The Implosion Of Public Markets

by: Kurt Dew

The nature of financial claims and the behavior of those who create and trade them are rapidly evolving.

This article describes the forces driving change.

In coming articles, winners and losers will be identified.

Feels like the world… is closing in on me.

- The Isley Brothers

Many market mavens, such as Ben Carlson, author of the blog, A Wealth of Common Sense, believe that it is useful to split markets into those for traders and those for owners. The headline development of markets is the growth of privately held markets, which service the world's owners; at the expense of publicly held markets. As the world's creator-owners desert public markets, publicly traded financial instruments are evolving to cater to traders.

In my most recent article, I trace the recent development of markets tailored to suit traders and owners. The message of that earlier argument is that owners and traders do not play well with each other. The reasons are - first that traders have a more profound understanding of the essence of the two separate activities than do owners; second that owners are guilty of a certain amount of hubris. The financial attention devoted to the world's owners is growing. As a result trader's markets must consolidate - become more efficient - to survive.

What is out-of-date in the markets that cater to traders? Now is the time to ask. Financial markets and financial instruments are increasingly crossing old boundaries. Once, futures exchanges traded only futures; options exchanges, only options; and securities exchanges, only securities. Now all exchange management firms trade everything. And the distinction between futures securities and options is becoming less apparent. This article begins the process of identifying the anachronisms that this market meld has revealed.

This article is the first of a series identifying trends in trading technology. This first article focuses on the forces driving these coming changes.

Symptoms of market problems

First, the share of trading that happens away from the traditional exchanges is growing. Dark pools, among other electronic matching platforms managed by megabank broker-dealers and newer electronic platform management firms [such as Citadel and Virtu Financial Inc (VIRT)] opaque to the market, and multiple other types of platforms - such as ping pools, explained here - are gaining a greater share of public trading volume over time.

But all these once-new market platforms may already be old hat. The recent poor financial performance of those few high-frequency trading (HFT) firms that are publicly held attest to that possibility. It is time to reconsider the cluttered trading landscape produced by the confluence of several unnecessarily complicating factors.

Second, markets that ought to be consolidating are instead dividing. The reason; regulators are losing their grip on the markets' problems. The SEC, with its national market system (NMS), has hobbled the spot securities markets it regulates. The sine qua non of an efficient market is volume. But the SEC has created a system that encourages a multitude of different markets for each security, reducing volume in each separate market. The effect of the system of fees and subsidies that multiple markets create has been particularly disastrous.

And this market division continues. On January 12th, NYSE filed with the SEC to create its fourth exchange, dubbed NYSE National. Sensibly, NYSE National will not list new stocks, which will dramatically reduce NYSE National volume around the market open and close. As such, NYSE National will compete with the various BATS exchanges [owned by CBOE Global Markets (CBOE)].

Sources of the problems

The factors: First, an awkward combination of well-meaning, poorly conceived SEC rules; Second, the megabanks' desperate attempt to hold on to their out-of-date market prerogatives. Third, an artificial division of markets into futures and spot markets, as exchanges seek to choose regulators that meet their needs at the expense of the trading public.

Who Trades?

Who inhabits the shrinking world of traders? The owner's term for traders, "Wall Street," refers, roughly speaking, to several institutions:

  • Broker-dealers, such as the megabanks [Bank of America (NYSE:BAC), Citigroup (C), Deutsche Bank (DB), Goldman Sachs (GS), JPMorgan Chase (JPM), Morgan Stanley (MS), among others];
  • Exchange management firms [CME Group (CME), CBOE Global Management {the owner of BATS}, Intercontinental Exchange (ICE) {the owner of the New York Stock Exchange, and three other stock exchanges}, and NASDAQ Inc. (NDAQ)];
  • The primary clearing and investment management firms [Bank of New York Mellon (BK), State Street Corp. (STT), Depositary Trust and Clearing Corporation (OTC:DTCC), BlackRock (BLK), and Vanguard, among others].
  • Smaller trading platforms such a Citadel and Virtu.

These firms, roughly speaking, separate themselves into two components. First, they are traders, trading utilities, and trading advisers. Second, they provide services to the world's creator-owners. Within the trading firms, the two services are provided by brokers, clearers, and traders, on one hand; and bankers, on the other.

Traders trade, predict the performance of securities and commodities prices, sell securities, and provide transactions and clearing services. All these functions are about the here and now. A trader never thinks, "This company is undervalued. I'll wait until the minute before the rest of the world discovers this, then buy." No. The trader buys now. In the following minute, she tells the salesman to recommend the financial instrument to the firm's customers and passes her info to the firm's researchers. Assuming the trader has credibility, this announcement will immediately move the value of the company's stock to the appropriate level. As a result of the market response to the trader's will, the trader will see no point in holding the position she assumed. She's out of the stock hours after she jumped in.

Hence the bad rap traders get from creator-owners.

What's happening to traders?

Like Alice in Wonderland, average trading firm size is shrinking as the amount of capital necessary to make a market declines; and like Gulliver, the megabanks find themselves suddenly overrun by a herd of mini-firms. Similarly, the old-line exchange management firms find themselves similarly overrun by newer, smaller, more imaginative trading platforms. Regulators are losing their grip as this herd of unregulated, opaque markets multiplies. Survival will demand a different kind of risk management - less capital-intensive. This adjustment is well underway, as XTX Markets has moved up the league foreign exchange trading lists, once the jealously guarded domain of the megabanks.


Yet even this rapid adjustment by attacking smaller firms is too slow to be consistent with profitability. To survive the maelstrom of rapid change, identify the end-game. The outline of the next plateau in the evolution of the market is becoming clearer.

First, markets will become more homogeneous, melding into one market to maximize trading volume at the point of attack. Distinctions among instruments - a separate futures contract, spot instrument, and an option for every underlying market - are an unnecessary expense, wasteful of trader capital. These complicated versions of a single market produce little else other than jobs for mathematicians and writers of computer code.

Second, trading will concentrate. The trend from trading of individual securities to the trading of summary indexes will accelerate. Since publicly-traded firms are consciously avoiding damaging (damaging to holders of index EFTs and stock index futures) competition - "damaging competition" is defined as competitive advance that improves the lot of the innovating firm's shareholders, while reducing the value of competitor's shares by more than the greater value of the innovating firm's stock - the publicly-traded market as a whole is less risky and worth more in the short run.

But this damaging competition is the essential driver of financial efficiency. Financial instruments and markets are essentially a dynamic record-keeping system. As the availability of information explodes, the cost of information falls. The rate at which the trader must capture this value rises. The need for speed has eclipsed human capacity. Thus today, according to JPMorgan Chase, 90% of all transactions are conducted by computers.

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. I have no business relationship with any company whose stock is mentioned in this article.