I hadn’t set out to become an active blogger and I don’t anticipate that I really will. But reading some of the recent commentary on market practices has me concerned, primarily because much of it is based on a limited understanding of how financial markets work. So I have decided to wade in with a few comments on the current debate.
Over the last 2 months there has been a noticeable “up tick” in attention to the structure of the US securities markets, calls for banning certain practices regulating others and investigating everything from specific practices to the overall structure of the stock markets.
The last two years have brought us some of the most turbulent markets in history, and the last year has seen a surge in populism and a tilt away from a view that unfettered free markets and towards regulation. So the focus on the structure and regulation of the US securities markets is not surprising. Nor is it a bad thing to take a step back and review the structure of our markets and consider whether they can be improved.
While I am a strong advocate of free markets, even the most ardent Chicago-schooled economist will admit that for markets to function effectively certain conditions must be met. Reaching back into the depths of my undergraduate economics, the neoclassical definition of an efficient market includes:
- Large numbers of buyers and sellers, that are free to enter and exit the market
- Goods are identical
- Information is perfect (accurate, widely disseminated, and timely)
- Transaction costs are zero
- Participants act independently
Of course we live in the real world, these conditions don’t always exist, externalities do exist, and so there is an appropriate role for regulation to ensure that real markets function effectively, to ensure fairness (which doesn’t necessarily equal a level playing field for all) and to ensure that whatever the rules are, they are clear and stable. In particular, in a world where banks have been bailed out with public funds and subsidized by cheap central bank money, it is time to stop kidding ourselves that our financial markets are pure free markets and shouldn’t be subject to reasonable regulation.
While a “comprehensive, independent zero-based regulatory review of a broad range of market structure issues, analyzing the current market structure from the ground-up” (as urged by Sen. Edward E. Kaufman in a letter this week to the Securities and Exchange Commission) could be beneficial to the functioning of the US markets, any review should be based on a thorough understanding of the investment process and how trading is used to support that process.
Unfortunately much of the attention to financial markets in recent months has reached hysterical levels, is based on a poor understanding of how financial markets work, and has conflated different trading tactics (such as high frequency trading and “flash orders”) and unfairly demonized legitimate and beneficial aspects of our market structure.
As our elected and appointed officials consider the shape of future regulation for the securities markets, I would encourage them to consider some of the following points:
- We cannot look at the process of trading in isolation from the broader investment process. Trading ultimately serves to support an investment strategy, and the goals of that investment strategy should dictate the trading tactics used to achieve it. A large fund management company may form a fundamental, long-term view of a company from considering research, meeting with and assessing the companies management, the markets it serves, etc., and may want to own a large holding in the stock. An index fund may need to buy a stock because it has been added to the target index. A hedge fund may need to sell a stock simply because it that stock is highly liquid, the fund has experienced large redemptions and needs to raise cash quickly. An individual may want to buy a stock because he believes that recent news is positive for the stock and he wants to get in before the price runs up. A trader may buy or sell a stock because he detects short-term imbalances in the market. All of these are different strategies, with different sensitivities to timing, price, quantity, and certainty of execution.
- Since different people have different objectives when they trade, those objectives are not always in conflict. i.e. Trading does not have to be a zero sum game where one party wins at the expense of the other. For example, many professional traders buy and sell securities using strategies that either arbitrage across multiple markets or securities, or attempt to predict the movement of securities, in order to capture pennies in profit. The accusation leveled at these traders is that they are, in effect, stealing pennies (lots of them) from small investors who can’t afford the investment in technology and who lack the access of the big boys. That would be true if the small investor’s objective was to profit by making pennies on every trade. But it isn’t. The small investor is typically buying or selling because of a longer-term view of the prospects for the security, or because they need to raise cash, or for some other reason. The small investor who makes a decision to buy or sell 1,000 shares of a small cap stock is more interested in the certainty of getting his trade done, and whether trade is done at $1.63 or $1.64 is (relatively) less important than the fact that the stock has traded as high as $3.75 and as low as $0.40 in the last year. In this situation the small investor benefits from the liquidity and the improved price discovery provided by the institutional traders, and in effect may “pay up” a penny but in return benefit from the liquidity provided by the professionals.
- The same is true for institutions as well, i.e. professional money managers (pension fund managers, mutual fund managers, etc.) are all consumers of liquidity, not natural providers of liquidity. This is why electronic systems such as Instinet, which was originally a platform solely for buy-side institutions, didn’t establish meaningful traction until they opened up to market makers, the sell-side, and other providers of liquidity. Likewise LiquidNet has built a nice business matching “natural buyers” with “natural sellers”, but that segment of its business appears to have reached inherent growth limits. So while buy-side traders might like the idea of trading with their buy-side counterparties, they recognize that to get a trade done they frequently will have to go to a broker or an exchange or some other system that allows them to interact with active traders. (Instinet used to have an “Institution Only” order type to limit exposure of orders only to other buy side firms, but most traders learned that if they wanted to get done now, they needed to expose their orders to the broader market.)
- This is not so dissimilar to other markets we are all familiar with. If I am selling a used car, I can probably get a better price from another individual than I will get from a used car dealer. But I may not be able to find someone who wants exactly my car, I may need to negotiate with multiple potential buyers, make myself and my car available to visit in my spare time, etc.. So I am willing to accept a lower price from a dealer in return for the convenience the dealer provides. The dealer makes a small profit (arguably at my expense) in return for committing some capital, incurring some cost of sales, and taking a risk on his ability to re-sell the car. Even in the age of the internet, intermediaries add value.
- While it might seem as if the definition of a good (or “best”) execution should be a trade done at the best publicly displayed price (i.e. the National Best Bid/Offer), this may not be the case. As a seller of a used car, I might be happy to take a price just under “blue book value” in return for selling the car right now with no hassle. Similarly, a trader trying to unload a large position in a stock may be happy to accept a lower price in return for certainty and speed, or simply because a trade now eliminates the market risk of getting a trade done over a period of days or weeks. RegNMS (which enshrined the NBBO as the criteria for best execution) ignores the institutional investor whose primary objectives may have more to do with getting a large volume of shares traded with minimal market impact. And it is very difficult to move large blocks of stock with minimal impact in a market where the available quantity at the NBBO is 100 shares! So different traders will naturally have different criteria for “best execution.” While the US was implementing RegNMS, the European markets were phasing in MiFID, the Markets in Financial Instruments Directive. Both have obligations for “best execution”. However, where the US regulation defines “best execution” as a trade occurring at or inside the NBBO, MiFID simply requires institutions to have a policy to achieve best execution and a mechanism to enforce that policy. The US definition is too narrow, but at the same time, the MiFID requirement for best execution is loose enough to drive a truck (or lorry) through. What is required is a regulatory framework that recognizes that different investors have different objectives, and allows for a market structure that enables those different objectives to be achieved.
- Because different investors and traders have different objectives and strategies, a single one-size-fits-all marketplace can’t accommodate them all. In the world of physical goods we have multiple markets: retail and wholesale markets, discounts stores and high end boutiques, etc.. In a recent article in Waters, Al Berkeley, chairman of Pipeline argues for a competitive market structure that provides 3 “distinct types of liquidity pools with three sets of rules of engagement” to cater to different trading objectives. I don’t know if 3 is the magic number, but it is clearly preferable to look at discrete market segments and offer trading venues optimized for those market segments than it is to force everyone into a one-size-fits-all definition of how to trade.
- While it may play well to the crowds, the notion of a perfectly level playing field for individual investors and institutions is flawed. This is partly because individuals and institutions have different objectives and are playing with different quantities of money. It is why in the physical world we have wholesale markets (that cater to volume buyers and sellers) and retail markets. But it is also because no amount of regulation will change the fact that professionals will always have more resources available to them to trade, whether that is market data, faster computers and networks, teams of PhDs to analyze the markets, or the information advantage that comes from having teams of professionals trading in many markets and sharing their insights and information with each other. We can regulate a perfectly level playing field, but if we populate that field with players from the NFL and some high school kids, the high school kids are going to get hurt!
- This leads to one of the most fundamental observations of all: Over my career I have seen a number of regulations adopted that are claimed to benefit the individual investor (RegATS and RegNMS being the most prominent.) When carefully analyzed, however, they are designed to benefit the individual day trader, i.e. the individual who actively trades stocks and cares about short term swings in the market. Every study that I have seen shows that such traders as a group under-perform the market, and significantly under-perform the market on a risk adjusted basis (and yes, they tend to be normally distributed so that some will randomly appear to be smarter than the average bear.) The individual is better served by taking a truly long-term buy and hold strategy, or by investing in index funds, indexed ETFs, or managed mutual funds.
- In practice, institutions, either through IRAs and 401Ks or through pension plans, already manage most individual’s money. Even hedge funds, which are widely perceived to be the province of a small number of secretive, Ferrari driving young hotshot traders (granted, there are some of those), manage a significant amount of money on behalf of institutions (including pension funds.) In short, most individuals have more money in the market through mutual funds and hedge funds than through individual stocks that are actively traded.
- Therefore regulation that is really intended to benefit the individual should recognize that the individual is best served (and is already served) by professionals acting on his behalf. And so a desirable market structure is one in which institutions (pension plans, mutual funds, and even hedge funds) are able to trade effectively. It may play well to the crowds to talk about secretive hedge funds and dark pools, until you realize that these vehicles were developed to cater to the needs of professional investors who, for the most part, are ultimately acting on behalf of individuals.
- We currently operate in a world in which there are many different places to trade a stock, including stock exchanges, ATSs, ECNs, and brokers who match orders internally. These are all interconnected by intermarket linkages, smart order routers, and data aggregators, and any pricing discrepancies are monitored and instantly arbitraged away by a group of high speed traders. This competitive market has driven innovation and reduced the cost of trading. Equally important, because of the competition for order flow, if any exchange or trading venue introduces a practice that is bad for its clients, those clients will quickly shift their order flow to other more attractive venues. The most effective tool to improve quality of trading therefore is transparency, not of clients orders, but of the business practices (e.g. order matching process) employed by these venues.
The structure and regulation of our financial markets can certainly benefit from a comprehensive review, which in any event will be healthier than a knee-jerk reaction to poorly understood trading practices. That review should consider that
- Different participants in the marketplace have different objectives and that all trades shouldn’t be measured by the same yardstick,
- A “fair” market may not actually be one in which there is a single level playing field, but one in which different venues serve different segments of the market,
- The best interests of the individual investor are likely to be different than those of the individual day trader and in fact may be best served by a market structure that enables institutions (mutual funds, hedge funds, pension funds, etc.) to efficiently invest on behalf of those individuals.
- Competition for trade execution has substantially reduced the cost of trading over the last 20 years. We should encourage continued innovation and competition in the markets.
In a future post I will share my thoughts on some specific market practices, including dark pools, algorithms, high frequency trading, flash orders, etc..
Proton Advisors 