April 14, 2010
In the 1980s and 1990s a big word was passed around on college campuses and in corporate seminars: "disintermediation". It referred to cutting out the middle man. This was deemed to be good, and leading to lower retail prices and increased market efficiency. SEC rule 612 has either intentionally or otherwise created a perfect platform for a class of institutional middlemen to collect profits systematically, essentially without risk. The system is implemented on high-end computers connected by close-proximity gigabit networks, running trading algorithms on flash-trading platforms, and intermediating sub-penny trades. They are large, and net harmful to the retail traders and investors "behind" the NBBO, and do not add liquidity to markets. Many traders and investors reduce the liquidity they provide intentionally, after realizing they're being gamed and harmed by the system.
The government in general may not think it's in their interest to care about the health and well-being of traders. But it is. There is a lot of discussion about aging of the population and retiree's meager finances. The government should want people to finance their retirements independently, so that they will be some percentage less dependent on Social Security. Trading and investing are ways to accomplish that.
Social Security is in crisis, headed for broke, and resembles a basket of IOU's because Congress had raided it, and turned it into, some say, the biggest Ponzi scheme the world has ever known. It was not so long ago during the Bush Administration that we were discussing allowing workers to keep a portion of their Social Security payments private. That didn't fly, of course, because Congress wanted the (use of the) money first. "Too much risk" some legislators said. Well, I'd rather risk not having some capital than do without it as a certainty. If the US government spends itself into inflationary oblivion and I still get my nominal Social Security amount, that's doing without the value as a certainty.
Today there are more investment vehicles and products, more investor and trader education outlets, and more trading platforms and tools than ever before. But the market for retail traders has been substantially ruined by the strange phenomena of flash trading, dark pools, and sub-penny trading rules. We can see the expected results of these market distortions with certainty: Reduced liquidity, muted trading volumes, a higher percentage of trading volume in dark pools, and consolidation among players in the brokerage and investing industries. The liquidity and capital markets that wither today will result in less wealth creation, and specifically less employment, tomorrow. So those who pursue better employment statistics should consider carefully what people who understand capital markets say.
We should recall the original reason for the existence of a stock market. It is to enable companies to raise capital that they could not otherwise raise in the same timeframe to invest, take risks, and create wealth. And this happens regardless of the time that an individual trader or investor holds a given stock. Capital is capital, liquidity is liquidity, and the length of time a share is held averages out over time.
Even with efficient and fair capital markets, the US faces a challenge in getting back to good employment numbers. We are reminded that this was the first "SAP recession" where smaller and mid-sized companies had ERP systems in place, and could observe the efficiency effects of reducing employment and inventories as they happened. Some of the corporate fat that was worked out is never coming back, because how the companies function has changed. Add to that the effects of continuing globalization, and we will have an ongoing problem finding gainful employment for many, especially those without high-school education and technical skills. If some of them can be traders, that's a good thing. For others, we'd better dust off Milton Friedman's old books and reconsider the negative income tax for the long term. That's unless someone has a better idea.
I've outlined the present and future reasons to keep our capital markets fluid and efficient. And regardless of what some lobbyists for brokers will tell you, having the "middleman" doing sub-pennying is not helpful. The firms doing the sub-pennying and claiming to improve executions are nothing but middlemen, and are hurting trading and investing, not helping, as Dennis Dick has shown. One indicator of how sub-pennying is good for institutions rather than investors and traders is their cries of protest at the thought of shutting the party down. Hear them squeal 'n' squawk
Lastly, since the crisis began unfolding, a lot of people who really don't know what they're talking about have been saying and implying all sorts of bad things about speculators. They say buying and holding for the long term is somehow better than those "evil speculators" who are in and out quickly. "Speculation" is not a pejorative word it's a neutral word. Let's go back and examine its etymology.
A couple of dictionary sources say that "speculate" is from the 16th century Latin word speculari, which means to spy out" or "examine". Words from this root include the Latin "specere" (to look at), which became specimen spectacle, spectacles (glasses), spectator, spectacular, and others.
So, the speculator observes, spies out, conjectures about the trade, takes a risk, and pursues profit.
Every player in the market takes risks, as we've seen written large since 2007. We all can just choose our level of risk with the best information we have. Every player is in the market to make a profit, regardless of the time frame. And profit isn't evil either. On the other hand "illegal greed" that causes distortions in markets is not good. These trading rules enabling flash trading and sub-pennying that distort and undercut the NBBO and thereby drive liquidity from the market are not good either. If you want to reduce outsized profits and bonuses at some Wall Street institutions, why not start with eliminating Sub-Pennying? Let them make their money the old-fashioned way, by providing services and trading on an even playing field with the rest of us
Thanks for reading.