Who is to blame for market volatility? Last week alone, Bank of America, Apple Inc. and ExxonMobil lost more than $80 Billion in combined market capitalization. On Friday, Bank of America lost $10.1 billion in the first two-and-a-half hours of trading. Just today, in one hour of trade, Apple Inc. lost $13.3 billion in market cap from Friday’s close. And what do they have to do with America's downgrade? Large swings like these are all too common in our high-speed equity markets and many want to know at whom to point the finger. Look no further than the SEC.
Whether it is professional traders, institutional asset managers, hedge funds or simply John Doe investor, buyers and sellers are those ultimately responsible for price changes in stocks. Of course the SEC does not buy and sell stock, however they do have sole discretion on the way in which stocks are bought and sold. So while it is true that market participants are the cause of such wild volatility, it should not be the focus of the blame. Although there are instances of irrational and unreasonable moves in stocks, the question should not be to understand who causes this market abuse to occur, but rather to understand who allows it to happen.
In March, 2006 the SEC made a decision, following a proposal from then NYSE CEO and ex-Goldman Sachs president, John Thain to allow the stock exchange to adopt a hybrid trading system whereby select market participants were able to circumvent conventional modes of trading to execute transactions off market. The trades are made through electronic communications networks (ECNs) and can trade directly with the exchange, or trade directly with one another outside the market. This change greatly enhanced the speed of trading and allowed for computer execution of trades without the discretion of human oversight. It also facilitated higher volumes of exchange traded fund (ETF) trading. Around this same time and earlier, many large institutions were offering ETFs that track entire indexes like the S&P 500 as well as other baskets of stocks, commodities, and as they progressed, seemingly anything under the sun.
As the creators of ETFs multiplied their offerings with increased investor demand, it became necessary to amend other rules of the exchange to accommodate these new products and other financial innovations. The NYSE, again under John Thain, and other large institutions lobbied the SEC for the removal of the “uptick” rule. On July 6, 2007 the SEC complied and amended Regulation SHO and Rule 10a-1 to effectively allow any market participant to sell short any security without first waiting for a buyer, a rule that had been in place for over 70 years following the market deluge of the early 1930s.
Market participants could now control both sides of trading using computers to manipulate the buy side and the sell side equally, an ability that was never before possible, and one that large participants use to gross advantage. The SEC, as well as many market participants, claims that the changes greatly enhance speed, liquidity and price discovery. While this is true, it comes at the price of high volatility and a great loss of transparency as many transactions and orders take place outside the market.
Since the SEC made these changes, the average intraday trading range for the S&P 500 has doubled over the past four-years compared to the same period prior to the new rule making. This means that the price range for stocks from low to high on a daily basis has become twice as high on average. Another major change that has occurred as a result of these SEC changes is the difference between the previous day’s close and the next day’s opening price. Prior to the changes in market structure, stock prices used to open and close at the same price day-to-day. Following the changes, the stock market now gaps up or gaps down before average investors even have a chance to react. Just today, the difference between the Dow Jones Industrial Average's previous close and today's open was over 200 points.
The number of shares traded on a daily basis has also soared as a result of the changes. Since July 6, 2007 S&P daily trade volume has more than doubled. This has been a treasure trove for the SEC. The SEC collects fees associated with the transacting of stocks and in April of 2009 the SEC quadrupled those fees. They now represent about 15% of their $1.1 billion budget.
Despite the spikes in volatility as a result of the market changes enacted by the SEC, a reversion back to the more stable and transparent markets of the past does not appear to be in the cards. Under the new rules, a complex network of swaps, options, and other derivatives has developed to allow for the trading of newly created products like ETFs and exchange traded notes (ETNs). The creators of these products require the new market structure, and are greatly contributing to the increased volumes of trading. Their need for the new complex computerized market structure and the growing revenue stream flowing to the SEC easily sways the regulator’s decision in favor of today’s high-speed, volatile markets.
Following the May 6th flash crash Duncan Niederauer, the current CEO of the NYSE, chided the current market structure and asked for changes to be made. He said “This is the market structure we have all signed-up for in the United States,” and that he expected more harsh volatility in the future if nothing is done. Apparently May 6thwasn’t enough of a warning to make changes to market structure. Until the SEC begins to enact rules and changes that are in favor of the average investor as opposed to those that simply line the pockets of the SEC and benefit only large banks, it’s going to be a bumpy volatile ride ahead. Buckle your seatbelts.
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