Things had been improving for U.S. stock exchanges, with volume rising, the bull market entering its sixth year and investors coming back to the market.
The run of luck was broken yesterday by New York Attorney General Eric Schneiderman, who is probing whether U.S. markets are giving high-frequency traders unfair advantages by offering faster access and data than is normally available to the public. Nasdaq OMX Group Inc.’s stock fell the most in seven months.
For exchange executives, Schneiderman’s inquiry threatens to revive public scrutiny that peaked in the aftermath of the 2010 flash crash, when the Dow Jones Industrial Average fell almost 1,000 points in a matter of minutes. It’s raising questions about the fairness of markets just as Virtu Financial Inc., a high-frequency trader that has earned money every day but one for five years, prepares for an initial public offering.
“The investigation is totally appropriate,” Brian Barish, who helps oversee about $10 billion as president and chief investment officer of Denver-based Cambiar Investors LLC, said in a phone interview. “There is something ethically wrong with providing a certain group of individuals preferential access to information and preferential timing.”
Schneiderman’s investigation threatens to disrupt a model that market regulators have permitted for years as high-speed trading and concerns about its influence have grown. Trading firms pay to place their systems in the same data centers as the exchanges, a practice known as co-location that lets them directly plug in their companies’ servers and shave millionths of a second off transactions.
Shares of New York-based Nasdaq OMX fell 3.1 percent yesterday after Schneiderman’s review came to light, the most since Aug. 22, when a technical malfunction at the exchange forced it to temporarily halt trading for thousands of companies. Atlanta-based IntercontinentalExchange Group Inc., the owner of the New York Stock Exchange, lost 1.5 percent.
Man, Machine and the U.S. Stock Market
“We publicly file with the SEC for each and every one of these services, and we’re always engaged with government officials around the world,” Robert Madden, a spokesman for New York-based Nasdaq, said in a phone interview, referring to the U.S. Securities and Exchange Commission. He and Eric Ryan, a spokesman for NYSE, declined to comment on Schneiderman’s investigation. Madden also declined to comment on the drop in his company’s stock, as did ICE’s Kelly Loeffler.
The investigation comes amid a rally that lifted shares of the biggest market operators in 12 of the last 15 months. The Bloomberg World Exchanges Index of 26 stocks has advanced 45 percent since sinking to an eight-month low in June 2012, a period that encompasses ICE’s takeover of NYSE Euronext and about $110 billion of inflows into mutual and exchange-traded funds that own U.S. equities.
Citigroup Inc. analysts led by William Katz said the inquiry is an “incremental negative” for exchange owners that could threaten some of their revenue from market data and access. It “does reinforce our broad concern that relatively high multiples for the sector leave little room for error,” they wrote in a report yesterday.
ICE, up 66 percent since the end of 2012, trades for 25 times annual profit, compared with almost 14 for financial companies in the Standard & Poor’s 500 Index. Nasdaq’s price-earnings ratio is 14.6, up from as low as 8.5 in August 2011, according to data (NDAQ:US) compiled by Bloomberg.
One of the biggest high-frequency firms, Virtu, publicly released its IPO filing this month. The New York-based market maker provides quotes in more than 10,000 securities and contracts on more than 210 venues in 30 countries.
Virtu disclosed in the filing that the U.S. Commodity Futures Trading Commission is looking into its trading from July 2011 to November 2013, examining “our participation in certain incentive programs offered by exchanges or venues,” according to the IPO filing. Virtu said it doesn’t believe it broke any laws or CFTC rules.
Chris Concannon, Virtu’s president and chief operating officer, declined to comment last week on the CFTC inquiry or yesterday about Schneiderman’s probe, citing rules that prevent companies going through an IPO from speaking candidly. Steve Adamske, a CFTC spokesman, declined to comment on Virtu’s disclosure last week.
One reason exchange stocks are rising is improving market volume. An average of 6.9 billion shares a day have changed hands in the U.S. in 2014, a 7 percent increase from a year earlier and the first increase to start a year since before 2010, according to data compiled by Bloomberg.
The totals show the transformation that high-frequency firms have wrought. While combined volume on the NYSE and Nasdaq rarely exceeded 2 billion shares a day in the 1990s, today it’s regularly three times that in the U.S., thanks to the spread of high-speed computers and new regulations.
“This is a volume game,” said Thomas Caldwell, chief executive officer of Caldwell Securities Ltd. The firm manages about C$1 billion ($899 million) in Toronto. “Exchanges to some degree are addicted to the narcotic of high-frequency trading, which is why you haven’t seen them come out and lambaste this practice.”
Investors scarred by the 2008 bear market that erased $11 trillion from equities pulled almost $400 billion out of funds that invest in U.S. stocks in the four years through 2012. The trend reversed last year with about $18 billion going into stocks, according to data from the Washington-based Investment Company Institute. Another $18 billion has come in this year.
Volume had decreased since the bull market began in 2009, when almost 9.8 billion shares traded daily. The average fell to 8.5 billion in 2010, 7.8 billion in 2011, 6.4 billion in 2012 and 6.2 billion last year. As the average price of U.S. stocks increased, the value of daily transactions has risen to $273 billion so far in 2014 from $220 billion in 2009, data compiled by Bloomberg show.
Within Nasdaq’s business units, a division called access and broker services that made up 12 percent of the company’s fourth-quarter net revenue reported lower sales due in part to “modestly lower demand” for co-location and ports, according to the company’s Feb. 5 press release.
Services such as co-location are accounted for in NYSE Euronext’s technology services segment, a unit that generated $74 million of the company’s $890 million in total revenue during the three months ended Sept. 30. Market data produced $91 million of that total, according to a filing on Nov. 5.
Bloomberg LP, the parent of Bloomberg News, provides its clients with access to some proprietary exchange feeds.
Nasdaq OMX’s CEO Robert Greifeld received $13.8 million in total compensation for 2013, including a $1 million salary and $9.9 million in equity awards, according to a March 17 filing. His compensation rose 55 percent from 2012 even after an error at Nasdaq halted trading for thousands of U.S. stocks, such as Apple Inc. and Google Inc., for three hours on Aug. 22.
The practice of selling enhanced access to brokers grew up as American exchanges evolved from member-owned firms amid a flurry of regulation and computer advances in the 1990s. Among other changes, the government-mandated compression of stock trading increments to pennies from eighths and sixteenths of a dollar, a process known as decimalization, squeezed profits for market makers and specialists that had overseen stock trades.
Faced with the need to maintain liquidity on electronic platforms where profits were too fleeting for humans to capture, exchanges developed strategies to encourage computerized firms to post orders. Co-location and customized data feeds developed alongside the hodgepodge of fees and rebates that market operators use to keep high-frequency traders coming back.
Market maker privileges have been a hallmark of equity trading, starting with the sale of seats to brokers on exchange floors. LaBranche & Co., created in January 1924, became the first independent specialist firm to sell shares to the public in August 1999. In papers prepared for its initial public offering, LaBranche disclosed that it regularly turned about 71 percent of sales into profit before paying its managing directors. Earnings before that expense climbed at least 25 percent every year from 1995 through 1999.
Results like those, as well as concern that NYSE and Nasdaq were too powerful, helped spur reforms since 2000 such as decimalization and a broader overhaul known as Regulation NMS that was aimed at lowering barriers to trading. Through rules mandating that any order for stock be routed to whoever in the country was transmitting the best offer to buy or sell, regulators hoped competition among a much larger pool of de facto market makers would lower costs for investors.
That happened. Buying 1,000 shares of AT&T before 1975 would have cost $800 in commissions, Charles Schwab, who founded discount brokerage Charles Schwab Corp., told the U.S. Senate in February 2000. That’s roughly 100 times more than the fees paid by many retail stock-pickers today.
Schneiderman is amping up pressure on high-speed trading after federal regulators for years discussed whether new restrictions were needed. In February 2012, Daniel Hawke, the head of the SEC’s market-abuse unit, said the agency was examining practices such as co-location and rebates that exchanges pay to spur transactions. Last year, the Commodity Futures Trading Commission, announced a review of speed trading and sought industry input.
“We are working on these and a wide range of issues as part of our ongoing review of our current equity market structure,” John Nester, an SEC spokesman, said yesterday. “We appreciate hearing the views of all market participants and other interested parties, including Attorney General Schneiderman.”
To contact the reporters on this story: Gerrit De Vynck in Toronto at firstname.lastname@example.org; Lu Wang in New York at email@example.com
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