The consolidation of the world’s stock exchanges appears to be taking shape, with the New York Stock Exchange bidding for the Paris-based Euronext and NASDAQ now owning a blocking 25 percent of the London Stock Exchange. Stock Exchange mergers and increasing technological sophistication are universally assumed to be a good thing; the next downturn is however likely to poke a few holes in this assumption. New technology and inappropriate market structure may cause a market meltdown of their own.
The arrival of computer and Internet technology has greatly changed the business of trading stocks. Before 1971, stocks were traded on physical trading floors by human traders. Trades took up to a minute or so to be transacted, and experienced traders greatly improved their profitability by picking up non-verbal signals from the market – not only the expressions and voice intonation of other traders, but more important the volume and timbre of the noise produced by the trading floor as a whole. An active market was much noisier than a quiet one, a fearful market sounded different from a confident one, and the sound of market panic was unique – as recorded by so amateur an observer as Winston Churchill, who was present in the gallery of the New York Stock Exchange for Black Tuesday of 1929. Studies have shown that only 7 percent of the information transfer in a conversation consists of the words themselves; with experience and flair traders could pick up the other 93 percent, and adjust their trading strategies accordingly.
This efficient system began to change a surprisingly long time ago, in the 1970s. In 1971, the National Association of Securities Dealers inaugurated NASDAQ, a primitive electronic trading system for stocks that were not listed on a major stock exchange. In 1978, the New York Stock Exchange loosened the rule by which all trading in NYSE-listed stocks had to take place on the exchange, and inaugurated the Intermarket Trading System, by which bids on regional stock exchanges and (eventually) electronic platforms could pre-empt the NYSE bid on a transaction. During the 1990s, a number of electronic trading platforms grew up, initially for NASDAQ-quoted stocks, but after 2001 for NYSE-quoted stocks.
The result was a fragmentation of the market, by which, as well as the NYSE specialists, various entrepreneurial trading systems could post bids and offers for stocks. Consequently, liquidity was no longer concentrated in one location, instead being spread between a number of different locations, each of which used a different trading system, traded at different speeds and charged different fees. In 2005, the Securities and Exchange Commission promulgated Rule NME, which was intended to provide a system by which the quotes in different locations could be brought together. When Rule NME takes final effect, currently expected in February 2007, it will inevitably force the majority of NYSE trading into electronic form. However as demonstrated by Michael Richter of Lime Brokerage LLC at a meeting of QWAFAFEW, the quantitative finance workshop Tuesday, the NME system does not in reality achieve its objective of trade optimization, since it forces trading to the location at which the best price is displayed, whether or not that best price applies to the full amount of a trading order.
In London, the Financial Services Act of 1986 abolished the distinction between brokers and jobbers, and effectively forced the abandonment of the London Stock Exchange trading floor and the redundancy of experienced floor brokers (“jobbers” in London terminology) whose expertise in “reading” the market had all at once become obsolete. By moving to an all-electronic market so early, London applied a heavy roller to the playing field whose gradations had protected London merchant banks, brokers and jobbers for the preceding two centuries. The result was inevitable; by the turn of the century almost all significant London financial institutions were owned by deep-pocketed foreign shareholders, and the City’s unique capability in international finance had disappeared – it had become simply a branch nexus for overpaid primarily foreign traders, with real control exercised in Frankfurt, New York and elsewhere. Now the LSE is to be controlled, not by the NYSE, which would have produced a certain amount of operating synergy, but by NASDAQ, a purely electronic exchange that does not trade most “blue chips” and whose standards of probity have repeatedly come into question.
There were important interests which pushed through the trading changes in New York and London, in the form of the big balance sheet universal banks that saw the possibility to dominate the market, and those interests are vehement in defense of the current system. At the QWAFAFEW meeting, my suggestion that there were two sides to the question of what form trading should take, human floor broker or computer screen, was met with aggressive hostility from the traders present, who scoffed at the thought that they might have to wait for 30 whole seconds for a trade to clear, and at the previous NYSE automated trading rules that had limited automated trade orders on any security to 1099 shares in a 30 minute period.
In reality, Rule NME addresses a problem that would never have existed had not the major New York investment banks and electronic trading platforms forced the NYSE to abandon its trading monopoly on NYSE stocks — without such abandonment, all orders on NYSE stocks would have cleared through the central NYSE specialist, as had historically been the case. Even in the post-Rule NME world, a significant volume of trades may still be carried out by the specialist. In the test run of the new system for one share, Lucent, on May 12, 2006 97 percent of the trades cleared through the automated system, but only 74 percent of the volume – large or complex trades still required the intervention of the human NYSE specialist. However, it is unlikely that NYSE specialists can survive on trading only a quarter of the total volume in their stock, so that after NME becomes operational, the NYSE will presumably go the way of the LSE, and the trading floor will rapidly fall into disuse.
The profusion of trading platforms that grew up after the ending of the NYSE monopoly thus appears likely to be short-lived, as the “competition” that was so trumpeted as a reason for ending the NYSE monopoly is subsumed into a worldwide oligopoly of no more than 3-4 major multinational exchanges, all of them electronic. Trading will thus be possible 24 hours a day (probably on balance a good thing, although likely to produce insomnia for those involved) and it will also take place instantaneously, with trading positions being matched electronically, and trade completion times being measured in milliseconds.
This has been sold as a benefit to humanity, one of the inevitable advances that science brings, but in reality it is no means certain that the new system will be foolproof, or can be made so. In particular, there must be a serious question as to what will happen to the new trading system in a sharp market break such as occurred in 1987, but has not been repeated since.
1987 is now a very long time ago; very few active traders now in the market had direct experience of that event (while even the financial community mostly has to work till 55 or so, very few 55 year olds are still employed on trading desks; if still in financial employment, the over 50s are in research or management.) Nevertheless, those traders who know their financial history will remember that the principal cause of the 22 percent market drop was not an economic factor (there was no recession in the United States or elsewhere for the 2 years following the crash) but electronic “program trading” that produced a cascade of sell orders, which intensified uncontrollably as the market dropped. While the human specialists of the NYSE continued trading throughout the episode, NASDAQ, already electronic, was effectively closed for several hours during the worst of the crisis.
The NYSE now has “circuit breakers” that impose progressively more serious restrictions on trading at times when the market is down more than 2 percent. Effectively, electronic trading becomes restricted, and the market returns to a human-based system. However, what will happen when the trading floor has been closed? We cannot assume that the NYSE human floor specialists will remain dormant, carrying out only a small part of the day to day trading, only to lurch back into action, after maybe 20 years in quiescence, every time there is a market crisis – there is no conceivable business model that would make such a deal attractive for them.
In a market crisis, the order flow is unbalanced – that is more or less the definition of a market crisis. Believers in the Efficient Market Hypothesis will intone pompously that this is impossible, that there is always a price at which the market will clear, but anyone who has experienced a true market crisis of the 1987 type knows that this is nonsense – price discovery is not continuous, and trader and investor psychology are sufficiently volatile that in a crisis, the volume of sellers simply overwhelms buyers.
In such a crisis, what is needed is hysteresis — the engineering property by which an object does not deform infinitely fast, but resists rapid change, and pushes back harder, the faster the change. A market with hysteresis will decline only moderately, and trading volume will slow to accommodate the specialists’ need to keep their books more or less in balance. At such a time, delaying factors such as the October 1929 NYSE ticker tape that ran three hours late on the worst day of the crisis are of inestimable value, as are human specialists who can take the temperature of the market and trade only slowly, adjusting their prices by trial and error until a new equilibrium is found.
An electronic system, which trades in milliseconds and if orders are seriously unbalanced has no means of finding a new equilibrium, will break down. All the effort to make the system more “efficient” will have removed the hysteresis and made the market unstable. Either the electronic system will refuse to trade at all, or it will trade wildly, oscillating its prices by huge amounts as new orders are received and producing a chaotic market (in the mathematical sense) in which uncertainty is maximized and price discovery becomes impossible. If the entire world’s stock markets are linked into one huge electronic exchange, this oscillation and refusal to trade will be continuous, with chaotic conditions in one market quickly spreading to engulf every market in the globe. Only the blessed release of Friday night, and the 24-hour market’s closure, will produce an end to the madness.
If that market behavior doesn’t itself produce a collapse in the capitalist system, the reactions of terrified politicians to their constituents’ bewilderment, anger and huge losses certainly will. The Wall Street Crash was wrongly blamed for the Great Depression for half a century after it occurred, and produced some of the most counterproductive market regulations ever seen (notably the Glass Steagall Act, which split commercial and investment banking, de-capitalized the latter, and came close to shutting the U.S. capital markets for a decade.)
This time, the hysterical and punitive politicians will be right; the crash really will have been the fault of greedy capitalists, those who forced the world’s stock markets into an electronic trading monopoly.
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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.