I can see clearly now, the rain is gone… It's gonna be a bright, bright, sun-shiny day.
- Johnny Nash
The stock exchange management firms have outperformed the stock market; performance measured by the performance of index exchange-traded funds (ETFs) during most of the past decade. This sterling performance record, like most such records, comes with the standard disclaimer, “Past results are no guarantee of future performance.” With the new administration, this disclaimer is particularly cogent. Storm clouds approach. The exchange fees that have fattened the profits of these firms are under direct SEC threat.
The new SEC chairman, Jay Clayton, has delivered his first opinion of what the SEC will be about in this new administration. He said that the focus will be on Main Street. Lovely sentiment, that. The centerpiece of his speech was dead on – there is a conspicuous absence of investor risk-taking opportunity to be found in public markets, lately.
There are two portions of the Clayton speech that promise important departures from the SEC of Mary Jo White’s tenure:
- Clayton’s concern for emerging creative corporations’ desertion of the publicly traded marketplace.
- Clayton’s suggestion that exchanges’ maker-taker fees may be on the way out.
Corporate defections from the publicly traded markets
The root of this problem lies in the disinterest of emerging growth firms in public listing; the shrinking number of innovative firms that go public. Clayton focused on the damage this presents to ordinary investors who don’t have access to privately held investments.
It will be interesting to see how he manages to balance the fundamental SEC mandate to assure adequate disclosure by firms offering securities to the public, with his concern for lack of Main Street investor access to securities of firms that remain private - expressly to avoid this disclosure. There is no question of the need for change. Certainly, there are reasons to doubt that publicly traded securities are the road to riches today.
But wait. After all, it’s not just the clever risk-takers that avoid the public markets. There are privately held firms out there with good reason to hide their performance.
Why publicly traded firms have become so boring
- Large publicly held corporations have become glorified ATMs.
The public giants mostly receive investor funds, only to return the money in the form of dividends and stock buybacks. This commitment to return investors their funds, rather than reinvest them, is a response to the short-term focus of public markets' traders. Investors usually reward this corporate game of pass-the-trash. The current Big Bank mini-rally, for example, owes much to a series of such promises – the centerpiece of this quarter’s Big Bank earnings announcements.
- Publicly traded markets have generated a self-defeating churning mentality.
More than 50% of all exchange orders are generated by computers, without direct human involvement. Worse, most of these orders are never executed. Under the rubric high-frequency traders (HFT), public market trading lately has less to do with underlying corporate risk-taking fundamentals than ever before.
Yet these HFTs, the darlings of the early years of this decade, have proven that computers are no different from humans, in the sense that any strategy, whether human- or computer -driven, rapidly self-destructs due to imitation and creator over-fishing of the innovative lake.
- The rise of index ETFs.
My personal choice of investment strategy, the index ETF, is mindless investment personified. As index investing grows in popularity, there are certain inevitable consequences for corporate creativity within the index-included firms. Most obviously, large competitors are all owned by the same people in an index fund. When one firm creates a profit at the expense of another, index investors neither gain nor lose. Thus, the incentive for index fund managers to encourage innovation is dulled.
But these index ETFs constitute the most rapidly growing, in total volume terms, segment of the stock market. Index ETFs are a haven for the multitudes to hide their lack of information. Yet nobody’s human-managed funds improve on the performance of index ETFs for long. It seems ever-harder to make a case for the activist investor alternative.
A second SEC concern: the negative effect of SEC regulation on stock market micro-structure
There is good reason to take stock exchange and other stock market micro-structure concerns out of the SEC’s portfolio of regulatory responsibilities. Not least because market micro-structure has an understandably low priority compared to the SEC’s fundamental role as the driver of American capital formation: disclosure and enforcement.
The SEC’s attitude toward its responsibility for the health of the exchange management firms [Intercontinental Exchange (ICE), Nasdaq Inc. (NDAQ), CBOE Holdings (CBOE)] is an archaic artifact of the time when exchanges were non-profit, making their role as non-government market regulators arguably appropriate. Now these firms are profit-driven, creating a rapidly increasing conflict among the three parties the stock markets serve: investors, broker-dealers, and the exchanges themselves.
IEX, the new exchange famed for introducing the speed bump to stock market trading, will not make its bones with that highly publicized notion. IEX will make its reputation, or fail, based on two other, more subtle but more important, ways in which the new exchange is unique:
- IEX shuns the parasitic revenues of other stock exchanges, such as the maker-taker subsidy. More broadly, IEX takes a longer-term view of revenue generation, seeking to build broad customer loyalty, rather than to favor the sell-side, as have the old-line stock exchanges.
- IEX seeks innovation through internal R&D, not through preferential customer-promoted R&D. But IEX has something to learn about R&D in financial markets. IEX management is technically excellent but also composed of market newbies. IEX’s cautious approach to innovation and its regulatory responsibilities makes sense in manufacturing or tech, where market share is the issue. But exchange trading is a winner-take-all, “What have you done for me lately?” enterprise. To succeed, IEX must drop the hammer – make radical change that has big-time associated risk.
IEX is interesting because it is one of the few potential sources of radical financial changes that can move market micro-structure out of its post-2000 doldrums. The source of the stall in stock market development - the well-intentioned but obsolete SEC Securities Information Processor (SIP) – is, according to Matt Andresen, one of the creators of SIP and currently CEO of Headlands Technologies, out-of-date. Andresen informs us:
"The reasons we [SIP’s originators] came out with maker-taker pricing no longer exist, and it is worth readdressing those fundamental assumptions for how we stimulate competition between exchanges, and between exchanges and off-market venues."
Maker-taker fees are components of the panoply of fees imposed on traders by the old-line exchanges that should be relegated to the history books. At the outset of this new SEC era, it seems that the odds of an SEC rollback of the abuses of exchange prerogatives resulting from SEC maternalism have improved.
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.