Broken Markets or Broken Rhetoric?
James J. Angel, Ph.D. CFA Visiting Associate Professor
The Wharton School University of Pennsylvania
Associate Professor McDonough School of Business
Georgetown University [email protected]
About #GUFinProf • Studies financial markets and regulation
– Visited over 70 exchanges around the world – Former Chair of Nasdaq Economic Advisory Board – Public member of Direct Edge Board of Directors – 10 patents on trading technology – Warned SEC 5 times in writing in year before
Flash Crash that markets were vulnerable to major technical glitches
– Testified 5 times before U.S. Congress • B.S. Caltech, MBA Harvard, Ph.D. Berkeley • At Georgetown since 1991 • At Wharton 2012-2014 • [email protected] • 202 687 3765 • Twitter: #GuFinProf
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Key points • Lots of rhetoric about a “broken” market structure • Internal industry infighting has spilled into the public arena
– The media loves a good fight! • My take on it: Our markets are (mostly) better, but they are different than
before. – Different imperfections
• Fail in different ways • Need to work on these rough edges!
• What is broken – Need better containment against technical failures – The decline in the number of public companies: Need to experiment!
• Let issuers pick their own tick sizes – they have the incentives to get it right. – Regulation: Push SEC to hire experienced market people and move SEC to NY. – Volume drought
• Need more companies, more splits, longer trading hours for most active stocks.
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We are under attack.
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Some people just hate us.
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It’s not just from the tinfoil hats
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Public perception
• “Of 878 students at 18 high schools across 11 different states surveyed by the Financial Literacy Group, three-quarters of them said they agreed with this statement: ‘The stock market is rigged mostly to benefit greedy Wall Street bankers.’”
• New York Times, Andrew Ross Sorkin, – http://dealbook.nytimes.com/2012/08/06/why-
are-investors-fleeing-equities-hint-its-not-the-computers/
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Thousands of complaints to SEC
• http://www.sec.gov/comments/s7-21-09/s72109-42.htm
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This is not new
• “Meanwhile, individual investors are coming to the realization that the stock market is rigged against them.” – New York Times, January 17, 1988.
– “The money market is manipulated down just as the
stock market is manipulated up, the two manipulations being complementary and part of the some dark plot.”
– New York Times, The Financial Situation, November 20, 1904
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Misleading Media Reports
• http://www.nytimes.com/2009/07/24/business/24trading.html?_r=4&adxnnl=1&ref=business&adxnnlx=1255964744-hsGxQ2eMFrQcW2cnqFYOtw
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And the politicians rise to the occasion
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The regulators listen.
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And the regulators act
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So what’s going on?
• Are the markets really broken? • Or is it just broken rhetoric?
• Is it just the usual whining or is there really a
broken-market wolf out there?
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Whenever there is a meltdown…
• There is a call to “arrest the usual suspects”
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This is routine • Whenever markets go down…
– Anyone who made money gets blamed • Either for causing the problem • Or for profiting from it.
• Calls for reform – To fix problems – And to punish the bloodsucking fascist insects that prey
upon the people.
• This has been going on for hundreds of years – Amsterdam attempted to ban short selling soon after
modern equity trading began.
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Populist misunderstanding
• If I don’t understand it, it must be bad. • If I lost money in the market, and someone
else is making money, then they must have stolen it from me.
• And we want revenge!!!!!!!!!!!!!!!!!!!!!!!!
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Long standing populist mistrust of financial markets.
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The Al Berkeley Analogy
• Former Nasdaq President • Our markets today are like a 4-team soccer
game. – Buyers and sellers are competing with goals at
the North and South ends of the field. – Exchanges and ATS’s have goals on the East and
West sides. – You can’t tell the players from their jerseys. – They all want to control the ball.
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Commercial disputes
• Players don’t hesitate to lobby regulators and legislators to come to their side.
• The media love a fight – Happy to let us box in public.
• We put nasty names on things we don’t like – “Dark” pools, “naked” short selling, “naked” access,
“predatory” algos…
– Media picks it up and dark names scare the public.
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But this can backfire
• Reg NMS was the result of a previous NYSE lobbying campaign to protect the old trade-through rule which kept the ECNs from effectively competing in NYSE-listed stocks.
• But the SEC only protected “fast” markets. – NYSE forced to automate
• And forced to route orders to competition.
• Result: Massive erosion in NYSE market share.
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NYSE-listed market shares
NYSE
NYSE-Arca
NasdaqOMX Group
BATS
Direct Edge
Other
Total
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The allegations
• “Market fragmentation and HFT have scared away investors” – Co-location, HFT, “dark pools” allegedly steal
money from retail investors
• Excessive “fragmentation” leads to complexity – Complexity = risk
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Where’s the proof?
• By traditional measures of market quality, things are better than ever for the individual investor.
• So why is there so much grumbling?
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Our markets are mostly better now
• Lower transactions costs benefit retail investors.
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Executions are faster
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Market Order Execution Speed
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If our market structure is so bad…
• Why are other nations copying us? – Monopoly exchanges deliver monopoly service
and cost. – Competition improves the breed. – Need for-profit incentives to bring in real
competition.
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Institutional trading costs are low in the U.S.
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Latin America
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Canada UK Developed Europe ex-
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Institutional Trading Costs (bps)
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But… Some of the complaints have merit
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What was scary about the Flash Crash
• 1. Flash Crash revealed that market had no shock absorbers to prevent chaotic behavior. – Revealed that nobody had the big picture in mind.
• 2. SEC could not deliver a credible story in a timely manner about what happened. – Even though practitioners were telling them
within hours.
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Don’t be LULD into complacency
• Post Flash Crash reforms are steps in the right direction, but further refinement is needed. – Interactions of different circuit breakers not well
thought out! • Will break in some unexpected way when a real
tsunami of message traffic hits.
– Shock absorbers need to be based on data integrity as well as price.
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And there will be another incident…
• We just don’t know where or when. • Tsunamis of message traffic are predictable in
times of great uncertainty. • Market barely withstood “Twitter Crash”
– But what if it had been real news?
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Message traffic is still an issue that costs all of us money.
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Quotes per minute per security
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Quotes-to-trades are down from their peak.
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Other allegations have less merit.
• Excessive fragmentation?
• Do we have too many supermarkets?
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“Excessive” Competition?
• Our “open architecture” market makes it easy for new innovative entrants to come in. – Competition has improved the markets.
• Consolidation is provided by smart routers. • The network of all buyers and sellers is the
market, rather than any one trading platform.
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All HFT are not alike
• We need to get the message out that many HFTs do things that help the market – Market making – ETF arbitrage
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Regulation is broken
• Over 100 different financial regulators at state and federal levels – Overlapping jurisdictions – Turf battles – Contradictory regulatory philosophies – Dysfunctional bureaucratic cultures that value
paperwork over common sense.
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We have been penny wise and pound foolish in funding the SEC
• Cumulative SEC Budget in real dollars since 1934: About $21 billion
• Less than investor losses from one Enron or one Madoff!
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The Result
• Failing to fund the SEC has resulted in a financial police force that only writes speeding tickets on Main Street while the criminals go on stealing.
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Need for fundamental reform
• To change an organizations culture, need to change the people.
• Staff SEC with fewer lawyers, but more people with market experience.
• Every time the SEC testifies before Congress, they should be asked how many CFAs, MBAs, FINRA license holders, engineers, and IT professionals work for them in addition to JDs.
• How many have two or more years of work experience in the financial services industry?
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Move SEC to New York City • The SEC does not understand markets.
– Located in DC, far from the markets. – DC labor pool mostly government types.
• Move SEC to NY to attract more market savvy employees.
• Put in same building as other financial regulators to facilitate information and people flow among agencies.
• More jobs for NY & NJ Congressional Districts = more support for SEC budget. – Move as much of SEC as possible to other Congressional
Districts. – Leave only a few Congressional liaisons in DC.
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Our vocabulary is broken.
• Dark pools – Custom-display markets
• Naked anything • “Fragmented”
– Implies something is broken
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Our supply of new companies is broken.
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This is a crisis!
• Only 3,565 firms in Wilshire “5000” • As of March 31, 2013
– Used to have around 8,000.
• At current rate of decline, we will not have 500 public U.S. companies left for the S&P500 by 2060.
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Numerous contributing factors
• Litigation mess – “If I go public, I get sued.”
• Compliance burdens – Sarbanes Oxley, etc.
• Market structure – Old NASDAQ very different from old NYSE – Wider spreads provided financial incentive for
industry to market smaller stocks – Now we have almost no differences between the two
exchanges.
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We need to experiment!
• Industry and regulators need to be open to different ways of trading small stocks.
• Sponsored liquidity – Direct payments from issuers
• 12b-1 style fees? – 1 to 5 cents a share fee – Set by issuer – Could be used to pay for
• Market making • Research • Commission-free trading
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Volume is broken. Why?
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Average Daily US Equity Share Volume
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Many reasons for volume drought
• Post-crisis return to normal – Uncertainty leads to high volatility and volume – Low VIX = low volume
• Shake-out in the HFT space – Competition has shrunk returns to HFT
• Loss of “investor confidence”? – Media narrative
• Fewer companies
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To increase volume
• More companies • More stock splits for high-priced stocks
– Over $100 stocks have more volatility than they should.
– NYSE and NASDAQ should stop charging fees for splits. • Extend trading hours in most active stocks
– Already good enough liquidity in many active stocks in extended trading like BAC.
– Start with Dow, Nasdaq100, S&P100 and largest ETFs & ADRs.
– Extend to 5PM ET and see what happens.
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Summary
• Our markets are not “broken” but they can be improved. – Need better containments for technology failures and
data overloads. – Need willingness to experiment with different market
structures for small-cap stocks • Let issuers pick their ticks • 12b1 fees for equities
– Need more experienced regulators • Push SEC to hire experienced market plumbers and move to
NY.
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