January 18, 2023

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.

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