because there’s no efficient way to move money of size in the current structure (a disastrous design for anyone who gets supply, demand, scarcity and choice – basic economic concepts).

We’re in it.  The only question now is the length of the slope.

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