A Better Exchange

 

I read with interest David Brooks' op-ed piece in the Times, The Moral Power of Curiosity. It was about Michael Lewis’ new book, "Flash Boys.” I want to read this, having enjoyed (?) his previous bestsellers. The new book, like "The Big Short” focuses on a few insiders who figure out how things are working on Wall Street (or not). In "Flash Boys” one of the good guys, Brad Katsuyama decides to design an exchange where "market rigging” would not work. Why didn’t he shut up and make money like so many others? Wasn’t it all legal?

 

My question for the Forum: why doesn’t Congress immediately pass a few laws which will support such an Exchange?

Bart

 

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Last Sunday's New York Times magazine had Brad Katsuyama on its cover, and a main story of his exploits and interviews with the others who helped form the new exchange.  He was leaked off that his job at Royal Bank of Canada was being made difficult by the fast traders screwing around with him.  Whenever he tried to buy a big amount  or sell at a listed price, the price would move away.  The fast traders "spoofed" by offering to buy or sell, and when a large enough offer came back their computers dropped the offer within microseconds and returned immediately with a worse deal.  In addition, the big transfer shares for their customers without going to the markets at all.  The big banks still do, and anybody who uses one of them as a broker is guaranteed to lose several cents per shore on any trades.  The new exchange that Katsuyama and his partners from RBC built will allow only three options... and offer to buy or  an offer to sell at a started price, or an order to buy or sell at the mean of the last buy and sell offers, combined with a coil of optical fiber a few miles long that delays any responses by a sufficient fraction of a second that fast trading is physically impossible.  Any offer can be executed before it can be withdrawn.  If Congress doesnt act, their exchange will either drive the NYSE and others out of business of force them to install similar gadgetry. 

Jacques Read

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Congress won't pass such a law because they will get paid more for not doing it compared to doing it.

John Futhey

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The problem is not the laws, it is the technology and the attitude. The stock markets have a valid purpose in that they provide a place for investors to move capital to the companies they think will be most productive. The traders in the market also have a valid purpose, by speculating they provide liquidity to the investors. Insider trading, as properly defined, is the use of inside knowledge that an announcement is about to be made to profit by jumping the market. That is already against the law.

The insiders Lewis talks of (and I liked his first two books) in this case are not dealing in information about the company, they are looking at the trades another trader is making. I think I've mentioned it before, the stock markets have been "dishonest" since the Sixties in my definition. An honest market is one where a multitude of individual decisions comes to a value. In the mid sixties we had the academics seeking a quantification of value - they came up with stability of quarterly earnings growth. Problem there is that the criterion is invalid, a quarter is too short a period. I worked for a firm in the seventies that would pay overtime to get shipments out on the weekend at the end of the quarter so they could book them as sales in a bad quarter - and would hold shipments back at the end of a good quarter just to make that appearance of a steady growth of quarterly earnings. It cost the firm money, but enhanced the stock in the eyes of the academics. The other Sixties factor was the go-go fund, the Manhattan Fund under Gerry Tsai being the first. Use a mutual fund as a trading mechanism to beat the market instead of a long term investment medium. The fallacy there is that if everyone is trying to beat the market with massive funds then they become the market. By 1970 the funds were more concerned about finding out what the others were doing than evaluating long term investments. There is a parallel to the now illegal pooling of the Twenties - although that was collusion and this was competition.

The current scam is the leasing of high speed lines into the exchanges so that trades executed on one can be seen then jumped on another before the original trader gets through to them. This is "insider" at the trade level, not the investor level.

To me the problem is the entire idea of massive trading for profit - it is pooling in a new way. Computerized trading, based on market movements, is anathema to me. In the old days a floor trader on the NYSE didn't want to know what should happen, he just wanted to see what was happening. But he was an intermediary, he bought his inventory in round lots so that his firm could sell odd lots - his success was when his minute by minute inventory matched the orders coming into his firm (thin when there was selling, heavy when there was buying). But this wasn't massive trading, it was at the margin.

My old rule was that an honest market was about 80% investors and 20% speculation - I think it is now reversed, and the market dictates the price rather than the investment value. Our Carl Icahn has done very well by looking at investment value, as has Warren Buffet (although their approaches are different in many ways).

Glass/Steagal was a good law, but its repeal didn't cause a problem as it had been already effectively repealed by the Bank Holding Company Act of the Seventies.

This is off the top of my head, and I haven't fully thought out this new issue. But I think we need less laws on the details and a few simple ones on the specifics. It is too late tonight for me to propose them, but they basically have to do with the size of automated transactions (in relation to the outstanding stock). That would not limit a large buy or sell negotiated between stockholders off market. The also would go back to the basic principle of Glass/Steagal so that investment banks had to be partnerships with unlimited liability so that speculation would be with the speculator's money rather than corporate funds.

I'll drop it here for further thought and comment.

Best, Jon (Murphy)

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A simple answer from one who has dallied in the market for over forty years with little trades and smaller earnings, the politicians are too busy protecting their backends as they prepare for the next election just around the corner.  If the Tea Party doesn't have them scared, the NRA or the latest environmental cause keeps their eye on "the money" and not on the nation.  Greed and Self interest rule the halls of Congress these days.  There are too many politicians and too few statesmen for the good of the nation.   

That's my two bits (and only worth that at most) for today.  I hope to see you at the Reunions and would be interested in hearing more on the subject.   

Al Kissling

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Bart – You have touched a nerve.  I have a lot to say about HFT (high frequency trading) and have been saying a lot about it to many people in recent years.

 

Here’s my story:  I have always been interested in the why and wherefore of our equity markets.  Why do they behave the way they do?  Why does Black Swan theory seem so applicable to what happens from time to time our markets?  How does the changing constituency of the players change the way markets behave?

 

So when I realized a number of years ago that the majority of the trading volume in our markets was accounted for by HFTs, a group of firms that few knew anything about, and that at the same time the behavior of the markets was changing in ways that seemed to defy rationale explanation, I knew I had to find out what this HFT thing was all about.  By then I had a large, deep Wall Street network, so I started asking questions.  No one seemed to have answers until I spoke with a very good friend with whom I had over the years had many confidential conversations.  He had for many years been a key partner in one of the biggest Wall Street firms, one known far and wide for its trading acumen.

 

Even he knew little when we started to talk.  He knew the rudiments of how the HFTs operated but little more, and even I knew that by then.  What we wanted to know was just how much profit these guys were siphoning from other investors by front running them.  This guy is very well connected with some of the biggest, most clued-in and powerful hedge funds, so he called in a few favors and basically got a few people to say a few things that knocked our socks off.  He was told that these guys were making returns of 100 to 200% per annum (I am not sure this is accurate; it seems high to me but I hope the truth will now come out.  Maybe it is accurate due to the use of leverage).

 

My background as an active equity manager gave me insight into the business of trying to buy and sell large blocks of stock while making as little impact on the market as possible.  I knew that most money managers stayed fully invested, so when they wanted to buy stock in new ideas they also often had to also move large amounts of stock at the same time.  Often it was more important to raise cash in a hurry than to quibble over what then were eighths and quarters, or even points.  And often there might be a number of buyers competing to buy the same stocks, so here again it was more important to get position than quibble over price.

 

So I could easily see how effective HFTing could be.  But to be making profits of as much as $30 billion a year by some reports by front running almost all transaction activity on the exchanges?  I was shocked and horrified that the SEC was allowing this.  And I still am.  By my back-of-the-envelope math these guys have to be making a lot more than a penny a share on average.  Whatever they are making is coming right out of the pockets of other market participants and their beneficial interests.

 

Now that the cat is out of the bag it will be interesting to see if our regulators put a stop to it.  I can imagine many large brokerage firms will hate to see it go, especially if their own dark pools get closed down at the same time.

 

Eldon/Don (Mayer)

 

 

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 Jon, et al, it seems to me that a responsible lawmaker will provide a legal framework which permits those charged with the administration of the system to regulate trade. Those who participate should expect a fair transaction all other things being equal. If my broker knows something yours does not it may result in a greater profit when the transaction concludes. Technology, as Jon says has clearly entered the market big time. It can give some traders better information though "insider” information is illegal. We have put a few away for this, but not all who have indulged by any means. I don’t know any but I’m guessing. It does bother me (if Jon is right that the market is 80% speculation) that this is not a good thing. What bothers me particularly are the "advantages” that some traders have managed for themselves. Being able to negotiate a trade after the market has closed is one example from a few years back. I think that was found to be "inappropriate” if not illegal and no one served any hard time. As Jon points out the newest scam is "jumping the trade.” I ask you, does this make for a more efficient market?  If you were the Wizard of Wall Street would you put an end to it? If so, why isn’t there more protesting from our senators and congressmen? Is it less important than Benghazi? Now I have my copy of Flash Boys and am settling in, hoping to understand all of this better. Bart

Bart, et al., 

Better information is not "insider" information - although it is often considered such. There was a case some years back in California where a stock analyst specializing in insurance companies discovered what he considered to be fraudulent accounting practices in the industry. He reported this to the state insurance  commission and got a tepid response. He kept pressing his case with them for months with no results. Finally he sent out a letter to his clients informing them of the problem. He was accused of disseminating inside information, to whit - the information he gained through his access to the companies books. He had no more access than any other analyst, but he was able to see the potential problem and warn his clients (who paid him for his work). Despite the fact that he first went to the authorities and they sat on their hands he lost his license and was barred from the industry.

Another case was that of Thomas Lamont, chairman of Morgan Bank. He was on the board of Texas Gulf Sulfur and attended a meeting one morning. TGS said they were announcing a major ore discovery that day. On his return to his office he sent messages to his fiduciary clients to "keep an eye on the broad tape (the Dow/Jones news ticker) today". He did not mention the company, nor that he had been at a board meeting, nor any other hint as to what to look for. He was accused of disseminating insider information. The government's argument was that information, even if published, is not general to the public until the public has had time to absorb it. He was found innocent 18 months later, but unfortunately for him the finding was posthumous.

The cases are different, but have a similar theme. This is not a partisan issue, nor a recent one (Lamont's case was in the '70s). The government regulators feel, and have felt for a long time, that no one should have an advantage (and this applies to many things, not just investment). That, in effect, says that if I pay a talented analyst for his opinions I cannot act on them until the entire populace has the benefit of them. That is very different than the collusion involved when a real insider passes on specific information about an impending transaction or discovery. There is a fine line, some could disagree on the Lamont case and also the McDonnell/Douglas case where a trust officer overheard a conversation between corporate finance officers in the Chase men's room (he was in a stall, they were at the urinal). But there also arises the civil question of fiduciary responsibility to paying clients. If a fiduciary gets information, no matter how (unless it is in collusion or bribery), is he liable to civil suit by his clients for not acting on it? I don't know the answer, and I don't think there will ever be a true line drawn as each case has different merits.

With my apologies for rambling on I'll come back to Glass/Steagel. I'm with Bart and Paul Volcker (whom I lunched with often when he was an economist at Chase) on the separation of commercial banking from investment banking. But, as I said, the act was effectively repealed by the Bank Holding Company Act. Even now the banks aren't actually gambling depositor's money in their trading subsidiaries, at least not directly. But they are doing so effectively by attributing the capital reserves of the holding company to both operations. Not meaning to pick on CitiBank, just using them as the names work. We have the commercial bank, then CitiGroup, then CitiCorp (or is it vice versa). The funding isn't merged, but the effect is.

More important to me - and I'm going to beat this dead horse as it is a pet peeve of mine (Wm. Safire always said he wanted to buy a dog and name him Peeve so he could day "this is my pet, Peeve"), is the format of the investment banking companies. Traditionally the investment banks were partnerships. That started to change in the '70s and accelerated more recently as they became corporations. The difference is that a corporation, the modern heir of the "joint stock company" that was invented in the 15th C., has limited liability on the part of the owners (stockholders). Their liability is limited to their investment (the value of their stock). A partnership, on the other hand, is owned directly by the partners and their personal liability is not limited. If a corporation goes bankrupt the stockholders can only lose all their investment in that corporation, they cannot lose their other assets. If a partnership goes under and there are claims against it the partners are responsible for all those claims personally, including the loss of their personal assets not involved in the partnership. The lawyers among us may dispute my description in the details, but it is close enough in principle.

Some of the most egregious transactions of the recent crunch, and of previous crunches, have involved some very risky bets on the markets. I won't detail them, but could. In the days when the investment banks were partnerships they never would have been made - when that trader proposed his bet the partners would have said "no way". The lads at AIG (after Spitzer got rid of Hank Greenberg, who had a balanced approach) made committments in the mortgage market on bad bets - but they only lost their jobs, not the houses and yachts they'd bought with their bonuses. And that brings up another aspect of this. There is no excuse for a bonus system in a corporation, unless it is an incentive for good work. Wall Street bonuses were a tradition in partnerships, and a good one.

A partnership is not taxed, the partners are taxed as individuals. A partnership cannot allocate income to dividends and other expenses, the income over and above the direct expense of employee salaries is personal income to the partners according to their percent ownership. For that reason the annual bonus to the salaried employees is given. It is a way to share a good year with the employees instead of the government. This may sound to some of you like manipulation, but it isn't. "Back in the day" the employees of partnerships took lower salaries than they might get with a corporation in the hopes that they had chosen a good firm and would share in the good years. The bonuses weren't individual, they were a percentage of salary. I remember a lady I dated who was a secretary for Bill Morris's muni firm when he hit two big offerings (he started the use of a computer to scale his bids on a time value of money calculation). She got a year and a half salary as a bonus that year.

The key is that those who gamble should take personal liability for that gamble. And I'm not denigrating the gamble in the markets - there is a gamble in any venture. In the corporate environment the only gamble by the individual is his salary and job. That is a good thing, not all of us want to take the risk of our assets. A good bank, be it a country bank or a major one, is an established business with a certain format. The same applies to any other established corporation that changes with time (I say that as there might have been a General Buggy Whip corporation that could have lost out had it not changed to making cars). The corporation is designed to have an infinite life time as the share can be sold or passed on as inheritance - so it has no incentive to exploit short term gain to the deficit of the long term. That said, too many modern crony corporations (GE under Immelt) are looking at the short term profit to management. Engine Charlie Wilson is quoted as saying that what is good for GM is good for the country - but they leave out that he preceded that with what is good for the country is good for GM. What would have been good for General Buggy Whip would have been to gradually change their product.

OK, did it again and got into a ramble. Let us come back to the principle of investment versus speculation. Investment is the support of a project, the early joint stock companies included The Virginia Company (which lost money). The stock markets allow investors to get out of their investment if they no longer believe in it, or if they have personal need for the money back. Other investors may have a belief in the company, at the offered price, and buy into it. But there are not always investors to take you out of your investment - and that is where the speculator becomes necessary. He provides liquidity with his gambles. When the market is basically an investment market with the liquidity provided by the speculators it is a healthy market. Sadly our markets have become mainly speculative, in the sense that the short term gain has become king. If the speculators (the investment bankers who are dominated by their trading desk) are corporations then there is no personal liability. Note that I don't denigrate the investment banks who take positions as investors - our Bill Hambrecht took a long term position with Apple, Genentech and others before they came to market - they wouldn't exist without his "gamble", but it was a gamble based on an investment decision rather than a speculative one.

A final comment, the use of high speed computers to make large trades - be they the ones that have been done for many years by mutual funds and other funds or this new "jumping the trade" with a high speed connection - are not speculations in the proper sense of the word. The approximately five or ten major go-go fund managers in Wall Street in the late sixties and early seventies who drank together at the "in" bar (can't remember the name) didn't collude, but they tried to figure where the other was going. Investment became a thing of the past with most funds back then - but it still exists (Buffet and Icahn, and others - all in different ways).

Laws or regulations won't cure the problem, they will just provide more ways to get around them. Many years ago I had a rule I wanted to enforce. You can buy any amount of stock you want (as a percentage of the outstanding stock of the corporation) in a single trade or a close sequence of trades. But you can only sell a certain percent over a period of time. Not a practical rule, nor even necessary. Remember the Texas brothers who tried to corner the market (I think it was silver, but it might have been another commodity). They got to 80% (about), then went broke they found they couldn't control it.

Simple rule. Personal liability for trading firms (other than the dealers who buy inventory for the day to day transactions - but they aren't a problem). That is self policing. My old buddy Paul would probably agree.

Best, Jon (Murphy)