By Pam Martens: April 21, 2014
Since the launch of the new Michael Lewis book, “Flash Boys,” at the end of March with wall to wall media coverage, including his pronouncement on 60 Minutes that the stock market is rigged against average investors, there has been a whirlwind of damage control.
The FBI announced that an investigation was already in the works, the New York State Attorney General is issuing subpoenas and a civil war (frequently not so civil) has broken out among industry titans staking out their media turf on whether the market is or is not rigged by high frequency traders. Not in dispute is the fact that these high frequency traders have armed themselves with superfast computers, algorithms and artificial intelligence programs, all of which the New York Stock Exchange and NASDAQ have obligingly allowed – for annual fees running into tens of thousands of dollars – to co-locate next to the exchange’s own computers so the high speed traders can jump in front of the less tech savvy traders and steal pennies from millions of trades each and every day – a loss of billions of dollars to pensions and ordinary investors each year.
Proposals for leveling the playing field for institutional investors and large traders have been publicized, but what about the small investor? What would it take to convince the average American investor that they can safely buy 20 shares, or 50 shares or 100 shares in a solid American company on a U.S.-based stock exchange without getting fleeced?
James Kidney, the former SEC attorney who caused a stir this month when it was revealed that he had criticized management at the SEC for policing “the broken windows on the street level” while ignoring the “penthouse floors” in a speech at his retirement party after more than two decades at the Federal agency, has a thought-provoking idea presented below.
Asking Capitalism to Cure Capitalist Woes:
The US Exchange, a Market for the Rest of Us
By James A. Kidney
James A. Kidney, Former SEC Trial Attorney
High-speed trading, synthetic credit derivatives and other risky Wall Street products are described as refinements of our capitalist system — or lamented as the inevitable product of emerging technology. But the system benefits traders more than real capitalists – those who seek investors on the basis of the merit of their products and services to customers. The response to the many problems posed by these new technologies, products and delivery systems is predictable: New statutes and rules, inevitably chewed into mush by politicians and lobbyists, and long delays in implementation by regulators. By the time these new rules are in place, Wall Street has found ways to circumvent them, requiring a new cycle of debate, lobbying and minimally effective rule-making in response to the next resulting crisis.
One possible solution seems to have been overlooked: Bringing capitalism to the capital markets. It is not that the trading markets have lacked opportunistic capitalists. Entire new trading platforms have been created to supplement or replace the traditional New York Stock Exchange, the NASDAQ and the old American Stock Exchange. Certainly, many new trading products have been invented. But few of these developments address any real need except trading itself. Let me post an example, simple and naïve as it may be, of how capitalism genuinely could improve the market beyond meeting the needs of traders themselves. The notion can at least be the start of something. But first, some background.
One of the more amazing and not particularly useful products of the digital age is “program trading” on the New York Stock Exchange and other exchanges which usually relies on “flash trading.” This usually means trading dictated by algorithms applying predetermined buy/sell formulas through computers, resulting in buying and selling securities in microseconds. Sometimes, the computerized trading merely sends buy or sell signals testing the market, not executing any trades at all. In any given week, the NYSE reports that program trades account for about 30 percent of all trading volume on the NYSE. Some other exchanges, including some you may never have heard of, such as BATS, rely even more heavily on program trading.
Program trading also has been a factor in the popularity among large banks, brokers and hedge funds for trading platforms known as “dark pools.” These platforms rely on secrecy to place orders for large blocs of stocks without disclosing the transactions to the larger market until they are fully executed. According to broker Rosenblatt Securities, these “off-line” platforms account for close to 40 percent of all trading on some days. An article last year in The New York Times (“As Market Heats Up, Trading Slips Into Shadows,” March 31, 2013), stated that one reason for the growth of dark pools is to avoid volatility caused by high speed trading. A large buy or sell order, even if executed over a full market day or days, could trigger flash trading algorithms, dramatically moving the stock price before a large order could be fully executed. Dark pools are intended to avoid this result by maximizing secrecy – hiding true supply and demand from the investing public.
Michael Lewis recently wrote a book about flash trading; this article was first written a year ago and offered unsuccessfully for publication. It has been updated slightly, but does not account for any information in Lewis’s book.
Speeds you are accustomed to on the internet, even when you use the office computer, are miserably slow for computerized trading purposes. A collection of exchanges in the United States and Europe have spent at least $2 billion in the last five or six years upgrading their systems so that literally thousands of trades can be conducted in the blink of an eye. The results have sometimes been disastrous, such as the troubled initial public offering of Facebook in May 2012 and the wild market swing caused by a software foul-up at Knight Capital in August 2012. High speed trading also encourages – and perhaps proves – the notion that the equity markets are no place for small investors like you and me to trade individual stocks.
Like Sisyphus repeatedly rolling his stone up hill only to have it roll back down, regulators struggle to address each new trick by Wall Street to make money off of trading that doesn’t add much or anything to the value of the economy, except the Wall Street economy. Here is Bloomberg News on efforts initiated last year to limit the damage from high speed trading: “Regulators have been fine-tuning systems for pausing trading since the so-called flash crash of May 2010 briefly erased $862 billion from equity markets. Two initiatives for curtailing volatility to be implemented April 8  for one-year pilots: a program known as limit-up/limit-down for individual shares and a refurbished system for halting all exchange-listed equity trading in U.S. securities and futures markets during periods of extreme volatility.” (“NYSE Plans to End LRP Curbs as New Circuit Breakers Enacted,” by Nina Mehta, Bloomberg News, April 2, 2013).
The same Bloomberg article quotes former SEC Chairman Mary Schapiro saying that “the initiatives we approved are the product of a significant effort to devise a sophisticated, yet workable and effective, way to protect our markets from excessive volatility. In today’s complex electronic markets, we need an automated and appropriately calibrated way to pause or limit trading if prices move too far too fast.” In other words, high speed trading is a market threat. But who would risk the ire of Wall Street (and politicians yelling about curbs on capitalism) by doing something simple, such as eliminating it? No. Instead, Rube Goldberg contraptions are invented in the name of regulation to be circumvented by Wall Street as soon as possible, requiring more contraptions – and more taxpayer money to create and enforce them.
High speed trading clearly has contributed risk to the market without much, if any, relationship to the quality of securities traded or any commensurate benefit to capital creation. High speed trading, like synthetic credit derivatives and many other risky trading products, are instruments to make money on trading per se, not through investments in companies that manufacture products or sell services. (Synthetic CDOs don’t invest in anything – they are just betting instruments). Lost in the greed of Wall Street institutions — from banks to hedge funds to old fashioned risk arbitrageurs — is the essential fact that trading is not itself capitalism. It is only a means by which capitalism is able to function. Trading is intended to allocate the assessments of investors about the caliber of companies whose stocks are traded, not the caliber of algorithms based on movements of a penny or less per share. When trading injects additional risk and uncertainty to the capital markets without any commensurate benefit other than to the trading itself, it loses its utility to capitalism and to the economic well-being of the nation.
One trolls the internet in vain for reasons why high speed trading is a benefit to anyone except traders — who make small amounts rapidly multiplied for each trade that amount to billions of dollars over the course of a year — and large hedge funds and banks acting on their own accounts, who have the funds to drive stock prices up or down in small increments, presumably for their own profit based on proprietary algorithms entered into a computer by highly paid “quants” and thereafter untouched by human brains. The usual defense to this madness is that the markets require liquidity, but there are few answers to why liquidity is required in milliseconds, or even minutes, or how such trading contributes to a reliable and stable marketplace for the trillions of dollars worth of equities traded each year and which, along with the credit markets, underpins the world’s economy. In fact, the argument is usually circular: High speed trading causes great market volatility which requires high speed trading to liquidate quickly in the face of volatility.
High speed trading was beyond the imagination of the stock brokers gathered under a buttonwood tree on Wall Street in 1792 who founded what later became the NYSE. It was even beyond the imagination of Wall Street traders in the 1960s, when brokerage firms were still processing trades by hand. The NYSE had to close down each Wednesday for several weeks to catch up with volume and to begin applying modern electronics to nineteenth century processes. Similarly, the crash of 1987 caused such heavy trading volume that the NYSE had to end trading at 2 p.m. for a week thereafter to allow extra hours to process the orders. In such “olden days,” settlement of buy and sell orders required five trading days, later shortened to three. How times have changed! For high frequency traders, a few seconds is far too long to execute a trade because it allows another trader’s algorithm to intervene and upset the economic logic leading to a small decimal of profit per share.
The nation’s chief securities regulator, the SEC, is attempting to deal with high speed trading in its usual way – monitoring and regulation. The former acting chairman, Elisse Walter, stated that “rather than just trying to reduce the impact of these disruptions, we’re trying to eliminate the causes by focusing on systems compliance and integrity.” Although Walter presumably did not mean to say so, a fair conclusion from her comment is that the SEC will be fighting the last war, not the next one.
Let us remind ourselves what trading of equity securities (i.e., stocks of companies) is supposed to be about. Companies, both new companies that don’t have much more than a great idea, and more mature companies that need to grow and expand their product line, need capital. One way of getting capital is to borrow it, which is one reason why we have credit markets. But another is to issue stock which, in effect, gives the public a chance to “own” a piece of the company. Although only the initial price of the stock goes directly to the company, the company has a strong interest in the secondary market for its securities. A strong secondary market stock price has many virtues for the issuer. It permits it to qualify for a more favorable interest rate when it borrows money. It allows the company to issue fewer stocks at a higher price when it returns to the equity market. A high stock price has significant reputational value and, since the 1980s, the price of company stock has been a significant factor in executive compensation. For these reasons and many more, a company has a strong continuing interest in the secondary market for its securities.
Any company, but particularly those perceived by the market as successful, has an interest in a safe, secure marketplace in which companies are assessed – and their stock purchased – based on fair evaluations of their products, their market share, their finances and their management. Investors have a congruent interest in an open, fair marketplace. The essential benefit of a functioning market is the allocation of capital based on investor perceptions of quality and risk fairly disclosed.
High frequency trading meets few or none of these goals of a capitalist market. Specific developments of companies are either ignored, or are reflected only by the penny movements of stocks in nanoseconds. The same trader may buy and sell the same stock many times during the course of a day or even in the course of a few hours. High frequency trading time is totally unrelated to the time constraints imposed on humans and on the companies they work for. Companies make major decisions over the space of days, weeks or even months. The results of those decisions are not reflected in earnings statements for many more months. New products require lots of real time to find markets and old products require at least as much time for the market to reject them in favor of a new flavor.
Judging corporate performance requires a much more leisurely market in which a real human has an opportunity to digest the latest corporate news or make a considered decision among several companies or industries, even in the absence of big news, before investing. The market for such considered judgments has been stolen.
Capitalism itself should provide a better way of making the market work for its intended purpose – distribution of capital to businesses offering products and services intended to create new wealth, and not just trading profits – rather than impose more regulation on the existing stock market. For example, capitalism could create an alternative type of stock market specifically for the careful investors who want to make money by owning a piece of a good company. It would require a new kind of security, one different from current common stocks in only one significant way. We could call these types of stocks the US Security – for both the United States and “us,” the folks who don’t make millions on Wall Street but wish to participate in the capital markets without being pawns of the large traders. They would be bought and sold only on the US Exchange, or USE, because the market will be specifically focused on the benefit to the country, not just of Wall Street.
The US Security would be based on a simple requirement: It could not be traded until some reasonable period after it was purchased. If I bought 100 shares of IBM US Securities, I could not sell before expiration of a minimal holding period, perhaps three trading days or five, recalling the old trade settlement periods. Thereafter, I could sell the security whenever I wished, but only to someone else who would have to hold it three or five trading days before selling it again. Specialist traders, whose job it is to maintain an orderly flow of trading, like the old floor brokers on the NYSE, could be exempted from the trading rule as long as it was for the purpose of maintaining order flow. An investor might avoid ruinous risk from sudden unexpected news about a security by being able to place a limit order at a fairly high delta, such as 5 percent below purchase price. But other than reasonable exceptions such as these, a US Security would have to be held for some human scale period before it could be sold. To enforce and safeguard these requirements, a US Security could be bought and sold only on the US Exchange.
Trading in street name might complicate matters slightly. But trades could be electronically tagged to forbid sale before a certain date three or five business days hence or if the price drops a specified percent below execution prices. The same technology geniuses that write software for algorithms and flash trading surely can find a way to apply these rules without other inadvertent disruption of trade practices.
Two requirements must be met if the US Security is to have any chance of gaining at least a foothold in the securities markets. First, major corporations would have to be willing to issue US Securities. This need not be difficult or expensive. The SEC could agree that existing registration statements need only be amended to include US Securities and corporations could rely on their existing prospectuses, quarterly and annual reports and other filings. Issuers should see that the US Security has many advantages, not least of which is reducing market volatility and uncertainty, and begin issuing such securities quickly. They might even offer investors the opportunity to exchange their existing stock for the new stock, probably a distasteful bargain for large traders and banks, but attractive to smaller investors who feel otherwise locked out of the market.
The second requirement is the entirely new stock exchange mentioned earlier, the US Exchange. Without it, Wall Street would make sure the US Security was short lived. The capital required for such a new stock exchange would not be great. Seats could be purchased by brokers who cater to smaller investors, such as E-Trade, AmeriTrade and Charles Schwab, as well as the large Wall Street banks. Although we are talking about creating a bit of a throwback to restore sanity in markets damaged by unwise high speed digitization, the emphasis is on unwise. There is no need to return to floor brokers and large granite buildings, the heritage of the NYSE. All trading at the USE would be online, through broker-dealers such as the aforementioned, and any other broker-dealer willing to abide by the exchange rules. Companies would be listed if they offered US Securities and qualified under the new exchange’s rules.
This proposal seems elegant in its simplicity. It would cure most of the volatility ills and risk of glitches in high speed trading, at little damage to the true needs of a liquid market in equities. Smaller investors could return to the market in individual stocks and not feel completely at the mercy of mysterious program trading taking place far from their view. Issuers could embrace the new USE and its propensity to restore thoughtful buying and selling of securities in human time rather than digital time. Eventually, the pricing of US Securities might vary significantly for the better from the more volatile securities now traded on the NYSE and other exchanges. It is difficult to see how the US Security and a slower market would damage the economy, except the economy of Big Wall Street, but Wall Street could join in the new issue’s success as long as it played politely. Very few new SEC rules would be required in regulating the market.
Of course the whole US Securities plan could fail even if it got started. A sufficient number of companies might not issue US Securities, possibly out of fear of offending Wall Street banks. Those banks and other big investors would discourage issuers from participation and take other steps to crush the US market before it could even begin. Some capital would have to be attracted to create the exchange, even with the built-in advantage of an existing internet structure. One can imagine myriad obstacles. But the US Security is only one possible answer to satisfy a need based on capitalism. The point is for entrepreneurs, corporations and large investors to begin thinking of alternatives to the existing market system which will return capitalism to its true purpose – to create new wealth, not just move around existing wealth – and to do so by attracting smaller investors to markets which are safe, sane, reliable and benefit the country. Responding successfully with new markets and products will have hits and misses, risks and rewards. That’s capitalism. Let’s try it.
James A. Kidney was a trial attorney in the SEC Division of Enforcement in Washington, D.C. for 25 years. He retired in March. His job did not involve writing rules and proposing regulations. The opinions expressed are his own, and do not represent any views of the SEC.