THE STATE OF US EQUITY MARKET STRUCTURE & ITS ECONOMIC CONSEQUENCES
By: Thomas Caldwell
My job with Caldwell Financial Limited is managing long-term and semi-permanent funds on a strategic basis. Basically big picture plays such as our NYSE (NYX) activities. A great ‘old guy role’ in that one is not tied to the quote machine. Being based in Toronto provides a great perspective advantage when looking at U.S. markets, the economy, and American politics. One sees the good, the bad, and the ugly more clearly. We can watch America beat up on itself and occasionally see opportunities through the negativity. One is removed from the ‘group think,’ background static and occasionally constricting view of America within America. It is always a good idea, as Robbie Burns said, “to see ourselves as others see us.” That is my task today, to give a foreign perspective of America, but in only one sector.
I gave an interview to give a foreign perspective of America’s capital market structure two years ago to Forbes. Note: I was pre-op re a back injury and on heavy medication. My two quotes re U.S. capital markets were:
- “U.S. capital markets are no more than a bundle of unintended consequences.”
- And responding to how it got there “The regulators got snookered by the gamesters.”
Those sentiments hold throughout this article.
Structure of Capital Markets
Again, I am writing about the structure of capital markets, not the current levels or trends in America’s equity or bond markets. Current events are underpinned by a generally favorable economic environment – low interest rates, low inflation, economic growth estimated at 3% around year-end, funds flowing back into equities, a housing market turn around, tons of cash in the system and on the sidelines, repatriation of manufacturing and cheap energy, etc. The sporadic crises we confront (Cyprus) are all solvable, despite the rhetoric and media hype. All this positive background can mask structural flaws.
Capital market structure is a rather arcane topic. That is probably why no politician really cares to look at it. There are more votes possible having a new regulation named after you that may or may not address some abuse or violation. Political and regulatory involvement tends to be reactive, probably over-reactive, to blow ups. Once more regulations are enacted, then regulators and legislators are off to the next hot issue for further profile enhancement.
Market structure is critical to economic growth, innovation, job creation and America’s leadership in the financial world. The problem is no one is looking at the relationships between seemingly unconnected sectors or events and their unintended consequences.
Let me start with the NYX as we were once the largest owners, prior to their demutualization, with 49 seats. This can provide some perspective. Stock exchanges used to be wonderful proxies for an economy or region. Virtually every successful enterprise eventually ended up being publicly traded and/or raising funds on some exchange. That was the elemental role of an exchange – democratizing access to both capital and investment opportunities. Individuals could participate in a small way in others’ ideas, skills, and drive. Stock exchanges provided that efficient match up, along with subsequent liquidity.
In early 2000 or thereabouts, institutions and large trading operators saw the merit in creating their own trading environments. Cost and speed were their stated motivators and they rallied to Washington under the banner of: ‘competition is good for all.’ In some sense, it was a good motive, covering a bad motive. As trading volumes were increasing (partly derivative driven), many financial institutions saw an opportunity to reduce trading costs and generate revenues by becoming exchanges themselves.
Seeing overall order flow was an added bonus.
This also fit with the SEC’s negative bias toward NYX. Although equity trading was essentially a duopoly with NASDAQ, NYX was the target with its dominant market share of approximately 80% of all equities trading. There was also a bit of a turf war as to who should speak for investors and corporate America. (NYX missed this). The net result was Regulation NMS (National Market System), which effectively shattered the cash equities trading business. The industry was fragmented into approximately 65 quasi exchanges and dark and lit pools. This bled off volume and squeezed trading fees to near zero.
We now have competition based on trading fees such as ‘taker- payer’ models, since all exchanges have pretty much reached the same speed of execution. Do keep in mind that NYX was not an innocent bystander to all of this. They had become both lazy and stupid – you can be one but you cannot survive being both. Archaic trading systems, inadequate re-investment, and poor management had also become part of NYX’s brand.
Bottom line, competition is good. Hyper competition is not. Sadly, hyper is what Reg NMS brought.
Some of the results:
- NYX, a 220 year old icon is being taken over by a 13 year old upstart commodity exchange.
- The only real income for equities exchanges now is selling data and information.
- Mergers became necessary in order to cut overheads and generate greater volumes. The failed DB/NYX merger clearly illustrated that rationale.
- Exchanges have become addicted to High Frequency Trading (HFT), much of which is simply arbing between the fee structures of various exchange environments. At best, some HFT is gaming and at worst manipulative.
- NYX, ex-Euronext, has a value less than that of the Toronto Stock Exchange.
- Exchanges and their listed companies have historically had a mutual congratulatory relationship. Each benefits from the stature of the other. Reduce the status of your major exchange and you reduce the reasons for being a publicly traded company. More on this later.
Let us move on to the Flash Crash of May 2010 in order to illustrate the role and depth of thought processes at the regulatory level. Dubbed the Flash Crash, the SEC, in its wisdom, got rid of the ‘uptick rule’ which had constrained short selling. It was not a panacea, but it worked for decades. The timing of this change, during a period of major volatility in stock markets, was particularly odd, if not downright suspicious.
Their substitute was to introduce ‘circuit breakers’ which would suspend trading, for a time, during periods of extreme volatility. These circuit breakers applied only to the two major markets, but not to the numerous other market environments that grew out of Reg NMS. One did not have to be a member of Mensa to see how that would work out. It was a formula for disaster
On a given day, the reason does not really matter, a few major stocks were getting hit and the circuit breakers cut in on NYX and NASDAQ. Given that so much trading is ‘algorithmic’ (ie: computer driven), no one told the computers that the major markets were ‘paused.’ The computers started hitting the bids on thin quasi markets and when the major markets re-opened, they had to adjust to the new, even lower priced reality - and so it continued.
Prior to the post mortem congressional investigation there were very strong rumors that the SEC threatened some registrants against saying anything negative about the role of the SEC in this debacle, as it could possibly result in approval ‘problems’ in the future. I, for one, believe the rumors. It is like a Wesley Snipes movie. Suffice to say that market fragmentation can lead to price volatility and the undercutting of ‘price discovery’ for a given trade. The determining of the correct price for a trade is a key function of any exchange environment. The current system puts this and consequently public trust at risk.
The major exchanges are now generally seen as gaming institutions, addicted to high frequency trading for volumes and disconnected from their original, foundational role. NYX now accounts for roughly 20% of U.S. equities trades, down from the 80% noted earlier.
A key point here is, the diminished status and size of NYX also inadvertently enhances the status of their international competition, such as: London, Deutsche Boerse, Toronto, Singapore, Hong Kong and even Australia.
By 2002, the ‘villains’ from Tyco, Enron, and Worldcom were already in jail, yet an optics driven administration, congress and regulator grasped the idea that they must be seen as ‘doing something.’ I call it the Thomas Dewey, Rudy Giuliani, Elliott Spitzer factor. It is how you get a chance at being governor or president, assuming you do not do something cosmically stupid in the interim a la Mr. Spitzer. Tough on crime plays well in America.
Sarbanes-Oxley was the brainchild to come out of these events. Sadly, America occasionally gets caught in its own pride or hubris. Once adopted, SOX was hailed as the ‘gold standard’ for corporate governance and the rest of the world would rush to come up this new U.S. standard.
The reality is a long way from that self congratulatory claim. SOX has cost corporations billions of dollars in compliance bills, without saving investors one dollar. SOX may, in fact, have indirectly contributed to the financial crisis of 2008, as Directors focused more on SOX requirements and potential penalties than corporate risk. Note my personal experience. SOX also raised the cost and risk of being a public company in America to exorbitant levels.
New public issues, international listings and the U.S. economy in general have all been directly and negatively impacted by SOX. Note the cost for one mid-sized company, approximately $1.2 million per year.
Regarding securities regulations – simple is better, less is more – as long as it’s meaningful. Easier to police and comply with ‘Principles based’ versus ‘Rules based.’
Next, let’s take a cursory look at the U.S. banking crisis. This occurred when regulators were conned into scrapping the Glass-Steagall Act, which separated commercial banking from investment banking and which kept the U.S. banking system secure for almost 70 years. With its removal (championed by Sandy Weil of Citibank), investment bankers now had access to customer deposits and the rest is history. The system collapsed in less than a decade. Remember, banking should be boring. “3 – 6 – 3” take in money at 3%, lend it at 6% and go home at 3 o’clock.
Glass-Steagall’s incredibly complex replacement is Dodd-Frank. The Dodd-Frank guidelines for conducting our ‘affairs’ contains more words than the Old Testament, New Testament and Koran combined. Remember that’s just the guidelines, not the specific regulations. Glass-Steagall was 53 pages in total – policy and regulations.
The recurring theme out of Washington appears to be the move from simplicity, to complexity, to gaming, to ‘blow-ups,’ to yet more complicated and costly regulations. With every crisis, regulatory strangulation is accelerated, whether relevant and effective or not.
What SOX did for the accounting profession Dodd-Frank will provide for the legal community. As Oscar Wilde said: “the bureaucracy has to expand to meet the needs of an expanding bureaucracy.” The U.S. economy and many leading U.S. corporations have the size and depth to absorb some of this regulatory over-reach. It is, however, becoming a significant cost item, particularly when one considers the level of fines, which have now become a major funding source for both governments and regulators. They are sort of like parking tickets for municipal governments. All of this affects competitiveness.
Again, the problem is there is no political advantage to be gained by dealing with American capital market structures. The world won’t end because of these matters, but they will simply be an unseen break on economic growth.
America’s real strength has always been innovation. That will be curtailed. Even private equity funding sources think in terms of some liquidity event such as an IPO. The more this ‘out’ is delayed due to the costs and the mass required to access public funds, the more costly and reluctant those sources will become.
There is an interesting market observation here. Twenty plus years ago investors made real money on new companies after they did an IPO, such as: Intel, Microsoft, and Apple. Today that is becoming more of a rarity (note Facebook, Groupon, etc.) The big money is being made earlier on by private equity organizations prior to an IPO. Companies have to be larger to ‘go public’ due to increased regulatory burdens and risks.
This means the average American retail investor is being deprived of growth opportunities (and risks) to participate earlier in the growth phase. The public market is becoming a bit more of a dumping ground for the earlier stage investors. This has significant ramifications for America’s view of new, publicly traded companies. Investors do not need many duds to get the message. It also supports the growing interest in private equity investments.
Let us look briefly at three other sectors which impact capital markets and indeed innovation:
Civil Law Factors
It is not hard to see suing one another as America’s national sport. This presents a high risk and significant cost to doing business in America, particularly public companies.
- Loewen Group, a Canadian consolidator of funeral homes, failed in a $2 million takeover of a Mississippi funeral home. In a law suit, brought by the Mississippi funeral home, the state court awarded damages of $ 2 billion, which bankrupted Loewen.
- NYX, John Thain and Caldwell attacked in a frivolous suite where the plaintiff claimed she was given incorrect insider information. Our cost was $250,000 just to monitor that idiocy.
- The standard and recurring lawsuits whenever a merger is announced, claiming no merger necessary had management been competent. On every occasion, a few pension funds are paid millions of dollars in “blackmail” just to go away.
- Eg. Courts are often used to seek competitive advantage. Continual assaults on CBOE’s exclusive contract to trade S&P Options.
- British Petroleum (BP) is now facing claims that have long ago entered the fictional realm – with court backing. This is punitive rather than valid loss compensation. Some have even suggested they are being targeted, more than their U.S. partners, simply for being “foreign”.
- Best is Bank of America and Citi Group suing Standards & Poors for being too optimistic in rating structured products (ie: sub-prime mortgage paper) the banks created.
Criminal Law Factors
When Chuck Colson was in prison in the 70s, there were 250,000 individuals in prison in America. Today there are more than 2,500,000 people in U.S. jails. Even with drugs, America’s population has not grown ten-fold in that time frame. America’s approximate 90% criminal conviction rate is either the result of superlative police work or coercion, when confronted with draconian sentencing possibilities.
For example, the pursuit of Michael Steinberg at SAC may well be an effort to get Steve Cohen. No doubt Michael will have a choice between a 30 year sentence or 6 months of community service if he can come up with a tale that sticks regarding Cohen. The $155 million Picasso purchase simply made Cohen a more highly prized target.
U.S. also uses “stack on charges” such as mail fraud, obstruction of justice, or even Rico laws in order to both intimidate and enhance sentencing. Cases in point are Martha Stewart, Conrad Black and even Leona Helmsley. Abusive cases are Noranda re: price fixing in uranium, when they weren’t in that business and the “fast boat” company shake down by authorities.
The final point of foreign concern re: the U.S. is that of political risk. In the non-American world there are numerous phrases such as: “If there is anything more dangerous than being America’s enemy, it is being their friend. They always turn on their friends” and “Today’s friend is tomorrow’s enemy.” Eg: Villa, Batista, Noriega, Diem, the Shah of Iran, Mubarek (Note: Saudi & Israel) and even Saddam Hussein.
America should consider the basic fact that anyone who makes serious money in the emerging world will have some connection with the government of the day. India, for example is probably controlled by no more than 30 families, probably 10 families. It is easy to become an inadvertent target with governmental changes such as the ‘Arab Spring.’ Which may well become the ‘Fundamentalist Winter.’ In the Middle East, the Iranian freeze on assets and bank accounts, roughly thirty years ago, is still a vivid memory.
The good news is environments for capital have become like reverse beauty contests. Who is the least bad? Within that context, America still has charm, but it is fading.
The question comes down to something I asked several years ago in NYC. The U.S. has lost leadership in autos, consumer electronics and manufacturing. Why not in financial services? The bottom line is the risks versus costs for foreign companies and investors operating in America. These concerns transcend America’s huge pools of capital. To paraphrase: risk trumps potential gain.
There was a time when viable alternatives did not exist. That is no longer the case as other large pools of capital exist in environments without the same risks and costs. For example, London, Dubai, Singapore, Hong Kong, Bombay, Toronto, Sydney, Shanghai, etc. London led the financial world last year in terms of deals done.
The U.S. is now in competition with the world, but is still looking inward regarding capital markets and structures. The connection of these disparate sectors is a factor. America is not competing against itself or internally any more. The extra territorial environment is becoming increasingly important for Americans and foreign investors alike.
The Role of the Private Market
From an American entrepreneur’s perspective, I would think long and hard before doing an IPO in America. Stay private as long as you can and if needs be, access private equity or list in Canada. For small startups, ‘crowd financing’ is becoming a means of avoiding regulatory burdens. I have often joked that prospectuses only protect the life style of those who write them. Our NY securities lawyers have expanded tenfold in under ten years.
An interesting phenomenon that may, in part, be a result of the above, is the numerous U.S. corporations opting out of the public markets – or going private. Dell, Heinz, NYX, American Greeting Cards, etc.
One calculation, we noticed when we were accumulating exchanges around the world, is the relationship between a country’s GDP and the market capitalization of their publicly-traded companies. If the latter was smaller than the former, it meant wealth was concentrated in too few hands and the environment was inherently unstable (higher crime, for example).
Reduced public participation in public markets can have far reaching economic and political consequences. People become alienated if they cannot participate in the growth of their economy. I believe that is happening as America strives towards the “perfectly regulated market”. It can become so constraining as to undercut capital’s economic contribution and thus curtail economic growth. Only the largest companies can survive regulatory strangulation.
At present, there is neither the will, nor even the capability, to stand back and examine the unintended consequences of the combined regulatory, civil and criminal law and geopolitical concerns impacting American capital markets in the world’s eyes. America will continue to grow (I am an incurable optimist), but its dominance will increasingly come under pressure due to self-inflicted wounds. My comments come as someone who is pro-American. We Canadians could not have picked a better neighbor and by the way the same holds for America. Russia, China and Germany (they are fun guys) would be sub-optimal alternatives for either of us. Also one of our sons is an American. He is a pain, but I am sure there is no connection.