This past week was not our industry’s finest. Yes, our markets performed well from an operational standpoint, in spite of extreme volatility and concentrated spikes in volumes. However, the perception of our industry took a substantial hit. There was confusion about the rules that govern our market structure and about business practices. Investors questioned the basic fairness of our markets, playing into the fear that certain rules are only applied when individuals stand to make money and professionals stand to lose money.
Few Facts, Many Allegations, and Unfortunate Timing
What investors needed last week was leadership, education, and facts. Unfortunately, those were in short supply. This created a vacuum that was filled by the speculations and allegations. We also witnessed confrontations rooted in the demonization of hedge funds and that short-selling is un-American and evil. The result was several days of mild chaos that could not be tempered.
Among the more disturbing allegations that came out of this hectic time were accusations of market manipulation. In an era of great cynicism about government and big business, people are primed to believe these kinds of claims. Painting the financial markets as a crooked casino can severely undermine confidence, and confidence can be hard to restore.
Topping it all off, the timing of last week’s events was grossly unfortunate in that it took place during a transition of power in the White House. The Senate, while doing its best, has yet to confirm the nomination of Gary Gensler and the natural turnover of SEC staff that comes with a changing of the guard could delay the response time of our industry’s chief regulator. Both of these situations are short term and will eventually resolve themselves we just need some patience, which unfortunately, is also in short supply.
Democratization of our markets
The democratization of our markets was at the core of many conversations last week. Which is a good thing, but not new. The democratization of our markets began more than 45 years when in 1975 the SEC ordered the end of fixed commission rates for all securities transactions. While some brokerages tried to maintain existing rates, Charles Schwab created a new kind of brokerage – a discount brokerage, which today has over 30 million client accounts worldwide and over $3 trillion in client assets. Today, there are more than 3,500 brokerage firms for investors to choose from and if dissatisfied with their current brokerage, investors can easily move their assets to a new one.
Fast forward to 1998, when the SEC approved the Limit Order Display Rule, which gives investors the ability to directly advertise their trading interest to the marketplace, enabling them to trade inside the current bid-ask spread and thereby compete with market maker quotations. This was a pinnacle moment in the democratization of our markets. Investors were provided the ability to place a better bid or offer directly from their account into the market and have that order be protected from trades occurring elsewhere at inferior prices.
These are just some examples of our industry’s willingness to level the playing field for all investors and our desire to continue to improve upon that principle.
The Next Steps
For the Industry
Our markets are in a constant state of evolution. There have been pinnacle moments in its history when inefficiencies that impede that evolutionary process from moving forward are flushed out. For example, in the aftermath of Reg NMS in 2005 and the birth of electronic trading, we experienced the May 6, 2010 Flash Crash.
Last week, we saw a market place that in past decade has enabled millions of investors to connect and trade with little to no friction collide with the world of social media. We as an industry need to understand the significance of that collision and appreciate the crossroad we are at. What happened last week is bigger than one company and one stock.
We will also have to look at a number of areas that don’t get discussed that often–stock lending practices, requirements for clearing capital, capitalization requirements to be a self-clearing broker/dealer, etc. and provide education delivered in such a way that investors can understand it and at times when the information is needed. In other words, we need to do better.
As we begin a new week, we all need to do some self-reflection on how to improve the current state for investors. Our response needs to be a combination of gaining a deeper understanding on how our markets operate; engaging in robust dialogue and debate with industry colleagues and providing input to our regulatory and Congressional leaders.
We will also have to look at a number of areas that don’t get discussed that often–stock lending practices, requirements for clearing capital, capitalization requirements to be a self-clearing broker/dealer, etc. and provide education delivered in such a way that investors can understand it and at times when the information is needed. In other words, we need to do better.
For the Regulators – Short term
As the Commission has already stated, a rigorous investigation into violations of rules and law has begun. All would agree that this where their immediate attention should be and we’re confident that the wheels of justice will perform their duty. Simultaneously, however, the Commission also needs to being gathering data. Our industry and the investors we serve need information. A detailed report which recreates last week’s market actions and establishes a timeline of events would add substance to the conversations and debates playing out in the public domain. Having such a report would also be useful in determinations on whether existing rules need to be revised or new ones created. The Commission did this in the aftermath of the May 6, 2010 Flash Crash and a similar approach is required now.
For the Regulators – Longer term
As mentioned previously, we have to come to grips with the fact that social media is here to stay and will play an ever-increasing role in the markets. This reality needs to be embraced in both a welcoming and pragmatic way. If investors find value on these platforms, then we should respect that and where possible engage with them in the forum of their choice. On the other hand, investors who use these platforms and their operators need to realize that illegal activity is sometimes perpetuated via legal means. Inquiries by regulators, whether they be broad in nature about how the platform operates or narrow in regards to specific potential nefarious activity, is not an indictment on the platform itself or its users. Bad actors who violate our securities law need to be identified and brought to justice whether they are attending a legal idea event or engaging in manipulative behavior on a legal social platform in the public domain. Our regulatory agencies will need rethink what to do here and we encourage these platforms to work with them in a spirit of cooperation towards the interests of investors.
We may also have to rethink investor education. Retail brokerage firms have a fine line to walk. On the one hand, they want to make investing easy, not overwhelm people rules and disclosures. On the other hand, they have a duty to ensure that people understand what they’re getting themselves into. That challenge is difficult enough on the basic day-to-day trading issues. It gets taken to an even higher level when you include extraordinary events and marketconditions. But if we have learned anything from the events of this last week, it’s that retail investors get understandably annoyed when it seems that arbitrary rules are being applied on the fly. It’s hard to know what the answer is, but we must try to figure it out.
For Congress
Investors could benefit with visibility into the long term leadership at the SEC. We recognize the current demands on the Senate at this time and realize they are doing their best to expedite the nomination process to identify the Commission’s next Chairman.
We also look forward to the appropriate time when congressional hearings are held. Well timed hearings would provide an opportunity to review data; ask questions and discuss a broad range of topics that are directly and indirectly associated with recent events, such as the democratizing of our financial markets; addressing wealth and income disparities. These are all important topics that deserve the attention of Congress.
Finally, Congressional members should exercise caution when making claims of market manipulation absent the evidence to support such statements. To be clear, we are not claiming that market manipulation did or did not occur, we are simply saying that at this stage, we do not know with certainty.
Preserving Faith in the Markets
Investigating what happened, explaining what happened, punishing bad actors, enacting rules changes with an appreciation that we experienced a pinnacle moment—it’s not going to be easy. But it is essential that we do it all in order to preserve faith in the capital markets.