In the "state your conclusion upfront department," the Senate Permanent Subcommittee on Investigations has scheduled a hearing for June 17 titled "Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Stock Markets." They join the Securities and Exchange Commission, the FBI, the Justice Department, the Commodity Futures Trading Commission and, inevitably, Eric Schneiderman in uncovering what the New York attorney general calls "this new breed of predatory behavior."
Too bad none of the investigations will figure out that changing one word in a federal regulation can fix all this. Because none of them understands the old Wall Street adage: "On Wall Street, everybody gets paid."
Follow the money: In an initial public offering, the investment bankers get 7% underwriting fees, and the funds buying the newly issued shares get a 10%-15% first day trading pop. Mutual funds holding the stock charge 1%-2% annual fees, and hedge funds keep 20% of their upside. Stockbrokers sometimes collect commissions, though that's tougher in the days of $8.95 trades from discount brokers. And yes, stock traders need to get paid too.
Being a New York Stock Exchange specialist—each stock had one—was a lucrative business because there is information in every trade. Like Nasdaq market makers, they didn't charge commissions but instead would keep the spread, or the difference between the bid and the ask price, measured in quarters (25 cents) and eighths (12.5 cents). And specialists were notorious for front running customers. Simply put, if they didn't like the spread on a buy order, they would buy shares themselves and then raise the price of the shares they had to offer, knowing there was a buyer in the market. At a cocktail party many years ago, I asked a specialist about this and he told me, "You big investment banking guys shouldn't worry about it, we need to get paid too."
Adding insult to injury, spreads shrank to almost nothing after decimalization started on April 9, 2001. Even spreads of 1/16th or 6.025 cents were too large and we quickly moved to a penny. Trust me, it's hard to get paid trading for a penny spread.
Electronic trading was considered more efficient and even more honest. So in 2005 the SEC's Regulation National Market System or Reg NMS began encouraging it. At the same time, Wall Street firms stopped putting up their own capital or liquidity to facilitate trades because they couldn't get paid enough to bother. Over time they created their own electronic trading venues known as dark pools, to try to match customer buy and sell orders, but with little success until they let high-frequency trading into the pool.
Typical of most regulations, Reg NMS has had many unintended consequences. The main culprit has been NMS Rule 611, known as the Order Protection Rule. Due to expensive lobbying by existing exchanges, the rule requires trades to take place at the "best price." Sounds fair, but these two words sparked, as exposed in Michael Lewis's "Flash Boys," a massive spend on servers and fiber lines by high-frequency trading firms.
This is hard to explain in a sentence, but let me try. High-frequency trading firms would post the "best price" for every stock and then when hit with a trade, knowing there was a buyer in the market, take advantage of the fragmentation of exchanges and dark pools and latency (high-frequency traders can get to an exchange faster than you) to buy up shares from other HFTs or from Wall Street dark pools, and then nudge the price up and sell those shares. In other words, front run the customer, just like the old NYSE. My guess is they make about half a percent a trade, or about the same as in the old days of a 1/8th of a dollar spread on a $25 stock.
In other words, in an era with no spreads or commissions for trading stocks, high-frequency trading is just a complex system to move the price of a stock in order to get paid. As dark pools discovered, no pay, no trade.
This can't and won't stand. It's sleazy and maybe even illegal, akin to nanosecond-scale insider trading. We can fix this with the stroke of a pen by changing NMS Rule 611 to read "best execution" instead of "best price."
If you are trying to buy 100,000 shares, an offer to buy 100 shares at $20 looks good, but it isn't if the price gets bumped by high-frequency traders to $20.10. Much better is an offer of 100,000 shares at $20.05. This offer is not the "best price" but certainly the "best execution."
Another action plan is to move to nickelization, with five cent spreads for blocks of 10,000 shares or more. Along with best execution, this would instantly see a return of Wall Street firms putting up capital to facilitate customer trades, because . . . they can get paid doing it.
Should we even care? I always felt that trading is just plumbing. Real value is added elsewhere on Wall Street. The risk is not that the markets are unfair, but that markets don't function and things start to back up.
Remember, it was as early as 2006 when the marks, or mark-to-market pricing, of Collateral Debt Obligations were wrong because they didn't trade much and we saw almost two more years of creating new mortgage derivatives that never would have existed if they were trading at correct lower prices. The financial crisis was mainly driven by the drop in value of mortgages from these last two years. Markets arealways about access to capital—feed the stars and starve the dogs. It is well-functioning markets, more than management or government, that yell stop and eventually whack the stock price of bad ideas like eToys, Enron and mortgage generation.
I have no doubt that congressional grandstanders will force regulators to cripple high-frequency traders—even turn them into exchanges and overregulate them—because, well, in Congress, everyone gets paid. But they risk damaging truly functioning markets if they don't get the rules right so that someone can get paid by trading.