SEC Must Put a Stop to Casino Markets
Leon Cooperman, Sal Arnuk and Joseph Saluzzi
September 24, 2012
A little less than 2,000 years ago, the Great Fire of Rome wiped out nearly three-quarters of the city. It was widely rumoured that Emperor Nero fiddled while his city burnt. A similar story may go down in history with our equity markets. Regulators have done little while recent events have wreaked havoc on what had been the best source of capital formation and creation in the world.
On August 1, Knight Capital’s rogue algorithm tore through the market for almost 45 minutes. Another episode – similar to the Madoff Ponzi scheme, the Flash Crash of May 2010, the BATS IPO and the Facebook IPO – that has devastated investor confidence and trust. How many more events do our regulators need to see before they recognise there is a problem?
In 1994, an academic paper titled “Why do Nasdaq market makers avoid odd-eight quotes?” found substantial evidence, albeit only circumstantial, that market makers were colluding to keep spreads artificially wide. The paper caused an immediate response from Washington. Wall Street firms were fined millions of dollars and the Securities and Exchange Commission embarked on a decade of new regulations. This culminated in July 2007 when the uptick rule for short sales was eliminated and Reg NMS, an attempt to modernise the structure of the national markets, was implemented.
The SEC hoped these new regulations would increase competition. Indeed, spreads have narrowed in the most active stocks and commission rates have dropped, but there’s no free lunch. Due to a lack of economic incentives, traditional market makers, who used to act as shock absorbers in times of volatility, have exited the business, only to be replaced by “automated market makers”. Their operating model is based on paying brokers to direct trades to them – called “payment for order flow” – and then using powerful computer systems to make a small profit per share on turnover of these trades.
Rather than helping customers achieve best execution, automated market makers use these orders to trade for their own account. They have little or no obligation to facilitate trades when times get tough. Moreover, the lack of spreads has caused many broker dealers to exit the business of underwriting IPOs, leaving a void in our economy.
The result is the fragmented equity market that we have today. Instead of a few non-profit, centralised exchanges with deep liquidity, our market structure is based on 13 for-profit exchanges, approximately 40 dark markets and a few dozen of these automated market makers. With all of their computer trading systems interacting at lightning speed, if anything gets out of whack, it’s like a room full of mousetraps loaded with ping pong balls going off. Clearly, the SEC’s market structure experiment has failed. Unless something changes, confidence-shaking events will only increase in frequency.
The SEC has proposed some fixes, but most are still on the shelf. More recently, as part of the JOBS Act – legislation designed to help start-ups and small businesses to raise money – the SEC was mandated to study how increasing spreads would affect liquidity. Last month, it recommended continued discussion.
There’s no more time for talk. Retail and institutional investors have already withdrawn more than $300bn from domestic equity mutual funds since the flash crash. The market needs to move from its current short-term casino environment and return to its true purpose – capital raising and allocation.
Here are three things the SEC can do that will have an immediate, beneficial effect:
• Reinstate the uptick rule and require more stringent obligations for market makers that may be exempt from this rule. This will slow and stabilise the market in times of stress. The uptick rule, which restricted short sales when a stock was moving lower, was introduced in the Securities Exchange Act of 1934 to prevent market abuses. It was appropriate then and it is appropriate now.
• Eliminate all forms of payment for order flow. This will change the economic model of automated market makers from disadvantaging customers to serving them.
• Set up a pilot programme to study wider tick sizes. Rather than talking about it, this will show us if larger spreads would really help realign trading to serve all participants.
There is no need for the heavy hand of regulation to start all over again. These simple changes will go a long way to getting rid of the microsecond arbitrage games that have turned our market into a casino. The sooner the SEC acts, the faster we can start rebuilding trust and confidence in our market.
Or we can just watch it burn to the ground.
Leon Cooperman is chairman and CEO of Omega Advisors and a former chairman and CEO of Goldman Sachs Asset Management. Sal Arnuk and Joseph Saluzzi are co-founders of Themis Trading