When Defense is Offense: A Troubled Week for the Exchanges
While we are never one to throw peanuts from the cheap seats, the fact-of-the-matter is that publicly traded U.S. stock exchanges had a rough week from an operations standpoint. To put it lightly. After coming public in a reverse IPO by buying innovative trading system Archipelago in 2006, the formerly private New York Stock Exchange now publicly trades under the symbol NYX. Its New York cross town rival, the NASDAQ Stock Market, also offered shares to the public for the first time last decade in 2002, with investors now able to buy into its fairly stable earnings stream and steady free cash flow business by investing in shares of NDAQ.
Yesterday, every major global financial media outlet was alerted to the fact that NASDAQ had shut down its trading systems, and for just over a 3 hour period, mass media was focused on an impending disruption to the trading landscape as we know it. Labeled as the “Flash Freeze,” Thursday’s event was being built up as a major market event for all investors, on par with the May 6th, 2010 “Flash Crash” where the Dow Jones Industrial Average experienced its biggest intraday drop ever of 1,000 points.
We disagree.
This week’s shutdown, while troublesome, was not the watershed event of 2010. In fact, it displays the prudence and early warning signals that now exist in the market structure industry to prevent trading sessions like the Flash Crash. The Flash Crash occurred because of a confluence of events. That trading session on May 6th, 2010 started with troubling news out of Greece with riots and sovereign debt worries which forced the Dow down 300 points to start the day. By 2:45 pm however, the markets were in complete freefall, with an incremental decline of over 600 points to tally nearly a 1,000 point decline at one point reaching a 9.9% loss for the Dow Jones Industrials on the day.
The combustible combination of massive selling pressure in stock futures; algorithmic traders pulling completely out of the market; and trading orders going off at stub quotes, or inactive limit orders way off of market prices, all aggregated together to trigger this unprecedented intraday move. While the Dow essentially recaptured this “glitch” of a 600 point move, to finish down its original indication of 300 points for the day, the damage was already done with investors of all stripes suddenly highly suspicious of a cobbled together exchange trading system that can be prone to malfunction.
While investors and analysts are still waiting for a technical layman’s explanation as to why NASDAQ shuttered its systems for most of the day, we argue that the exchange acted appropriately and stopped trading to avoid any cascading of an initial problem into a more noteworthy event. The fact-of-the-matter is that the current U.S. stock market system is a puzzle of multi-level trading systems with different classes of market data speeds, a bee’s nest of legacy order books, and now the added complication of dark pools or off exchange trading systems. The real blame lies at the regulatory level with the historically liberal policies of the Securities and Exchange Commission having allowed too many trading venues to develop. This has resulted in the patchwork of a operational landscape we call the U.S. stock market.
After the Flash Crash, the SEC conducted a 5 month investigation of the inputs driving that significant event. The agency has already commented that it is looking into the NASDAQ shutdown this week. One of the agency’s most revealing findings however, may in fact be its decade long approval of new exchange products, new multi level trading venues, and its support of off exchange traded systems which has now complicated formerly simple operations.
Both publicly traded stock exchanges are dealing with these operational complications on a day-to-day basis, in addition to having to run for-profit businesses that are fighting four consecutive year of stock volume declines and ongoing market share losses from more aggressive broker dealers and alternative trading venues. NASDAQ stock is currently at a crossroads, with NDAQ now screening well in our internal quantitative model at Hedgeye Risk Management, but from a fundamental research standpoint with now new operational uncertainties as of this week’s event.
Warren Buffett championed the idea that investors should not have a quote machine in their office and that securities should be bought for meaningful periods where one wouldn’t have to see a public price every moment of every day. While we agree with this principle, and are not concerned with a 3 hour preemptive shut down of the exchange to avoid broader systemic issues, as a research department with the ability to recommend NDAQ stock, we encourage a forthright and actionable explanation from both the company’s management and U.S. regulators. The SEC is just as much to blame here as NDAQ and we are not mixing our alphabet soup in this statement.
