Pitfalls in Today’s US Stock Market – Part 2

Thursday, May 27, 2010

This write-up continues yesterday’s discussion of an investment approach that seeks to frighten investors into selling at abnormally low prices. Under “II. Why is it allowed to exist,” we covered the removal of short-selling controls (uptick and “naked”) and weak enforcement of false rumors. Today, we will review two other important, negative forces in the markets: securities trading without protection and hedge funds’ potentially disruptive effects.

Securities trading without protection

The SEC, purportedly to diminish the New York Stock Exchange’s (NYSE’s) “monopoly,” instituted Regulation NMS (National Market System) in March 2007 with this fanfare:

[Reg NMS is] a series of initiatives designed to modernize and strengthen the national market system for equity securities. [It seeks to foster both] competition among individual markets and competition among individual orders.”

The SEC allowed, even encouraged, the use of alternative stock exchanges and trading systems.

While this may seem laudable, it seriously damaged investor protection by removing the NYSE from its supportive role. To handle trading, the NYSE used “specialists,” well-financed firms that handled designated NYSE-listed stocks. Their role was to maintain a fair and orderly market and to provide liquidity as needed to provide a reasonable quotation (bid/ask).

Reg NMS included the cessation of passing all NYSE-listed share orders through the NYSE system. (The goal was to speed up transactions.) This meant specialists lost the inside view they needed to determine when and how to commit their capital to meet their goals. Therefore, the specialist system became inoperable.

This change had been coming for some time. For example,

“The California Public Employees’ Retirement System sued the New York Stock Exchange and its seven specialist firms Tuesday, alleging that improprieties in the NYSE’s tradition-bound trading system have cost U.S. investors more than $150 million over the last three years.

“The lawsuit, which seeks class-action status, was spurred by a Securities and Exchange Commission investigation into the specialist firms, which operate on the NYSE trading floor as middlemen between buyers and sellers of stock.”

(“CalPERS Sues NYSE, Specialist Firms,” Los Angeles Times,by Kathy M. Kristof, December 17, 2003)

May 6, 2010, showed the result of having disparate, uncoordinated exchanges and trading systems handling investors’ trades. The desire for computerized speed has produced a “National Market System” that is no system. It’s a free-for-all with game-playing (e.g., “dark pools” and “flash trading”) designed to suck out mini-amounts from high volume trading.

Whereas, the NYSE specialist firms earned $150 million over three years serving a real purpose, today’s computerized trading income provides no benefit to investors. And the high volume is simply a symptom of the systems, not a measure of real liquidity. So, when times get tough (like on May 6), “fair and orderly” and “liquidity as needed to provide a reasonable quotation” was no where to be seen – except at the NYSE, where people wrestled to meet the exchange’s goals even as the rest of the system undermined them.

Note: I realize that the specialist system is not perfect. Seeing all pending orders gives the specialist true inside information. The NYSE, as the leading US stock exchange, had sought to ensure that specialists did not take advantage of that information. The specialists could, in the normal course of maintaining a fair and orderly market, earn a good income – whenever short-term imbalances occurred, they were able to buy at the bid and later sell at the ask, and vice versa. (They were prevented from taking advantage, such as stepping in before another order, triggering a limit order, painting the tape, etc.)

So, what’s the SEC up to following May 6? How do they propose to fix the NMS weaknesses that were exposed? These are their announced actions so far:

  • Discover what caused May 6’s snafu (I believe they’ve given up on this one – perhaps because NMS is at the heart of the problem)
  • Meet with exchanges and trading system heads and tell them to coordinate circuit breakers. (This is a non-solution – see “Circuit Breakers Seen as No Help,” The Wall Street Journal, by Kristina Peterson, May 27)
  • Look at “gigabytes of data” for that trading day. They’ve evidently given up on this one, too, finding the data so fragmented as to be unusable. Hence, “SEC proposes central database for all trading data” (The Washington Post, by Zachary A. Goldfarb, May 26). From that article:

“As financial markets have rapidly grown in size and complexity, regulators have faced an increasingly difficult task of investigating allegations of fraud and understanding the root causes of anomalous events such as the ‘flash crash’ of May 6.”

“The many exchanges and self-regulatory organizations that Wall Street has set up to monitor financial activity have different standards for keeping track of trades, which occur at lightning speed on electronic hubs located around the world.

“As a result, SEC Chairman Mary L. Schapiro said, ‘stock market regulators tracking suspicious activity or reconstructing an unusual event must obtain and merge an immense volume of disparate data from a number of different markets and market participants.’”

The most disturbing revelation of Chairman Schapiro’s statement is that the SEC has been operating partially blind. They have supposedly been using a computerized system to keep watch on all trading so as to spot indications of illegal activity (such as insider trading). Now they admit they have been unable to fulfill that watchdog role. Since there have been “a number of different markets and market participants” for many years… Well, you can finish this sentence as well as I.

Hedge funds – unregistered, unregulated and secret

What makes the items above so dangerous is the presence of massive amounts of money that are free to take advantage of them. Not since investment corporations and investment pools roamed the markets in the 1920s have investors had to deal with such large, potentially disruptive (and destructive) forces.

Congress and the SEC, even when pressed by many Wall Streeters, have been unwilling to act. There is a simple step: Apply the long-established rules and regulations to hedge funds. For example, put them under the 1940 Investment Company Act. (That is where the 1920s investment corporations/pools went.) Not doing so means the markets remain at risk from these independent funds’ aggressive, hidden tactics that can include the items above. This is Wall Street game-playing at its worst.

So… As investors, we can certainly seek ways to take advantage of today’s conditions. But, more importantly, we must guard against being caught in the pitfalls. Tomorrow, I’ll discuss how.

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