As I noted inÂ The Stock Market Is an “Attractive Nuisance” and Should Be Closed, the stock market now bears little resemblance to traditional markets.Â Today’s market has as much in common with the market of the 1960s as a horse-drawn carriage has with a Formula 1 race car. Most of the trading on the market is done by computers that hold shares for perhaps 11 seconds before skimming a slice from investors who lack the high-speed data flows from the exchanges, warp-speed processing power and sophisticated algorithms.
CHS: Your book poses this question: what can we do to restore the integrity of our stock markets?Scott:Â This is essentially the role of the SEC, and itâs pretty clear that theyâve dropped the ball. In part this is due to the dramatic speed of the technology revolution that has completely overhauled the market. Itâs easy to forget that just 10 years ago humans dominated trading. While, as I show in Dark Pools, the revolution had already begun in the early 2000s â sparked in many ways by Josh Levine and The Island ECN he build â it remained in its infancy. But now itâs clear to anyone paying attention that the market has been transformed, like a VW Bug turning into a Formula One race car, and the SEC doesnât know whatâs going on under the hood.
This conclusion isnât up for debate. Mary Schapiro as much as admitted to Congress last year that she and her agency canât surveille the market. That really is worrisome for obvious reasons. So what are they waiting for? Itâs true that recently the SEC approved the so-called consolidated audit trail, or the CAT, which is billed as a giant eye in the sky for the market. But itâs still in the planning stages and who knows when it will actually be implementedâor whether it will actually be able to capture whatâs going on.
CHS: While there are various regulatory âtweaksâ that could be put in place (requiring a holding time of 1 minute for all securities, for example), I wonder if we donât need a more fundamental âre-setâ that asks what role the market should play in finance and the economy inhabited by everyday investors.
Scott:Â I think there are a lot of people in the industry wondering about whether there needs to be a massive overhaul. But itâs probably not a good idea for that to be imposed on the market by the SEC. The uncertainty would be potentially destabilizing. And I just donât see it happening.
I think the change needs to come from within the market and needs to be imposed by its most important usersâI mean, not the high-frequency traders, who are running the show at the exchanges in many waysâbut the institutions, the giant mutual fund companies, the pension funds, the long-short hedge funds. They need to exert pressure on the exchanges to stop giving advantages to high-frequency firms.
Part of the problem is that many of these firms havenât been paying attention to the changes, and again I point to the speed with which they have taken place. But more are waking up â I hope in part because some of them have read my book.
Thank you, Scott, for explaining the realities of the market and for your feedback on what could be done to restore a transparent, open market.Â It sounds like traditional market heavy-weights–institutions, mutual funds and pension funds–will only regain a say by removing their participation (and liquidity) from the current stock market: exit equities and go on strike, so to speak, until the exchanges and the SEC ban high-frequency trading, outlaw front-running and restore real transparency.
If the traditional heavy-weights abandoned the market, that would leave only the HFT firms and the Federal Reserve’s proxies in the market, poaching each other in an ever-tightening circle of parasitic predation.
Removing liquidity that can be skimmed would push the present market into a highly vulnerable instability. The resulting implosion would “clear the decks” for meaningful reform.
If the traditional heavy-weights foolishly continue providing the “dumb money” that’s being skimmed, perhaps retail investors could start a small, limited exchange that banned HFT, front-running and all the other manipulations.Â Such a market could restore one of the market original purposes, raising capital for new enterprises, and enable small retail traders access to an unmanipulated market.
Here are some common-sense rules for such a “new market”:
1. Every offer and bid will be left up for 15 minutes and cannot be withdrawn until 15 minutes has passed.
2. Every security–stock or option–must be held for a minimum of one hour.
3. Every trade must be placed by a human being.
4. No equivalent of the ES/E-Mini contract–the futures contract for the S&P 500–will be allowed. The E-Mini contract is the favorite tool of the Federal Reserve’s proxies, the Plunge Protection Team and other offically sanctioned manipulators, as a relatively modest sum of money can buy a boatload of contracts that ramp up the market.
5. All bids, offers and trades will be transparently displayed in a form and media freely available to all traders with a standard PC and Internet connection.
6. Any violation of #3 will cause the traderÂ and the firm he/she works forÂ to be banned from trading on the exchange for life–one strike, you’re out.
Is such a retail-trader friendly exchange possible?Â There would certainly be a nice profit in it, for everyone who is tired of providing liquidity for HFT firms would flee the existing exchanges in a New York minute.
Given a choice between listing on the pseudo-market or a legitimate albeit smaller exchange (it would be a binary choice, you can only list in one or the other), many small-cap and micro-cap companies would choose the unmanipulated exchange once liquidity and demand reached critical mass.
New video:Â Gordon Long and I discuss “Marginal Return”: