Until last week it had become capital-markets haute couture to mock Michael Lewis here a year past his seminal fast-trading tome "Flash Boys."
Trading community TABB Forum advertised this headline: "Dear Michael Lewis: If You Don't Understand Something, Please Ask for Assistance." CNBC's Bob Pisani, in a piece called "Michael Lewis' 'Flash Boys' one year on," compared those decrying market structure to paranoid political conspiracists.
Then authorities arrested Navinder Singh Sarao in London, where, under the thunder of Heathrow jets, the solo trader working from home ostensibly cratered U.S. stocks on May 6, 2010, or what is now called the "Flash Crash."
This stock market where all is well and Michael Lewis is uninformed produces a lot of unsettling headlines. I hope the Commodity Futures Trading Commission, regulators behind the Sarao sting, weren't hoping to calm nerves. The public is apt to conclude U.S. equities are like a vial of nitroglycerin.
A New York trader for a prominent firm said to me, "It used to be that if somebody was behaving badly, the rest of us stopped trading with him. Today under forced regulatory anonymity, somebody I think is a friend could be screwing me."
What if anonymity is crowding markets with charlatans (think cyber bullies)? Finra, the financial industry regulatory body, imposed $135 million in fines in 2014 versus $60 million in 2013. The Securities and Exchange Commission in 2014 collected a record $4.1 billion via 755 enforcement actions, up from $3.4 billion in 2013.
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The SEC touts muscular vigilance but we want less malfeasance. Perhaps structural problems go beyond whether some dodgy Londoner transacting in futures contracts to trick others might have precipitated an epochal stock swoon.
Consider how stock prices are set. Not to pick on the Nasdaq but in 2004, that exchange had $540 million in gross revenue, $56 million of direct costs including what it called "liquidity rebates," and $11.4 million of net income. By 2007, Nasdaq gross revenues were $2.4 billion, direct costs including liquidity rebates were $1.6 billion, net income, about $518 million.
Growth, in part, came from acquiring electronic venues — but that's not the point. They were paying somebody $1.6 billion to trade. In the 21st century, listing exchanges have no shares. Stocks are outside the market system in brokerage accounts, which have been forced to separate from the exchanges they started.
How to get those shares to the Nasdaq? Offer a coupon. What we've come to call high-frequency trading was in the beginning coupon-cashing. Bringing shares to the exchanges repeatedly, these firms were paid about 25 cents for each hundred shares sold.
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Do that a lot, and it adds up to, in the Nasdaq's case in 2007, north of $1 billion. The Nasdaq paid about $1 billion in rebates in 2014 too. Extrapolate similar rebates to other exchanges, and it's $3 billion.
What matters is that exchanges continue paying traders to anonymously set prices. No data standard displays these facts. Public companies, the constituency my firm serves, suppose investors are doing it. The past ten years we've written software and algorithms to quantify how money behaves in shares. High-speed traders are secretly gobbling stock buybacks, distorting prices and volume and fostering intraday volatility.
Mr. Sarao was hoping to profit on spreads. Well, that's true marketwide. Thirty brokers — intermediaries, not investors — command 90 percent of market volume, half trading their own accounts, and constantly changing prices. ModernIR data show HFT is often 8 to 10 times the price-setter of investment behavior. Pegging fragile prices set by high-speed traders are trillions of passive dollars in our retirement accounts at BlackRock and Vanguard.
Regulators claim Mr. Sarao spoofed markets — instantly canceled his orders. Yet the Immediate or Cancel (IOC) order type is legally and widely used in equity and derivative markets. The SEC's own data show the cancel-to-trade rate in the largest Exchange-Traded Funds is 1,000-to-1.
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If we want regulatory chest-beating and a cycle of pushing the Sisyphean Stone of Stupidity up the hill so it can roll down again, let's keep this up. Or instead we could listen to Michael Lewis and revamp market structure.
Remove anonymity. Finra should require any executing broker it regulates to publicly post within 12 hours all executed trades by security and long and short volume. If a stock trades a million shares, anybody should be able to add up volume by executing broker (including HFT firms) and get a million shares and know which part is long and short. Finra already requires these data points on electronic tickets and could make this proposal reality with a simple rule-filing.
We can go on chasing cheaters and congratulating ourselves, doing the same thing over and expecting different results. Or we can turn the market into a mirror.
And maybe instead of criticizing Michael Lewis, we should thank him for shining truthful light.
Commentary by Tim Quast, founder and president of Modern IR, a Denver-based market-structure analytics firm for investor-relations professionals.