Can't you find another way of doin' it, baby? Can't you?
-- Sam and Dave
This article is the fourth in a series considering the relationship between law and economics in financial markets. These articles question the quality of the law that governs our right to trade - to efficiently, non-violently, transfer financial property. Are the contracts that govern financial transactions today responsive to the needs of traders and the public at large? My answer is a resounding "No." Financial instrument trading is the new "Wild West."
Articles about the rights and obligations of traders are a yawn. This is largely because individual traders of a certain age - those of us who remember picking up a phone, being chatted up by our brokers, and otherwise spending the better part of an hour going from the decision to enter a trade to receiving a confirmation - are still wowed by the fact that trades take only seconds to execute; cost a small fraction of the old commissions; and the information we need to form opinions, ubiquitous and free.
But that does not mean - emphatically - that the average trader is treated fairly. She is not. Technology is changing so rapidly that an exploited public cannot see that reality.
My experience with financial law as it affects transactions in the United States was gleaned during the years when financial futures and OTC derivatives were new to the world - government was unsure what to do with these new financial instruments. But as usual, government was inclined to protect the interests of the established few. Except for the countervailing pressure of U.S., and interestingly U.K., financial law; those established few would have killed financial futures before they got off the ground.
I knew then, and now, that without pressure from the trading public, transactions would be conducted for the benefit of the few. And government, without substantial public pressure; inclined to back the interests of these few. Right now, the few are getting away with murder.
Despite my libertarian tendencies, I believe the Rule of Law is the essential source of protection for the many from the prerogatives of the privileged few - the result of a life spent in places where there is no law (Afghanistan), little law (Iraq), too much obscure, unenforced law (Continental Europe), or law that depends upon the center of military power (Turkey).
What is Rule of Law? Simply speaking, it is a code of behavior that is that binds both government officials and the public, and is well understood by all. To work, the law must be clear, stable, and certain. Of course, that is an ideal, nowhere a reality.
This series of articles show that U.S. transactions law is none of the above. Transactions law is usefully separated into two venues:
- The law governing exchange trading.
- The law governing over-the-counter trading.
OTC Trading, briefly. The period from the explosion of Eurodollar, foreign exchange, metals, and energy trading in 1970 until the Financial Crisis, to be a time when OTC trading was not governed by law. That has changed. OTC trading is now governed by very poorly framed and enforced laws that benefit nobody. The result, circa 2008, was a situation not much different from today's Afghanistan, where a figurehead government masks the activities of war lords that actually determine the rules of OTC trading. I make this case, here and here. The main implication of this move from a lawless trading environment to one that is poorly governed is that investors may expect the long run performance of the existing financial institutions to be poor. Investors should seek to identify their replacements.
Exchange Trading. The exchange management business is marked by rapid implosion as the pace at which the bigger firms [CME Group (NASDAQ:CME), Intercontinental Exchange (NYSE:ICE) and the Chicago Board Options Exchange (NASDAQ:CBOE)] gobble up the rest quickens.
This sector of the financial markets is the more interesting one from the point of view of the law. In an earlier article I listed the two central qualities of an efficient contract. An efficient contract:
- Meets the original objectives of both parties to the deal, regardless of the outcome.
- Has no significant negative effect on third parties.
Property 2.) was the subject of my last article.
Property 1.) requires a little explaining. When I sell shares of common stock, for example, one common reason is that I believe the price will fall. If I view the transaction that way, the trade appears to be a zero sum game; a bet with the buyer. I win if the price falls; lose if it rises. There's nothing to see here, folks.
That is not the way to view this contract to understand its efficiency. My order to sell is a "process" that may resemble this:
- My sell order is bundled with many other sell orders. My broker then pays the exchange that first "sees" my sell order, a "liquidity removal fee" to place the order, since my market order "uses" liquidity. That fee is, of course, passed along to me.
- A small piece of my order is executed, since the resting orders are small. Something like the bait on your fishing pole. Then my remaining order "looks" at the data feeds from the other exchanges to see where the "next best" selling price is to be found.
- My first trade triggers dealers' collocated computers to pay this same exchange a "collocation fee" for early knowledge that my order is about to flee that first exchange in search of a fill.
- Algorithms are triggered within the dealers' collocated computers' memories, which send cancellations of the dealer's resting orders at other exchanges - avoiding my unconscious attempt to pick them off.
- Racing to the remaining exchanges to fill the rest of my order, at the cost of more "liquidity removal fees," the resting buys my order "saw" have been pulled.
- If the price on this exchange is as good as those my order "sees" when it takes another look at the exchange feeds from the other exchanges, I get my fill at the new, lower price. If not, return to step 2.)
Note that from the dealer's point of view, collocation protects the dealer from my attempt to pick her off. If I were a dealer, with the opportunity to pay such a fee, I wouldn't hesitate. But if you read Michael Lewis' book, "Flash Boys," you will read that the dealer is attempting to pick me off. I disagree. As long as both parties know the game, I see no "bad guys" here.
But the tale of this trade enables me to explain what I mean when I suggest that "a contract meets the mutual interest of the parties." I contend that the many fees the exchanges charge for the use of their execution services do not meet this standard of efficiency. The contract is in the interest of neither party, in that sense. The mutual interest of exchange customers, defined in this example as me (the seller) and the dealer (the buyer) does not require multiple fees for both of us.
For example, when my order and that of the buyer race back and forth among the 12 other exchanges that the SEC's National Market System (NYSE:NMS) compels a broker to send them, how is that better than a single exchange? If there were one exchange, collocation would be pointless and the whole race called off, eliminating the multiple fees accessed to both sides of the trade.
Transactions are not a zero sum game when there are 13 exchanges playing these games with every order. These exchanges represent a large fixed cost to every trader; one that the SEC does not examine.
When IEX came along with its speed bump, however, the subject of the senselessness of this silly system of order execution was brought up. It will be very interesting to see whether the other exchanges compete with IEX, offering different versions of the speed bump, and keeping the very abusive fees of the 12 other exchanges squarely in the public eye. I have the feeling we won't hear much more from the 12 unnecessary exchanges until IEX, inevitably, figures out how to take a serious share of business from them.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.