Ted Kaufman - United States Senator for Delaware

Fixing equity markets is not such an easy task

Source: Financial Times

By Larry Tabb

August 26, 2010

In a letter on August 5 to Securities and Exchange Commission chairman Mary Schapiro, US senator Ted KAUFMAN called for stricter governance of high-frequency trading and asked Ms Schapiro to re-think the idea that a faster, tighter market is better than a slower, deeper market. Senator KAUFMAN suggested that a slower market with wider spreads may be the best solution to both drive capital formation and create a market that benefits longer-term investors.

He proposed a nine-point plan that included greater oversight of HFT, reducing market fragmentation and harmonising stock exchange rule books. The senator might be on to something, but the challenges we face today are less structural and more economic and will not vanish with a new set of more robust equity execution rules. Investors have been running away from the US stock market in droves. Equity volumes are about half or less than the historic highs reached at the March 2009 market bottom, with average daily volumes for August in the low 6bn share range (numbers we have not seen since early 2008). What’s more, equity mutual fund flows have been negative since the beginning of the credit crisis. According to the Investment Company Institute, $157bn has been pulled out of US equity mutual funds since September 2008. And that does not include market value loss, just net redemptions.

Can we lay this state of affairs at the feet of market structure? I don’t think so. That would be like blaming the reservation system at a restaurant for its fading popularity. Sure, a better process would help, but there are plenty of other reasons why we choose to dine elsewhere. So what then is at the heart of our fading equity markets? The first chink in the armour is purely demographic. Baby boomers are getting closer to retirement and increasingly less inclined to own stocks. The United Nations pegs the number of US residents over 65 at roughly 13 per cent of the total population and estimates that will reach nearly 20 per cent in 20 years. Given this seismic shift, a move away from risk assets (equities) towards safer ones (cash and bonds) would not be surprising. Beyond demographics, the market’s performance during the past decade has not exactly engendered much confidence.

The market crashes of 2000-2001 and 2008-2009 wiped out virtually all equity gains, while the latter also demolished housing values and greatly curtailed credit. More recently, the May 6 “flash crash” and incessant talk of a double-dip recession have weighed heavily on investor sentiment. Government policy has not helped. Investors are not only worried about the markets but about the country’s political future. The corporate uncertainty generated by the passing of healthcare reform, financial reform and possibly a new energy policy – not to mention concern over how economic stimulus and tax policy will affect the deficit – has not created an investor-friendly climate. The vitriol directed at banks has not helped either, as the government has done its best to shift blame for the credit crisis on to financial intermediaries. Not that we should cry over banks; they deserve significant blame, but not all. It doesn’t take long to convince investors not to trust their nest eggs with firms that pushed a bunch of “s***ty deals,” as our legislators were fond of recounting.

In addition, the Sarbanes-Oxley Act of 2002 increased the risk and compliance cost of being public, and the Eliot Spitzer-driven Global Analyst Research Settlement of 2003 destroyed the business model for broker research, making it very difficult to get any information on many small and mid-cap equities. Without even biased market intelligence, investors simply stay away.

Monetary policy has not benefited the stock market either. Short-term rates at near zero and mortgage and high-yield bond rates at record lows should be good for equities. But the fear of deflation – a horrible development for equity markets as reduced wages and the incentive to delay buying will put a crimp on corporate revenues – is keeping would-be investors on the sidelines. I could go on.

But the point is clear: The challenge of fixing our equity markets is not as simple as “fixing” the market structure by widening spreads. Widening spreads across the board will only remove trading opportunities and increase trading costs. I would love to say widen spreads and tax the HFTs and everything will be fine, but in the end, I think increased spreads will only force institutional and retail investors to pay more for execution and make it harder to get in or out of an investment . . . and profits will just be re-allocated from the fast and fleet to slower players with larger pockets.

If we think by taxing high-frequency firms we will go back to a time when markets were slow and humans made trading decisions – forget it. When was the last time we replaced computers with humans?

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