A Citizens for a Sound Economy Foundation lunch meeting I attended last Wednesday (and to which I was attracted by its title “Who let the Bears Out”) on the subject of stock market deregulation was particularly interesting for one feature: All the panel speakers were in favor of it. During the meeting, the thought thus occurred to me (and, being the brash opinionated sort that I am, I expressed it during the question period): If stock market deregulation is so good, why has everybody lost their shirts?

The panel was an interesting bunch; Joe Lombard, Counsel to outgoing SEC Chairman Arthur Levitt, Matt Andresen, CEO of Island ECN, the online stock market, Gregory Smith, Senior Analyst at JP Morgan H&Q and Dr. Jerry Ellig, Senior Research Fellow at the Citizens for a Sound Economy Foundation. All of them were basically in favor of more deregulation, although naturally Andresen, the principal beneficiary of deregulation was most wholeheartedly in favor while Lombard, as befits a sober regulator, expressed some caveats.

A little history here. The traditional markets for U.S. stocks, the New York Stock Exchange and the American Stock Exchange, operate through a “specialist” system whereby each stock has a specialist who makes a market for all buyers and sellers in that stock.

All orders are displayed transparently, and the specialist is compelled to match buy and sell orders, while trading other than through the specialist is prohibited. Thus an investor wishing to trade within the “spread” between the bid and offer prices on a stock can place a limit order, and hope that another investor with opposite requirements will meet it.

The first major market innovation was the Automated Quotation system of the National Association of Securities Dealers, instituted in 1971 for those stocks not traded on the NYSE or the Amex. Under this system, a computer displays buy and sell orders, and brokers trade with each other with no specialist, and are able to bid against the computer ahead of their customers.

It is thus much more difficult for the outside investor to reduce the spread. Generally, with modern brokerage commissions, the spread is substantially more than the commission; a typical NASDAQ stock might be quoted at 5½ – 5¾, in which case an investor who buys 1,000 shares and then sells them again before the price has moved will pay a spread of $250, compared with commissions which might typically total $50 or less for the two transactions.

This was all in theory legitimate, but as readers may remember, NASDAQ market makers were compelled in 1998 to pay investors a total of $1.027 billion for conspiring to widen spreads and thereby defraud investors.

Following the establishment of NASDAQ, the SEC established a number of rules to ensure that outside investors were treated fairly. One was the “trade through” rule, a major focus of Wednesday’s discussion, whereby an investor must receive the best available price at the time his order is placed, on whatever exchange it may be quoted. Thus if a share is quoted at 31¼ on the NYSE, and 31 3/16 on the Boston Stock Exchange, a purchase order must be executed on Boston. With 1970’s technology, this was not a problem; the inter-exchange dealing system routed orders from one exchange to another within a couple of minutes.

With modern computer and telecommunications technology, and the advent of the Internet, the possibility arose of a fully automated system, of which Island ECN, founded in 1996 is now the largest; such systems represent 30 percent of trading volume in NASDAQ shares. However, in order for such systems to be feasible and profitable, all trading in them must be done internally, without the possibility of trades being re-routed to an outside exchange.

On reason for this is the differing transaction speeds; Island claims a transaction time of one millisecond, while the inter-exchange dealing system between the NYSE and the regional stock exchanges, which relies on 1970’s equipment, takes up to two minutes. Hence, to allow the creation of Island, the SEC dropped the “trade through” rule, and allowed transactions to be carried out on Island even if a better price was available elsewhere. Island now wishes to extend their trading activities to cover NYSE listed stocks, thus removing for such stocks also the investor protection of the trade through rule and, over a brief period of time, no doubt eliminating the specialists, thus subjecting outside investors in NYSE stocks to the full bid-offer spread of a NASDAQ trade.

At Wednesday’s meeting, Andresen propounded the theory that the trade through rule could in certain circumstances work to the investor’s disadvantage, because by the time the inter-exchange system had taken two minutes to route the order to Boston, the better price might have disappeared. He gave the extreme example of the initial public offering of Palm Pilot, which was issued at $35 per share and opened for trading at $165 per share.

An investor using “trade through” who had decided to buy at 165, and was re-routed to Boston would have found the price had dropped to about $140 before his buy order confirmation arrived and he was able to sell and stop his loss. In practice, however, investors who purchase in the immediate aftermarket at $165 a share which has been issued at $35 deserve, because of their sheer stupidity, all the losses they sustain. It is quite clear that in practice, in general “trade through” works strongly in favor of the outside investor by discouraging abuse and insider skimming. The “Two minutes to contact Boston” problem can be solved very simply by modernizing the inter-market computer system.

A further abuse of modern trading systems is the “payment for order flow.” Under this system, an electronic exchange such as Island can pay a large broker for its order flow, thus diverting investor trades to it without their knowledge. Naturally, this is open to numerous abuses, most notably that it represents an additional rent-seeking by the trading fraternity at the expense of investors. Andresen alleged that payments for order flow were supposed to be rebated to investors; even the heavily pro-deregulation panel did not agree with him that this reliably happened in practice.

The automated NASDAQ trading system has of course been remarkably successful. NASDAQ share trading volume surpassed that of the New York Stock Exchange in 1994 (while dollar volume remained lower as NASDAQ-quoted shares are generally lower priced than NYSE-quoted shares) and NASDAQ dollar volume surpassed it in 1999, though it has since dropped back significantly. NASDAQ itself became a shareholder-owned, for profit company in 2000, and expects to go public when market conditions permit. But, for the investors and for the economy as a whole, to what end?

Wednesday’s panel was in unanimous agreement that the introduction of competitive stock markets was an unalloyed good, as was increased trading volume. I wholeheartedly disagree. Competing stock markets, without a watertight “trade through” rule, simply fragment the auction process and allow insiders to skim additional returns at the expense of the investor. As a financial services practitioner for 25 years, I had been unaware of the developments in U.S. stock trading since my business school days; if I as a professional was unaware, then there can be no question that the vast majority of retail investors are unaware of the complex system which has replaced the NYSE specialist. Where there is customer ignorance, there will be insider profiteering and fraud, particularly in an industry with such lax ethical standards as stock brokerage.

Trading volume, too, is by no means an unalloyed benefit either to investors or to the U.S. economy as a whole. Trading volume on NASDAQ exploded most spectacularly in 1999-2000. Retail investors were drawn into the market partly by the easy money that appeared to be being made, and partly by huge advertising blitzes by the online brokers — E-trade’s advertising campaign alone is said to have cost more than $500 million. Investors were told that brokerage commissions had sunk far below previously prevailing levels, but were not informed of the additional returns being made by insiders from trading spreads, let alone such arcana as payment for order flow. Consequently, many of America’s brightest young people quit their jobs and took up occupations as speculative “day traders,” themselves pushing up prices and volume in a dizzying spiral, while investors as a whole were sucked into a tech sector that was ludicrously, impossibly overvalued. As one conservative, intelligent but non-professional investor said in sad retrospect “one could not have a social life in 1999 without being invested in tech stocks.”

Like all bubbles, the tech bubble burst. As I write, the NASDAQ index is down some 56 percent from its high, and has in my view very much further to fall, Huge amounts of precious American capital have been poured into a business that was supposed to have revolutionized U.S. productivity but in reality has yet to produce significant genuine profits for its shareholders. As a result of the misallocation of capital, the U.S. is in for a very nasty and probably prolonged recession. The day traders are looking for jobs, their capital wiped out. My conservative investor friend has lost much of her scarce capital, and is wholly disillusioned with the investment business and indeed with the United States in general.

And what of the SEC, that supposed guardian of investor rights? It did nothing to protect investors from the various accounting chicaneries of the last several years, allowing tech company executives to award themselves stock options worth many times their company’s profits, without disclosing the matter to shareholders except in an obscure and incomprehensible footnote to the accounts. Instead, it concentrated on introducing imaginary “competition” to stock exchange trading, allowing an explosion of investor rip-offs and trading volume, to the enormous benefit of the brokerage community but of nobody else.

Let us hope that President Bush will appoint a new Chairman of the SEC who will stamp out this chicanery root and branch. The SEC should encourage all serious companies to list their shares on the New York or American Stock Exchanges, where investors are properly protected, and leave NASDAQ to the fly-by-nights and the frauds who belong there. NASDAQ as presently constituted has become the casino of U.S. capitalism and has caused both investors and the U.S. economy huge damage by this. If reform proves to be impossible, then close down the casino — it will not be much missed.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.