Understanding Equity Markets

Understanding Equity Markets

Market Structure Boot Camp

The Mystery

NIRI Tri-State Mar 2012

2By ModernNetworks IR LLC. Not for distribution.

Are equity markets what they seem…?

Or something else altogether?

Markets Seem Vibrant

• VIX Volatility Index: – Mar 16, 2012: 15

• Historical average: c. 20• High near 80 in 2008, 45 in Aug 2011• Conclusion: LOW volatility

• Nasdaq: Over 3,000• NYSE: Above 13,000• S&P 500: Over 1,400



But Surface Deep Only?

How Many Stocks are in the Wilshire 5000?

What’s the Average Trade Size?How Much Volume is “Rational”?



AND SO BEGINS OUR STORY…

Fewer Companies…



National Market System stocks. Source: Wilshire Associates index composition.

But Growing Volume…



Source: SIFMA. US Key Statistics, published February 2012. Includes volume for NYSE, Arca, Nasdaq, BATS, Direct Edge. Excludes Pink Sheet OTC market.

And 10-Yr Flat Returns

• Dow Jones Industrial Index – returns inconsistent since the number of public companies began falling.



How Did We Get Here?

Via the National Market System

“Our national market system, as it has evolved since 1975, has sought the benefits of both market centralization -- deep, liquid markets -- and competition.”

Source: SEC Final Rule – Regulation ATS, 1998

• Result: Legislation transformed formerly private markets, with private prices and private data, into a semi-nationalized system.



Key Rules

• 1975 – Congress Mandated Natl Market System

• 1997 – Reg ATS/Order Handling Rules - PRICE

• 2000 – Decimalization – SPEED & PRICE• 2002 – Spitzer settlement – TRADING• 2007 – Reg NMS (523 pps) – PRICE, SPEED,

TRADING• Rule 605 - Best Execution Standards –

UNIFORMITY• Rule 606 - Order-Routing - AGGREGATION

RESULT: Fragmented, high-speed, quantitative market



A Structure Upended

• 1792-1997 • Today



Specialists, Market MakersBuyers

Sellers

Rebate TradersBlack boxesLiquidity providersArbitragersResting ordersOMS/EMSProprietary traders Linkage/InterdealersPrime brokerageRisk management

Buyers

Sellers

Exchange Evolution

• Previously Non-profit; now For-Profit• Adapting to Rules• Profits driven primarily by

data/transactions– ‘11 NYSE Gross Rev: Listings $446m; Other: $4.1b– ‘11 Nasdaq Gross Rev: Listings $369m; Other $3.1b

• Data revenue– Proprietary products and feeds– Share of revenue from consolidated tape:

• Since Reg NMS 25% share of trading, 25% share of value traded, and 50% share of quoting

• Transactional revenue – Trading in derivatives, bonds, equities– DERIVATIVES is the most profitable business

• Incentivized arbitrage, HFT, data=profitsNIRI Tri-State Mar 2012


Maker/Taker Model

• “Making” and “Taking” shares • “Liquidity Provider” = HFT=

“Making”• Buyers of shares=“Taking”• Liquidity: Exchanges PAY

$0.29/100sh• Taking: Exchanges CHARGE

$0.30/100• GOAL: Low spreads, price stability• REAL GOAL: PREVIOUS SLIDE

– To sustain market share– Encourage trading in many assets,

securities– For DATA/TRANSACTIONAL REVENUE



Volume vs. Liquidity

Volume: How much of something trades

Liquidity: How much of something exists

EXAMPLE: If I give you an apple, and you give it to another person, who passes it to yet one more, who gives it to a fourth person: Volume=4, Liquidity=1NIRI Tri-State Mar 2012


Algorithms

• If this flock of birds were trades: half would be trying to hide their intentions, and the other half, trying to divine what’s hidden.

• Algorithms fragment institutional orders into a million pieces – while other algorithms scans millions of orders for patterns.



Patterns in Trading

Nanex “Crop Circle” showing patterns in high-frequency trading over fractions of seconds:


17By ModernNetworks IR LLC. Not for

distribution.

ModernIR data showing patterns over days: 1. Strategic selling (tiptoeing an elephant across a putting green); 2. Statistical Arbitrage

Strategic selling Statistical Arbitrage

Who can compete with this? Only other algos.

Cisco HFT Router



What is the Impact on Investors?

How to Buy/Hold?

• 2000-2012: How do you buy and hold? Better to speculate

• EXCHANGES encourage arbitrage, transient trading• The RULE STRUCTURE best suits fast-moving money• RESULT: Buying and holding assets to leverage for

trading



Order Routing

• The Market becomes a giant funnel

• What starts as “investment” can transform into algorithmic trading

• INCENTIVES change how orders are routed:– “Liquidity Providers” aggregate executions

to earn money from orders at exchanges– A few large brokers dominate

• Results: – More uniformity– Fewer vibrant, competing

investment theses



Macro Factors

• Global=“Everywhere”• Statistical= “we’re using

math”• Arbitrage=“to profit on

spreads”



Global

Statistical

Arbitrage

• Dollar, currencies– Fed policy moves markets– Other central banks too– Forex: $4 trillion day, US alone– Constant fluctuations

• Floating currencies, HFT, regulated trades and prices, global multi-asset class trading…

• =ARBITRAGE“Fluctuations in the value of currency are always injurious, and to reduce these fluctuations to the lowest possible point will always be a leading purpose in wise legislation.” – Abraham Lincoln – Dec 1862 State of the Union Address

WHAT THIS MEANS TO PUBLIC COMPANIES



distribution.

Three Truths

• Your stock price, volume, reflect a mix of behaviors with differing purposes and time horizons – not just “investment” but also crowd behavior, speculative trading

• More than HALF your volume, regardless of market cap, is INTERMEDIATION

• Trading is math, and math can be measured



Three Behaviors

• Market Share of behavior, not WHO, is key to understanding price• Three major forms: Rational, Speculative, Programs (the crowd)



distribution.

Owners vs. Traders

• OWNERSHIP, TRADING, are not the same.

• Looking to changes in ownership – which are important – for why your price changes does not reflect market structure

• Akin to tracking the owners of apartment buildings to know who’s renting units.



Trading Behaviors



Program sentiment5-day Ave 42.93% Prev 5-day 44.35% Diff: -3.2%negative

Rational sentiment5-day Ave 13.56% Prev 5-day 10.84% Diff: 25.1%positive

Speculative sentiment 5-day Ave 32.62% Prev 5-day 33.58% Diff: -2.9%negative

Directional signalAve Midpoint Price5-day $8.26 Prev 5-day $8.05 Diff: 2.6%positive

Market Share - past five days:

Program -1.38%Rational 3.41%Speculative -0.94%Sum 1.09%Plus Price 3.69%positive 3.7%

• A different approach: • INSTEAD OF:

– “We heard that…”– OR “Fidelity sold 500,000 shares”

• WATCH FOR:– What behaviors are up, down– To what degree they set price

• AT RIGHT: – Programs are DOWN– Rational investment is UP– Speculation is DOWN– By MARKET SHARE, these translate

into likely forward price performance:– POSITIVE

Learn New Terms

• Describe market behavior differently: – Program trading (correlated “crowd behavior”)– Speculative Trading (trading volatility)– Rational investment activity (fundamentals)– Statistical Arbitrage (trading gaps)– Institutional Re-risking (balancing assets,

hedges)



Timing Matters

OPTIONS EXPIRATIONS – VIX/RVX, stocks, indices, currencies…

Most trading speculative or crowd behavior, hedges common

Money moves to address RISK, find SHORT-TERM GAPS

You must beware of this and factor it into your thinking – see ModernIR calendar for moreNIRI Tri-State Mar

2012By ModernNetworks IR LLC. Not for distribution. 29

Go on the Offensive

• Educate yourself on market structure

• Rational investing a lesser force; GOOD NEWS! Small actions, big results.

• Read Market Rules – Speak up– http://www.sec.gov/rules/sro.shtml

• Ask for Analytics – Ask your exchange to provide better information on trading



Where are We Headed?

SEC Budget



SEC Budget relies on HFT

Source: SEC 2012 Budget Request: http://www.sec.gov/about/secfy12congbudgjust.pdf

Dodd-Frank

Trading costs will increase:

Dodd-Frank routes regulatory charges for IPOs, secondaries, follow-ons, repurchases and proxy solicitations to the US Treasury. Since 1934, these fees have “offset” regulatory costs:

H. R. 4173—577(1) SECTION 6(b) OF THE SECURITIES ACT OF 1933.—Section6(b) of the Securities Act of 1933 (15 U.S.C. 77f(b)) is amended—(A) by striking ‘‘offsetting’’ each place that termappears and inserting ‘‘fee’’;

‘‘(5) FEE COLLECTIONS.—Fees collected pursuant to this subsectionfor fiscal year 2012 and each fiscal year thereaftershall be deposited and credited as general revenue of theTreasury and shall not be available for obligation.NIRI Tri-State Mar 2012


Crystal Ball

• Exchange Competition– BATS, Direct Edge, Chicago/National -

LISTINGS

• Market Risk: UNIFORMITY

• Money Will Continue to Seek Alternatives



Understanding Equity Markets

Investor Relations

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