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Why the Stock Markets Are Broken

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This chapter is from the book
The authors of Broken Markets explains that what was an imperfect, yet elegant, oligopoly of a few stock exchanges has become horribly fragmented, operating at insane speeds, in a crazy dance of arbitrage.

Are you an investor? Are you a stock market aficionado who loves to learn about companies, industries, and the variables that tie them to a stock price? Do you have an online brokerage account at Fidelity or TD Ameritrade, for example?

Do you watch Bloomberg TV or CNBC? Do you read The Wall Street Journal or the USA Today “Money” section? Did you once fall in love with Maria Bartiromo on TV?

Do you enjoy the feeling that each day in the market is a new puzzle to figure out? Do you like seeing your well-chosen investments appreciate over time so that you can retire and live out your dreams? Have you ever felt excited talking about a stock, good or bad, at a party?

Did the market scare you during the financial crisis in fall 2008? How about spring 2009? Does your brow furrow trying to understand how the market could move so drastically and with such speed?

Do 500-point Dow moves intraday concern you? How about 1,000-point moves? If you trade with stops, have you always been mortified and angry about how “they” seem to take your stock to that price level, trigger your stop loss, and then take the stock back from that limit?

Do you understand how—or where—stocks trade today? Do you think that you should?

Because the title of this book is Broken Markets, it is fair to assume that we believe that there’s something wrong with the stock market. It has changed so drastically, and so quickly, from the model that it was based on for more than a century. The stock market used to be a system—and a place—where investors traded capital. Now it is a loosely connected mess of more than 50 different exchanges, dark pools, and alternative trading venues focused on short-term trading. What was an imperfect, yet elegant, oligopoly of a few stock exchanges has become horribly fragmented, operating at insane speeds, in a crazy dance of arbitrage.

The market is like a shattered vase that is now held together with glue called high frequency trading (HFT), and that glue is weak—very weak. In addition to fragmentation, under the cover of the digital revolution, conflicted stakeholders—stock exchanges, brokers, and owners of ATSs (alternative trading systems)—have

  • Enlisted their own regulators to help them create a mechanism that places high-speed trading interests above the interests of all other market participants, particularly investors.
  • Converted member-owned nonprofit legal structures into ones that are for-profit, which have enabled them to embark upon new business models centered around the creation and distribution of data feeds.
  • Perverted the true purpose and usage of tools like dark pools from mechanisms to effect large block trades for large mutual and pension funds to a means to feed internalization and proprietary HFT.
  • Introduced new systemic risks resulting in markets that can violently careen out of control as they did on the May 6, 2010 Flash Crash.
  • Extracted the economics away from brokerage activities that nurture young companies and their IPOs.

Why Has Our Stock Market Structure Changed So Drastically?

The market has been hijacked. An evolved class of leveraged short-term, high-speed traders, sometimes called high frequency traders, who trade massive amounts of shares based on proprietary algorithms, has eclipsed other types of traders.

In the not-so-distant past, as little as ten years ago, most stocks were listed on the New York Stock Exchange (NYSE) or on the NASDAQ. When you, your mutual fund manager, or other fund managers wanted to buy or sell, a broker who was a member of the exchanges would execute the trade on your behalf in fairly centralized locations. You paid a commission or incurred a spread cost.

If the stock was listed on the NYSE, your order would be executed there, via your broker, with your instructions (that is, limit, market, stop loss, or good-till-cancel). Your order would make it to a specialist on the floor of the exchange who would execute it according to specific rules. The specialist’s role was to match buyers and sellers, in a fluid way, whether they were on his limit book or against an order “in the crowd.” In exchange for doing this, the specialist was allowed to trade alongside orders, taking advantage of his being privy to all the order flow.

If your stock was listed on NASDAQ, your order was represented and executed against an electronic dealer market. Those dealers would compete for your orders by adjusting their “market.” If a NASDAQ market maker was a better buyer of the stock, he would post a competitive bid that was equal to or higher than the other prevailing bids. If he was a better seller, he would post an offer price equal to or lower than the prevailing offers by other dealers. These market makers not only facilitated customer order flow, but similar to the specialists on the NYSE, they also traded for their own accounts.

The history of the NYSE dates back to a 1792 pact, called the Buttonwood Agreement, named for the tree under which the agreement was signed. Twenty-four brokers signed the document, which established rules for the buying and selling of equity ownership in American corporations. These rules of conduct and fair play served as the foundation for all securities trading globally for a century, and volume on the exchange steadily grew.

The significance of integrity and fair play was so important to the Board of the NYSE that when it expanded into a new building on Broad Street, the building featured an incredible sculpture by John Quincy Adams Ward titled “Integrity Protecting the Works of Man.” This sculpture features a 22-foot figure of Integrity in its center, with Agriculture and Mining to her left, and Science, Industry, and Invention to her right. How wise that NYSE Board was to recognize that economic growth and the stock market are intertwined. How wise for that NYSE Board to recognize that integrity forms the basis for trust and confidence. How wise for that NYSE Board to recognize the link between the stock exchange and capital formation!

Of course, over time, technologies evolved. Computers have made the markets faster and more efficient. Technological advances have empowered retail and institutional investors who can deal more directly in the marketplace, with fewer intermediaries, more control, and lower costs. The benefits have been substantial, to be sure. However, one class of market participants, HFT firms, has leveraged technology as well with automated programs that generate massive volumes for the stock exchanges. As they have grown, HFT firms have used their economic clout to extract an increasing number of perks and advantages from the exchanges, tilting the zero-sum game that is the stock market in the favor of HFTs versus investors.

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