Business Law Prof Blog

Professors on the Structure of the Trading Markets

     The NYSE merger has driven reporters to seek out and quote academics on the effect the deal on the structure of the trading markets.  A Business Week article on May 4th is classic.  First, the reporter quotes business professor Terrency Hendershott, from UC Berkeley, who repeats a familiar theme:  We are all better off if all securities for a single issuer are traded in a single market, that market will be the most liquid and deep and have the best prices.  [By the way Professor, E-Bay has many, many competitors.]  Then the reporter quotes finance professor Lawrence Harris, from USC, also a fan of consolidated trading markets who notes, to ease out concerns, that the SEC (he was recently the Chief Economist) has removed barriers to entry in the trading markets;  that is, new trading markets will emerge if the old ones get too pricey.

     What dreamers. 

      First, the two claims cannot be consistent.  A market driven to consolidate does have barriers to entry.  Those rushing to consolidate understand that the larger players will survive because there are barriers to entry that will discourage any smaller rivals.  The barriers can be "natural" (due to a market that inherently rewards size because of a correlation between size and decreasing costs) or "artificial" (due to government regulation that rewards size and incumbency).  I believe that the SEC's rules are the culprit, not natural market forces.  Others disagree.

     Second, and more important, is the recognition that all major trading market innovations in the last twenty years have come from outside the major incumbent trading markets, the NYSE and the Nasdaq.  The incumbents have fought them tooth and nail and continue to do so.  A consolidated trading market is a market inherently resistant to innovation and change.  And a supervisory government regulatory authority is not bright enough to decide on, let alone force, needed changes. [Democratic socialism fails as a government system because, while the theory is attractive to academics, in practice humans are fallible and cannot handle concentrated power;  a concentrated trading market will suffer the same fate.]      

     The proof is in the markets' history.  Most recent innovations came from electronic trading networks that emerged as competitors of the Nasdaq, a market that did not have a "trade through" rule.   The NYSE maintained an 80% market share in its listed securities with a "trade through" rule even though it sported an obsolete trading system.      

     So what does the SEC do?  Propose a Regulation that will, in effect, consolidate the markets in the hands of incumbents and attempt to impose a universal "trade through" rule.  The agency has learned nothing.

   

   

Specialist Firm LaBranche: Stock Price Hit New Low

       LaBranch & Company is a publicly traded specialist firm on the New York Stock Exchange (NYSE).  MarketWatch reported that on Monday the price of LaBranch shares fell 10% to $6.94 a share, the lowest closing price for a day since the company first sold shares to the public in 1999.  A share price of a rival specialist firm, Van der Moolen, also fell 3.5% on the day.  La Branch and Van de Moolen are the NYSE's two surviving independent specialists firms;  other specialist firms have been purchased by banking or brokerage holding companies.  [As an odd coincidence, this blog began that day with a morning post on the obsolescence of specialists.  ]

The price drops is the market's reassessment of the value of the specialists' function once new SEC Regulation NMS becomes effective and the NYSE closes its planned merger with Archipelego Holdings, an electronic trading platform.  The price drop should be compared with the recent price increase in the raw value of a seat on the NYSE, several of which are held by each firm.   An ownership interest in the NYSE is increasing in value, a specialists' license is not.  In other words, the market is projecting that the historically very lucrative traditional specialists' function will become largely obsolete. 

   

Hedge Funds

     Well known hedge funds have filed 13(d) statements (under the 34 Act), disclosing ownership positions in excess of 5% for both Wendy's and General Motors in the past week.  This could get very interesting.

     The hedge funds have decided to hunt in packs, which means that a single 13(d) statement will attract other hedge funds (and some of the more aggressive private equity funds) who will also take positions in the target stock.  The followers often buy less than a 5% stake and do not file a 13(d) becasue they are not "in concert" with the orginal filer.  In a matter of a few days, the hedge funds can hold 30 to 35% of the outstanding stock.

     The funds then approach the target board and demand structural changes in the company -- declare a dividend, spin off or liquidate a division, stop an acquisition, and, in extreme cases, put the company up for sale.  Once the company makes the change the funds hope to sell their shares on the stock price runup.  If the funds are correct that the requested change will unlock shareholder value, the funds make money. 

    This is another example of how major corporate goverance changes in the United States often come from outside the company.  Other examples include proxy contests, dissident shareholder pressure from institutional investors, government prosecutors (Spitzer or the SEC), takeovers (particularly LBOs), and, finally, bankruptcy reorganzations.  What is notable about the hedge fund involvement is that the funds have concluded that the old methods employed by management for resisting takeovers can be beat.  Their strategy depends on their success in pressuring a board to make the suggested changes.

     Watch Wendy's and General Motors to see if the hedge funds are correct.  Companies are not defenseless (among other things they may sue for a violation of 13(d)'s or 14(d)'s  group action rules).         

Will Post Confidential Comments on the Restructing of the Securities Markets

     Whenever I write about the structure of the country's securities markets I am asked:  "Who is paying you?" My answer:  "No one [in the industry]."  Most public comment on the new SEC Reg. NMS and the pending mergers is self-interested and "official."  There is so much cash at stake that market professionals are reluctant to talk and write candidly and openly about the changes for fear of offending a boss or client.  Professors are not immune;  many academics have an interest in grant money from market participants.  SEC insiders also are very, very careful in their public comments.  If you want to post an opinion confidentially, this is the place.  E-mail me, if interesting, I will post it without attribution here (or with attribution if you like). 

SEC and SROs

     A political compromise with the national stock exchanges in 1934 created our current SRO (Self Regulatory Organization) system of trading market regulation.  Each major trading exchange would regulate and discipline its own members, subject to oversight by the newly created Securities and Exchange Commission.  Over the years SEC oversight grew incrementially in power (through Congressional statute or SEC rule) with each new trading market scandal.  The SEC, on investigation of the scandal, would decide that the SRO was not viligent enough and needed a kick in the pants and more SEC supervision.

     The current proposal of the NYSE to become a publicly-traded corporation (it is now a New York not-for-profit corporation) has led to calls for the seperation of the SRO function of the NYSE from its trading operations.  This is not be an easy planning task should the SEC continue to favor some form of the SRO system.  Abolishing the SROs altogether would be the simplist and more efficient form of regulating the new NYSE.

    SROS have never worked as well as they claim to have worked.  I find the argument strange that a for-profit exchange can not be its own SRO but that a not-for-profit corporation can when the not-for-profit corporation is run for the exclusive benefit of members seeking huge profits.  It is nonsense.  The same reasons that cause one to worry about a for-profit exchange as an SRO should have caused the same worries about the current NYSE as an SRO.  The NYSE has never been and will never be a public interest organization.   

    In any event, the time is ripe and the whole SRO system ought to be abandoned.  The SEC ought to regulate the exchanges directly, without the use on a professional trade orgainization as an intermediary.  Imagine the cries of derision if Congress in the 1890s had let the owners of railroads set up a professional organization to regulate the railroad industry, overseen losely by the ICC.  What makes trading markets so special?   

NYSE Merger with Archipelago Holdings

     

On April 20th the NYSE announced that it would acquire Achipelago Holdings Inc., the

Chicago

operator of an electronic trading market.  Members of the NYSE, the owners of the exchange, are swapping their seats for cash and a seventy percent stock position in the surviving combined company.  NYSE seat prices have climbed fifty percent on the news and the shares of Archipelago have doubled in value (from over $16 a share to over $33 a share).  The current price of a NYSE seat is around $2.6 million;  in January seat prices were languishing at around $975,000. 

     This is a dramatic increase in value for both the buying and selling company in the acquisition and dwarfs the normal ten to fifteen percent total increase in value found in an average friendly acquisition.  What accounts for the market's unusual delight with the deal?

      First, the high post announcement values indicate that the market believes that the SEC will approve the deal and that the deal will close.  Second, the high values signal that the deal, post closing, will generate significant operating advantages.  Some advantage could be positive, such as operating efficiencies that reduce the costs of trading.  Other advantages could produce social costs, such as an increase in market power enabling the new NYSE to dominate rivals in its old market, listed shares, and in new  markets, Nasdaq listed shares and options on shares.  The market may be signaling that the country may end up with a single dominate, concentrated equity and options market, the NYSE, regulated as a public utility by the SEC -- an event that I view as ill-advised and most unfortunate.      

     In this regard the total share price increases on the Nasdaq/Instinet merger announcement do not match the market increases in the NYSE/Archipelago deal.  Nasdaq stock prices increased by fifty percent or so on the announcement of the merger but Instinet shares were offered a price that was lower that the last pre-announcement closing price (based on a argument that rumors had already run up the price).       

Stock Exchange Mergers and Regulation NMS

    

          It is not a coincidence that just a month or so after the Securities and Exchange Commission (the SEC) endorsed new Regulation NMS (for National Market System) the country’s two major securities trading centers, the NYSE and the Nasdaq, announced major mergers.  The NYSE is merging with Archipelago Holdings and the Nasdaq is merging with Instinet.  Both trading centers are trying to position themselves to be a dominant player in the newly restructured securities markets that will operation once the Regulation becomes effective early next year.

            Speculation over who will win and who will lose in the new trading regime established by the SEC Regulation is rampant among securities market professionals.  The NYSE anticipates that it will be a big winner if it can establish a sophisticated computerized trading system and take advantage of the new market wide “Trade Through” rule.  The Trade Through Rule requires that brokers execute client orders on the markets that published the best current prices.   

The Trade Through rule applies only to computerized systems and would otherwise leave out the NYSE’s open-outcry, floor trading system.  The acquisition of Archipelago gives the NYSE a sophisticated, proven computerized trading system.  Since the NYSE has over eighty percent of the trading volume of securities listed on the exchange and usually supports the best prices in those securities.  The NYSE hopes, therefore, that it will continue to dominate the market in its listed securities with its new computerized system. 

The flaw in the NYSE’s plan is the “market sweep” exception.  A broker can execute a large trade by cleaning out the NYSE’s best price at its stated volume and simultaneously finish the order by executing the remainder of the trade on any other market of its choice.  The trade does not have to wait for the NYSE to publish its next best price.  If traders routinely make such trades, the NYSE will have to increase the stated volume behind its best price to keep volume, adding risk to its specialist operations.

In any event, more people should be asking whether the SEC has the foresight to microstructure the country’s securities markets.  With Regulation NMS we are entering into the treatment of the nation’s securities markets as one of the most heavily regulated industries in the nation’s history in a peacetime economy.  We are only a half step away from the government’s acting like a public utility commission, controlling the activities of a single surviving gas or electric company operating in a given geographic area.       

At Long Last: NYSE Specialists Indicted

             The headlines in business section of April 13^th papers screamed that “15 Specialists on the NYSE Indicted.”  This is fifty or so years late but whose counting? 

            Specialists on the New York Stock Exchange have two functions:  they put other stock traders together (as agents and auctioneers) and they buy and sell stock for their own accounts (as dealers).  The second function can conflict with the first.

            The NYSE therefore regulates the dealer function.  Specialists have an “affirmative obligation” to trade so as to smooth out market prices and a “negative obligation” to not trade when the specialists could put together orders of other traders.  The negative obligation includes a prohibition on “front running” existing orders (trading in front of large orders that move the price) and on “inter-positioning” between existing orders (trading with existing orders that could be matched with other orders).

            I wrote in 1991 that the rules require a specialist to lose money and since specialist make obscene amounts of money, either the rules or the practice must be in question.  The NYSE went ballistic and threatened to sue me for trade libel. 

            Here is the argument:  The affirmative obligation requires a specialist to risk standing in the way of market forces (buy when prices are dropping and sell when prices are increasing) and losing money.  Their meager purchases cannot stop true market corrections and specialists who get on the wrong side of a correcting market are soon bankrupt.    The negative obligation requires specialists to stay out of the market in situations in which they know they can make a profit; it is an admonishment to not pick up the dollar on the sidewalk. 

It seems as though, on the rules, specialists have an affirmative obligation to lose money and a negative obligation against making money.   Sounds like a recipe for disaster;  yet specialists make gobs of money.  And specialists make most of their money trading in the most liquid (heavy volume) stocks, the stocks in which they are least needed to smooth out the market.  In heavy volume stocks the market is what it is and specialists trades are too small to matter.

The SEC and the Justice Department have poured over transcripts of specialists trades from 1999 to 2001 and decided that there are flagrant violations of the negative obligation by 20 of the specialists.  Imagine that.

The NYSE defends itself by saying that this is a small fraction of the trades and involve only a small fraction of the specialists.  The indicted specialists defend themselves by saying that their trading practices were “normal”; they were doing what they were taught to do and what everyone else does.

The indicted specialists’ argument is plausible.  They were just too obvious.

The transcripts of specialists’ trades are necessarily imprecise (the defense lawyers will make much of this argument) and identify only the most egregious examples of misbehavior.  Even these examples can be spun (there were oral, non recorded offers, for example).  There is much a clever specialist can do to camouflage problem trades, to say nothing of shenanigans at the opening and close of the markets.

What I hope the prosecutions will stimulate is 1) a clear identification of those situations in which a specialist can and should trade for his own account and 2) data on the frequency of how often those situations truly arise in liquid stocks.

My guess is that we will discover that there is little or no benefit to the market for specialists to trade for their own accounts in the liquid stocks, a suspicion that was first voiced by regulators over seventy years ago.