Monday, May 19, 2014
“The cars we drive say a lot about us.”
I’ve been doing a lot of reading lately on the operation of the stock market. Much attention is being paid to Michael Lewis’ latest book “Flash Boys” in which he lays out the argument that the U.S. stock market is rigged to provide several edges for professional traders, collectively called “high frequency traders” or HFT for short. Lewis’ book is merely the latest in a long line of books and white papers on the topic – you’ll find a list at the end of this commentary.
The stock market of today is nothing like the market that existed when I came into the financial business in 1982. In reading about the evolution of the stock market I started to look for parallels in innovation/change in other industries and the events that precipitated (forced) change and came to focus on the U.S. auto business. While the parallel is inexact (as most are) I think it interesting and instructive.
Innovation in the U.S. Auto Industry
I was born in the early 50s and came to know and love the U.S. cars of the 50s and 60s: Chevrolet, Ford, Chrysler, Studebaker, etc. As an aside, my family owned a 1958 VW Microbus, the first mini-van. We lived in Montana, and VW’s were so rare on the road at that time that owners would turn on their wipers in greeting an oncoming model.
In the 50’s and 60’s U.S. manufacturers were focused on competing on style differentiation and increased speed, not safety, reliability or economy. Cars were marketed as fashion, just like hemlines and changed as often. Going faster led to bigger engines and transmissions. In retrospect it seems like the rate of change in the auto business was slow, with most of the emphasis placed on “doing the same thing we did last year, but making it go faster and changing the style so buyers will feel left out if they don’t have the latest model”. A good example of this trend from the 50s are the so-called “Tri-Five Chevys” – the 1955, 56 and 57 Chevrolets that are distinct evolutions of the previous year’s style. You can pick any three or four consecutive years of the Chevrolet Corvette or Cadillac from the 50s or 60s and see the same ideas at work.
What changed to force innovation in the U.S. auto business in different directions? The rise of foreign competitors and the Arab oil embargo that started in 1973.
With the mass importing of foreign autos built by Volkswagen, Toyota, Honda and others, American consumers had more choices and those choices were less expensive and more economical than U.S. makes. The U.S. auto industry was initially slow to respond to foreign competition preferring their well-established path of “annual style changes and more speed”. Then came the Arab oil embargo in 1973. U.S. oil production had peaked in about 1970 and oil imports had become an increasingly-large portion of oil consumption in the U.S. The oil embargo forced consumers to evaluate the cost of getting around and U.S. autos were found to be seriously lacking in fuel economy in addition to a perceived quality gap. Innovation in the auto industry became focused on economy, safety and quality. The rate of change in autos picked up but not in the traditional style and speed categories. Car design became more homogeneous as the result of testing that revealed the “jelly bean” shape was more aerodynamic and thus more fuel-efficient. Consider auto design today – many cars on the road look very similar.
Consider the kind of car you can buy today for the price of a 1957 Chevrolet Bel Air which sold for $2,399. Adjusted for inflation, today’s price would be about $21,000. Style factors aside, the car you can buy today for that amount will be safer (disc brakes? seat belts? air bags? not in 1957), get better gas mileage (today’s V-8 engines have better fuel economy than the venerable Chevy 283) and be more dependable.
Bottom line: The U.S. auto industry would never have changed the direction of innovation without the influence of forces beyond their control: foreign competition and the Arab oil embargo. As a near-direct result, cars today are of uniformly higher quality, safer, more fuel efficient and a better comparative value for consumers.
Innovation in Stock Trading
The U.S. stock market essentially began as a gentleman’s club in New York City following the Revolutionary war with the signing of the “Buttonwood Agreement” which established a brief set of rules for trading securities. The Agreement was designed to reduce competition from “auctioneers” who were under-cutting the brokers trading in the New York Stock and Exchange Board. Virtually all securities trading in New York took place on what came to be called the New York Stock Exchange (NYSE). Stock exchanges were later opened in Philadelphia, Baltimore, Cincinnati, Chicago, San Francisco and other major U.S. cities.
These exchanges were organized as “open outcry” or “auction” markets. Your order to buy or sell stock on the NYSE would be taken to the Specialist (aka market-maker) who handled that stock and your order would compete with the other orders for the same stock. Your order was handled by people who dealt with other people. Specialists were broker-dealers who executed orders for customers and were required to maintain an orderly market in the stocks in which they specialized (hence the name). Maintaining an orderly market meant the Specialist was required to “make a market” in the stocks on his order book: to buy when there were no buyers and to sell when there were no sellers. For this responsibility, the market-maker/Specialist was allowed to earn a commission on the trades and to trade for his own account. For years, the NYSE had no real competitors and the majority of U.S. stock trading took place there.
In 1971, the National Association of Securities Dealers (NASD) opened the first electronic stock market – the National Association of Securities Dealers Automated Quotations (NASDAQ). The NASDAQ market was still run by people (though most of the trading was done by computer) and the NASDAQ market-makers were required to maintain an orderly market in the stocks for which they provided quotes – like the Specialist on the NYSE, they had to buy when there were no buyers and sell when there were no sellers. Like the NYSE Specialist, the NASDAQ market-makers were allowed to earn a profit on the trades passing through their books.
Nothing much changed until the mid 1990s. By this time there were a few more electronic markets, called “ECNs” for Electronic Crossing Markets which were designed for institutional traders such as pension funds and mutual fund companies. Changes in stock trading became driven by speed – the auction markets like the NYSE were “slow” and even the NASDAQ was slow by today’s standards. Differences between prices in different markets began to widen due in part to the asymmetry of information flow and traders sought ways to make money on the difference.
Needless to say, stock trading became faster and more dependent on computers than people. Your trades today are handled by computers dealing with other computers. Driven by the desire for faster trading on the part of market participants and the desire for fair markets on the part of the market regulators, a handful of landmark regulations and changes (including stock trading priced in pennies – “decimalization”) were implemented in the later 1990s and the 2000s. The New York Stock Exchange as we knew it ceased to exist in 2007 when it was converted to fully computerized trading. The floor of the exchange today exists only as a prop for television. Trading on the NYSE takes place in a large computer facility located in New Jersey.
The rise of computerized trading has led to the U.S. stock market being fragmented into more than 50 different trading venues. Market-making and the role of the NYSE specialist no longer exist. Trading is now controlled by ”liquidity providers” – broker-dealers (many of whom used to act as NYSE Specialists or NASDAQ market-makers) who stand ready to buy and sell stock but who are not required to do so. To participate in the markets these liquidity providers need only provide quotes at which they will buy and sell, but when prices aren’t moving in their direction, they simply cancel their quotes – essentially exiting the market - and the liquidity they were providing disappears. It is this kind of behavior that caused the Flash Crash of May 6, 2010 during which the Dow Jones Industrial Average dropped over 700 points in less than three minutes before recovering in nearly the same amount of time. Given the current structure of the markets, the occurrence of similar future crashes is highly likely.
Innovation in stock trading has been focused on speed and the markets today are more like a high-speed casino in which HFT firms earn billions of dollars every year basically scalping pennies all day long at the expense of other investors.
Bottom line: The drive for innovation in stock trading is still focused on speed, although there are signs of change (see Lewis’ book for details). We believe that a change in innovation will be forced on the U.S. stock markets but we don’t know what event or series of events will force that change in innovation as foreign competition and the Arab oil embargo forced a change in innovation on the U.S. auto business.
Flash Boys Michael Lewis
Broken Markets Sal Arnuk and Joseph Saluzzi
Dark Pools Scott Patterson
Inside the Black Box Rishi Narang
The Quants Scott Patterson
The Problem of HFT Haim Bodek
If time is short – and when isn’t it? – Flash Boys is probably the most “reader friendly” book on the list. If you are patient, you can get it (and the other titles) at your local library for free.