As IEX, the start-up star of Michael Lewis's "Flash Boys" and creator of a market speed bump, takes heat from critics including hedge-fund giant Citadel and the owner of the NYSE in its pursuit of becoming an exchange, it begs the question: Why do we have a market structure that emphasizes speed?
After all, if "buy-and-hold" money is the heart of capital formation, aren't fast markets contradictory?
Structurally, markets are fast because rules require all exchanges and brokers in the national market system to connect electronically, and then the stock exchange with the best price for both a bid to buy and an offer to sell gets to match the trade (or at least price it). So the market is a footrace to set prices.
What idiot thought everyone should be forced to share customers and prices?
In a word, Congress. In 1971, foreign investors were returning over-extended U.S. dollars for the gold backing them. The federal government, running out of metal, dropped the gold standard. The stock market reacted poorly. Fearing destabilization, Congress in 1975 added the National Market System amendments called Section 11A to the Securities and Exchange Act, decreeing securities markets a national asset that could affect interstate commerce, federal credit and taxing power, and the Federal Reserve System.
The wheels of bureaucracy turned slowly, so, it wasn't until 2005 that what Congress had envisioned was realized in the Securities and Exchange Commission's Regulation National Market System (Reg NMS). It said, in effect, that if markets are going to run on machines, then, by golly, the machines will be connected so everybody gets proper value. Defined how? Best price.
Today, bids and offers are frequently but a penny apart (and often less despite a proviso in Reg NMS against it because other rules permit sub-penny "price improvement"). Reg NMS also changed rules for market data, dividing its revenue according to how often exchanges matched buyers and sellers at the best price. The idea was to incentivize better prices but it made data a reason for setting them.
Ever looked up a quote? Cha-ching. Market data disseminating across the Web, through your online broker, via Bloomberg and Dow Jones, is big business. Exchanges began to pay for orders to gain market-share so whenever someone typed a stock symbol like "INTC" for a quote, the exchange earned money.
Thus, through a marriage of regulated, computerized orders at the best price, and trading incentives paid by exchanges, what we now call "high-frequency trading" was born. Moving shares around became a giant, multi-billion-dollar business as algorithms raced them from one exchange to another to set the best price.
Proponents like Citadel say this system has lowered trading costs, improved efficiency and reduced volatility. If volatility means "tending to vary often," is it true? Let's take a look at Pfizer stock as an example:
In the 50 trading days ended Jan. 15, Pfizer averaged about 102,000 trades each day. Over 50 days, that's, in effect, more than 5 million prices for the same product! In those 50 days, PFE averaged 1.7 percent daily volatility – the spread between the highest and lowest prices. PFE's average price over that period was $32.47, so 1.7 percent of that is about 55 cents daily.
Now, suppose a trader managed to perfectly buy the lowest price and sell the highest price every day. It would total $27.60, or an astonishing 85 percent of PFE's stock price. If a trader did that every day — bought and sold intraday — she would make a pile and own nothing. Where's the incentive to buy and hold? After all, from Nov. 3 through Jan. 15, (50 trading days), PFE dropped 12 percent to $30.81 from $34.97.
Securities and Exchange Commission chair Mary Jo White declared in a June 5, 2014 speech titled "Enhancing Our Equity Market Structure," that "we must evaluate all issues through the prism of the best interest of investors and the facilitation of capital formation for public companies. The secondary markets exist for investors and public companies, and their interests must be paramount."
Now you know why we have a fast market. The problem is its purpose and the rules governing it are at crosscurrents. Exchanges and traders like a fast market despite that contradiction because short-term trading built on data is profitable for everybody but long-term investors.
IEX is proposing a different approach. Maybe we should let the market decide.