March 1, 2021
This guest post is the first in our Voices series, where LTSE invites industry leaders to share their perspectives. Voices authors represent a range of expertise, and are asked to expand and challenge our understanding of current events and themes in the landscape of finance and technology.Amy Butte is the former CFO of the NYSE and highly-regarded industry research analyst. A financial services veteran, she has over two decades of experience across investment banking, national securities exchanges, and as a founder, board director, and advisor (including an advisor to LTSE). In this Voices post, Amy shares her response to recent market volatility and three ways the markets can rebuild trust.The frenzy around GameStop, Robinhood, and Reddit kickstarted some much needed conversations around ways to make trading fairer and how we can improve public trust in the markets. The New York Times DealBook recently outlined six suggestions to fix the markets, and we will certainly hear more at next week’s GameStop hearing.But to truly make sense of these events and rebuild trust coming out of this phenomenon, I suggest refocusing the dialogue on emphasizing and demystifying three core areas.
Long before Robinhood, zero commission trading was steadily trending over the last two decades. The business model has remained the same: brokerage firms (especially online firms who seek the most active traders) can compete on the price of a trade because they make money elsewhere.For example, firms make money on the “float” or the difference between what interest they pay on cash balances and what they earn. In today’s market that isn’t much (maybe a spread of 50bps), however, in a high interest rate environment it can be huge — up to a few hundreds basis points.Another way retail firms generate revenue is through fees on asset values. This is a stable approach that many asset gatherers use. For example, they provide a full service for 100 basis points for assets under control. But firms like Robinhood don’t cater to higher net worth clients. With average asset values orders up to several orders of magnitude lower than their counterparts, those fees don’t generate enough money to “keep the lights on.” That leaves Payment for Order Flow as the primary way to generate revenue. The brokerage firm, in this case, sells the trades on their platform to a third party market maker. The market maker is willing to pay for the flow because of the information they receive on those trades. In the world of trading, information can translate into money. For example, if they see momentum going into or away from a stock, it sends a signal for how they can trade or how tight a market they can make.Twenty years ago, when I was analyzing the business of online brokerages, we called this “risky revenue” in the context of understanding how trading activity translated to actual earnings. Today, research firms have estimated that online brokers receive $1 billion to $2 billion in payment for this flow. If a trading desk is willing to pay $1 billion, you can be sure they are making a minimum of 2X that amount for their coffers. In other words: free trades can actually be considered expensive due to the delay in execution. Dark markets, when trades aren’t shown to the entire marketplace at one time, are expensive for all types of investors — retail and institutional; speculators and long-term investors, alike.My recommendation: Regulators can require retail firms to be transparent about how they make their money, similar to public.com. While they may not yet be a profitable business, they are paving the way through transparency.
Trading and investing are not the same. They are both legitimate means of wealth transfer, however they are very different! Speculators, investment bankers, trading oriented broker dealers, clearing houses, and traditional exchanges (e.g. Nasdaq and NYSE) make money when there is a transaction. Asset managers and asset driven wealth managers make money when asset valuations increase. Motivations matter.Speculators focus on transactions that happen in the short-term. In contrast, investors benefit from long-term thinking. For example, asset managers focus on the increasing value of an asset over time. Warren Buffet’s time horizon is shaped on decades, not seconds, hours, or days. Mutual Fund managers are often paid on their performance over a multi-year time horizon. Contrast that with speculators, who seek to monetize short-term market movements. There is less of a care about the value of a company, but rather the ability to make money on volatility or movements in the stock.What if regulators required trades to be marked as long-term or short term? Whether you’re a speculator or investor, it would be interesting to know the long-term holdings as a percentage of the total float of a company, and especially help retail investors understand if the stock is in the hands of those with a long-term horizon or in the hands of those which may create added volatility. Companies will also benefit from knowing who is buying and selling their shares. This indicator wouldn’t change the reason for making a trade or investment, but it would tell the market, regulators, investors, and companies more about who is taking positions in the stock.
Want to know the dirty little secret of our markets? Long-term investors supplement the cost of trading for speculators or short-term traders. If you buy a share as a long-term investor, you pay the same per-share transaction fee as a speculative trader. However, the capacity required to support the infrastructure of trading is radically different. Traders send multiple messages for every trade they execute, testing the waters before they find the perfect place to enter a trade (nanoseconds and pennies matter).For example, the current NYSE daily average volume is approximately 1 billion shares a day, but messages, including dark messages, are estimated at 50 to 100 times that (we don’t know because the dark market is exactly that: dark). The size of the infrastructure needed to support that volume is incrementally more than if only long-term investors were transacting. Thus, taxing transactions more would only add to the free rider problem.One way Regulators can solve this: mandate that exchanges charge for messages, which would make the cost of trading more expensive for those just testing the waters. This would spread the cost of the infrastructure to those that use it most. Traditional exchanges will not implement this of their own accord as speculative traders are their best customers, and they generate the majority of their revenue from transaction fees, data fees (which also comes from their customers), and selling co-location spaces/technology to transaction oriented firms.The world of financial market structure is not always intuitive. But understanding the history and motivations behind how markets have evolved starts to decode it. Thus I encourage all participants, especially new Regulators, to understand the underlying motivations for each type of participant. The markets are here for all types of participants — but let’s not punish long-term investors in the process of managing the volatility of speculators.