October 13, 2010

What Should Your CFO Say About High Frequency Trading?

Boy, when it rains, it pours. Three years ago when we began grousing about how Reg NMS was turning equity trading into a foot race, people thought we’d been hitting the Hookah. Now it’s on 60 Minutes.

Along with Larry Leibowitz from the NYSE and Minoj Narang of Tradeworx, 60 Minutes interviewed Joe Saluzzi from Themis Trading (read their white papers about trading). Joe was on my panel about modern trading at NIRI National in 2009. Few people are better at explaining the peccadilloes of a market structure based on price and speed.

Here again is the problem, simplified to its most basic elements: Trades must meet at the best bid or offer. The participants able to get to the price fastest will always set the price. And because the exchanges and regulators alike have embraced a “maker/taker” model in place of the old auction and automated quotation systems, transient money is always setting your price. Yes, it requires the presence of something else underneath it, as the Flash Crash illustrated. But the structure, not the behavior, is the problem. The behavior is precisely what one would expect from the existing structure.

We think the solution is elementary, and we’ll come to it shortly. IR folks, here’s where you can exercise leadership. Investor Relations generally thinks and acts as it did before the Order Handling Rules forced exchanges to display prices from other markets, and before the Spitzer Settlement turned the sellside into information technology departments for the buyside, and before Reg NMS turned everybody trading equities into speculators.

Now at least, we realize something’s awry. Investment behavior isn’t setting stock prices often. In fact, value investment behavior prices according to criteria that are diametrically opposite of price and speed. But in order to buy shares, value buyers must abandon their core investment philosophy and act like intermediaries, racing from one minute price point to the next. In a sense, they’re forced to speculate on small moves.

The general posture of investor relations and corporate communications is to avoid discussing the markets. Well, these are our markets too! The SEC Acts – flawed though they may be and needing redacting – codify capital formation as the principal purpose. The acts require fair treatment for all constituents, and that means issuers and investors too, who are unconcerned about the number of price points between the bottom and the top of the book.

I’ll give you an example. When I first sat down in the IR chair in August 2001 at Surewest Communications, its stock listed on the bulletin board traded about 1,300 times… per month. Price was about $40. Compared against financial metrics such as pretax cash flows and earnings-per-share, it was a fair valuation.

When the stock moved to the National Market System, it soared to nearly $60 per share. When Worldcom, a giant and distant peer, filed for bankruptcy protection, it retreated nearly to $20.

The point is that the national market system and its relentless appeal to speed, price and trends, did not help the investors of Surewest. In hindsight, it might have been better to trade 1,300 times per month, with a value correlated to financial performance. The company had little more in common with Worldcom than a “telecommunications” tag.

IROs, CFOs, and CEOs, now is the time to voice concern about a structure created by regulators that impedes the formation of capital and disadvantages long-term holders. If you don’t, it won’t change, because the parties making the rules benefit from the existing structure.

Which leads us to our simple solution. It’s bothersome to me that, here in the US at least, our first response to a problem is to cast about for things to prohibit. Our governmental philosophy, which we seem to ignore when problems arise, is about unimpeded life, liberty and pursuit of happiness. Do we follow the SEC acts of 1933-34? One begins by declaiming the centrality of capital formation; the other enjoins against impediments to free markets and unfair advantages for some participants at the expense of others.

And what do we have? A capital market where Mail.ru, the giant Russian impending IPO, chooses London over New York. One in which price and speed horn out every other value metric, thus ensuring that only the fastest can play well.

The solution? Remove the price controls. Machines depend on patterns. Let them trade. So long as any other value metric can also play fairly. Machines using scraps of liquidity moved at great speed cannot trump a buyer placing an order for 500,000 shares $0.25 ABOVE the last price.

An unimpeded market would bring price and value back into correlation. The marriage of speed and price would no longer be the decreed, uniform denominator of every equity trade. Beauty would be in the eye of the beholder, as it should be.

Things will change when public companies speak up. Look at Joe Saluzzi, one trader at a small firm in New Jersey. He spoke up. Ears are open. Where is our Joe Saluzzi from a public c-suite?

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