The complexity and speed of stock trading — and the notion that the equity markets now tilt in favor of high-speed traders — erodes investor confidence. But it’s also particularly hurting thinly traded stocks, experts told the Senate Committee on Banking, Housing and Urban Affairs on Thursday.
Adding their voices to the chorus contending that the structure of stock markets is badly in need of reform, four panelists — including Andrew Brooks, head of U.S. equity trading at T. Rowe Price — questioned everything from the profit motivations of high-frequency trading firms (HFTs), to the uneven playing field for market-data access, to recent, numerous trading-systems glitches like the order mishap in the first hours of Facebook’s initial public offering.
“The myopic push for stock markets to move faster and faster has threatened the very market itself,” said Brooks in his testimony, and “the continued push for speed is not producing any marginal benefit for investors.”
But the technological revolution on Wall Street that has enabled the rise of HFTs — firms using superfast computers and networks to jump in and out of stocks and capitalize on other investors’ moves — is also hurting thinly traded, less-liquid stocks and the companies that issue them, panelists said.
A stock that’s traded infrequently doesn’t accurately reflect a company’s market value, usually doesn’t get covered by research analysts, and its price movements have little or no correlation with market news, says Michael Lynch, a managing director at Duff & Phelps, who was not testifying at the hearing. “Trading in companies that fit this description is driven by short-term liquidity needs of the investor as opposed to expectations regarding company performance,” he says.
“Our market is designed for Cisco [Systems], Microsoft, and Bank of America, not for a stock that trades by appointment,” said Chris Concannon, executive vice president of electronic market-maker Virtu Financial, in his prepared testimony before the Senate committee on Thursday. “The major market rules do not distinguish between the size or market capitalization of the listed company.”
Concannon pointed out that his institutional clients are struggling to trade less-liquid stocks, like those in the Russell 2000 Index.
Eric Noll, executive vice president of Nasdaq OMX, expressed a similar view on Wednesday at a conference on market quality hosted by Georgetown University’s McDonough School of Business. “The bottom 1,000 names [on Nasdaq] constitute less than 1% of trading volume,” he said. “It might be time to consider different market-structure models for different kinds of companies.”
What’s the connection between high-frequency trading and the travails of less-liquid stocks? The new, nonmarket-maker electronic traders are pushing out market makers because they can trade just as efficiently. A market maker (also called a specialist) is a broker-dealer firm that facilitates trading in a security by standing ready on the stock exchanges to buy or sell a stock — whether it’s a highly liquid one or not — at publicly quoted prices.
HFTs have focused on more-liquid names and ignored less-liquid ones because the economics are better, and that’s crowding out market makers, explained Larry Tabb, chief executive officer of TABB Group, a financial-markets research firm, in his prepared Senate testimony. In addition, exchanges, which are now for-profit entities, have an economic incentive to focus on the most active traders, Tabb says. Since they’re paid on the basis of trading frequency, they benefit from the work of HFTs. “[That makes] it harder for traditional market makers to survive, making it harder to provide liquidity for less-liquid and small-cap firms.”
True, the resulting market structure also means highly liquid names are traded with tight spreads and low costs. “However,” says Tabb, “the less-liquid names become very hard to trade. The least bit of activity causes significant price volatility, and makes it harder for investors to either get into or out of these stocks.” So large institutions “shy away from buying them altogether.”
One of the policy changes Tabb recommended to the committee was for the equity markets to widen minimum price variations, or “ticks,” as suggested in the Jumpstart Our Business Startups (JOBS) Act. The current one-cent trading increment for stocks has coincided with the drop in Nasdaq-registered market-making firms to 125 from about 500, says Traders Magazine.
Theoretically, wider ticks (the JOBS Act proposed a tick size of between two and nine cents for emerging growth companies) would enable broker-dealers to make money on providing liquidity in smaller stocks, which would give them more incentive to do so. They would also have more money to spend on writing research reports on these stocks, a critical piece of making a company’s shares more visible and attractive to investors.
But there’s also a bigger question involving market structure that affects all stocks: the obligation (or lack of one) for HFTs to provide liquidity. High-frequency traders claim they provide substantial liquidity to equity markets, as much as 50% according to some studies. But they have no formal duty to supply any. On days when the markets go haywire — like the May 6, 2010, “flash crash” when in 20 minutes the market lost, then regained, nearly $1 trillion of market value — that’s a problem.
High-frequency trading firms withdrew their orders from the market during the flash crash, said David Lauer, a former high-frequency trader and now a market-structure consultant at Better Markets. “We did not understand what was happening,” he said in his Senate testimony Thursday. “[We] did not trust our data feeds and had no obligation to remain active in the market.”
Accidental disruptions have increased with a rise of heavily computerized trading that some say has eroded investor confidence and led to a decline in IPOs. Examples include the botched IPOs of Facebook and BATS (itself an electronic trading market) and a trading error at Knight Capital Group that affected 140 stocks and caused a $440 million loss for the firm. (The BATS glitch led to a 9% price decline in shares of Apple and paused trading in the shares for five minutes, the Federal Reserve Bank of Chicago pointed out in a paper released this week.)
“Flash crashes, mini–flash crashes, and other market disruptions demonstrate the need for additional obligated liquidity in our market,” says Virtu Financial’s Concannon, acknowledging that such a need benefits his firm’s business. “However, I believe enhanced market-maker obligations should be targeted where they are most needed — and that is in our less-liquid stocks.”
But Tabb thinks not all the problems of the equity markets — decreasing ownership of individual companies’ securities and liquidity issues with small-cap stocks among them — can be laid at the door of HFTs.
“With all the macro risk in the market, investors are not worried about Coke or Pepsi or Ford or GM, they are worried about U.S. or China, technology or health care. They are then using exchange-traded funds (ETFs) to express those strategies,” he says.
Because most ETFs buy stocks on the basis of their inclusion in stock indices rather than share valuation or performance, Tabb says, companies’ shares tend to move in the same direction, instead of some appreciating and some depreciating in value.
But high correlations in movement between individual stocks not only erases the traditional benefits of diversification for individual investors, it calls into question the purpose of the stock markets, said Lauer. “It means that the market becomes a poor indicator of company value and performance, undermining one of its core functions.”