If TABB CEO Larry Tabb’s projections for 2013 hold true, we will see industry attrition in the coming year. Smaller balance sheets will result in less available risk capital, and a stringent Volcker Rule will change the participation and availability of short-term liquidity. In addition, the percentage of volume traded in the dark will continue to rise and, in my view, only the foolish or brave will short it at 36%. Meanwhile, the SEC has a plateful of Dodd-Frank and Volcker, and any propulsion in equities will be stymied by Mary Shapiro’s departure. A larger discussion about computerized trading was reignited by the Senate banking committee near the end of 2012, but as we have noted before, there’s no guarantee this stone will roll down the Hill to the SEC, let alone gather moss. And on the market side, ICE’s takeover of the NYSE will take up much of the energy and focus of this exchange, diluting a voice in the market.
When it comes to market structure, radical changes prompt polarized reactions, and we get a collective but disunited pushback against new proposals. These days it is pretty hard to contain any reform conversation, since it inevitably wends along connected paths to a clash of opinion. And as well they should, most market participants and -- perhaps especially -- the regulators fear the unintended consequences of regulation, let alone the effort and time that are consumed.
The opposite of radical or structural change is laissez-faire policy: Leave alone the complexity and paradoxes in the marketplace that come from diverse and entrenched interests, and let the market evolve naturally. Fragmentation will be at the mercy of natural attrition.
While we may see some participants or products falter in 2013, we will also see new entrants and innovation. As a result, the amount of net attrition is uncertain; so even if the equities markets outperform other markets, this may not be sufficient to take the sting out of the costs of fragmentation and compliance, which are rising faster than commission wallets can recover. It also does not add robustness to the environment. Favoring the market taking care of itself through natural evolution is all well and good, but Regulation NMS was not a natural phenomenon, and even nature needs a hand.
I have said before that I think capital markets citizenship means that those who profit from the market have a responsibility to improve, or at least safeguard, its quality. Responsibility in the broken window theory falls equally to the community to invest in keeping the environment in good standing as well as to the regulators (the “police”). Getting the market to act as a community is no mean feat, however, as profitability skews the lens for everyone.
[Related: “It’s Time to Take the Circle Out of the Round”]
And we won’t see anyone subject to curfew for causing havoc in the market, although it’s an interesting thought. Yet a willingness to aggressively address issues as they occur, within far shorter timeframes, would provide a more constant eye on the quality of the market and intolerance for disorder. Investigations take time, but the time to act on issues that affect everyday trading needs to be accelerated; Limit-Up, Limit-Down will be implemented in February only just ahead of the third anniversary of the Flash Crash.
Fixing problems more quickly, even as they occur, in the equities markets would undoubtedly incur direct costs. If this thereby also indirectly raises the price of participation too high for some so that it leads to a reshuffle of players and attrition, is that such a bad thing?
Effectively, any changes in market participants’ behavior (and, consequently, fragmentation) would become by-products of better enforcing rules and raising market quality. Maybe that’s wishful thinking, too, but as many people who tell me that we won’t have a market structure debate also acknowledge, the next Big Problem to hit the equity market will have a 2013 dateline. Yes, continually replacing broken windows and using reinforced glass is expensive; but new, fortified windows are considerably harder to break.
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7 Comments to "Changing the Equity Market by Fixing Broken Windows":
John Harris
08 January 2013
Actually, there is a different and older "broken window" lesson we all should heed, for it holds far more explanatory power, both for what ails the market and how to cure it. See Bastiat's "parable of the broken window" in his essay That Which Is Seen and That Which Is Not Seen:
http://en.wikisource.org/wiki/That_Which_Is_Seen,_and_That_Which_Is_Not_Seen
fodbarnes
08 January 2013
Looking across the wider economy there are multiple examples of market failures where a market structure has to be imposed by (additional) rules (regulation) in order to get the market to work well for society. However, the first step is for society to agree what it wants these additional rules to achieve. Which in this case means that the question "What is the capital (or equity) market for?" needs an answer. Only then can sensible market strutures be created.
Because the capital market does not produce final consumption goods or services, the answer to the core question has to reference impacts on the wider economy. It is perhaps this lack of explicit linkage to the wider economy that makes it hard for market participants to agree on what should be done. Without some external frame of reference, often my 'improvement' is your 'reduction in profit', and it is no surprise we can't agree.
Comments (6)
John Harris
08 January 2013
I'd welcome any of these examples, Mr. Barnes. From what I've seen, "market failure" is a euphemism for "bill of goods sold to gullible public by corrupt politicians as justification for forced monopolies or oligopolies." For some mysterious reason, enterprises that benefit from network effects or that require easements seem especially prone to the phenomenon.
fodbarnes
08 January 2013
John - at a very high level the rules that determine minimum quality standards (eg electrical safety) on goods fall into this category, so even in "normal" markets there are often quite a lot of special rules in particular markets to try to make the particular market work better. Conditions relating to interoperability of telecommunications networks and, in the past in the US (and still going strong in Europe) rules on Local Loop Unbundling significantly shaped the market structures in these networked industries. Where intervention has taken place to reduce vertical integration in networked industries (eg gas and electricity distribution networks) there are special rules on access conditions to enable multiple suppliers/competition to survive at other levels in distribution chain. Even Reg NMS was at least partially designed to open up the market for the provision of exchange services so as change the market structure.
These interventions don't always work as planned, but to decide whether or not they are useful requires some way of evaluating if they are, overall, producing a better or worse outcome.
(One very strange example - at least from a European persepctive - is the difference between how the NFL and the Football Leagues in Europe work. More severe market intervention in the USA, with arguably a better outcome for audiences/fans.)
Comments (6)
John Harris
08 January 2013
Thank you, Mr. Barnes. I wonder if you would agree with me that there is an enormous difference - not just economically but also politically and morally - between the two approaches you have outlined. It is one thing for market participants to join together voluntarily to promulgate and recommend standards, best practices, and the like, or even to cooperate to reduce product hazards and liability-insurance costs, e.g., through UL. It is quite another for them to agitate for laws and government-enforced regulations to bring about a market structure to their advantage. The former is entirely voluntary, admits of competition, and respects consumer choice, while still allowing for common law prohibitions against theft, fraud, trespass, recklessness, and negligence. The latter is compulsory, restricts competition and innovation, deprives consumers of choice, and replaces the rule of law with rule by political pull and influence.
Under the latter arrangement - political control of markets - even when it becomes obvious that said control is deleterious and politically untenable, entrenched players tend to rig even the new game in their favor. The 1984 consent decree that broke up "Ma Bell" is the archetypal example. The only consent decree that actually made any sense from a consumer-choice perspective would have limited the RBOCs to wireline easement activities only. All switching, routing, data processing, and wireless services should have been opened to competition. But the RBOCS were able to use their monopoly positions to subsidize their activities in putatively competitive markets and eventually to put all competitors in those markets out of business. Even MCI, the upstart that dared to challenge Ma Bell in court, was eventually consumed by Verizon (formerly GTE).
As for "society [agreeing on] what it wants," respectfully, that is impossible. "Society" has no mind of its own and can agree to nothing. Only individuals can think and agree. Healthy societies respect the rights of individuals to make their own choices as to which producers they wish to patronize.
Anonymous
09 January 2013
Coincidentally FINRA announced they're ramping up their enforcement efforts.
http://dealbook.nytimes.com/2013/01/08/regulator-plans-to-expand-its-focus/
John Harris
09 January 2013
This is a useful exercise for any intellectually-honest market participant to undertake, especially one who has ever started or run a broker-dealer that is a member of FINRA:
1) Watch the 60 Minutes feature on Citigroup whistleblower Richard Bowen and Citi's internal-control failures, misrepresentations concerning MBS, etc.:
http://dailybail.com/home/60-minutes-prosecuting-wall-street-fraud-at-citigroup-and-co.html
2) Read Citi's response to the 60 Minutes feature:
http://blog.citigroup.com/2011/12/citis-response-to-december-4-60-minutes-story.shtml
3) Ask yourself after doing both of the above, "Who's telling the truth?"
4) Note particularly this admission by Citi in its response to 60 Minutes: "Citi's business operations and financial condition were dramatically and adversely affected by the financial crisis that began to unfold in late 2007 with the collapse of the U.S. real estate market."
5) Now ask yourself, especially if you have a decent knowledge of FINRA's rules and regulations, how it is that a member firm as large and "systemically important" as Citi's BD could be allowed by FINRA to conduct business as usual after its parent publicly admits dramatic and adverse problems with its business operations and financial condition. And, of the nearly 5,000 firms forced to join FINRA and follow its dictates, how many would have received the same consideration?
FINRA is a farce. If it had any credibility whatsoever, it would right now be devoting 100% of its audit and enforcement resources to one subject: net capital fraud. It would be forcing every firm with significant exposures to structured products to prove its marks. But we all know that FINRA won't do that, because if it did, while 99% of its member firms would be fine, the tiny, remaining fraction would all be in net capital violation, and among those would be the biggest firms on the street.
What FINRA needs is a competitor. All but the biggest BDs should band together and start a new SRO. Leave FINRA with about five firms to regulate. Those are the ones it exists to protect anyway.