If at first you don’t succeed, try, try again. So it goes at the Nasdaq.

Last autumn the exchange proposed to charge small-cap companies fees of up to $100,000 to incentivize market-makers to trade small-cap ETFs, arguing to the SEC that it would infuse thinly traded securities with liquidity. The rule would have required the SEC, FINRA and the exchange itself to reverse longstanding prohibitions on paying market makers to trade securities. For certain exceptions only (of course, exchanges pay billions of dollars in rebates to “liquidity providers” each year).

The SEC promptly rejected the rule-filing. Now it’s back. See it here.

IR folks, do you know the adage about being wise as serpents but meek as doves? Question what you hear from exchanges that rely on data and transactions – not issuers – for revenue and profits. Take nothing at face value. Examine the facts.

First, why liquidity? Berkshire Hathaway Class A shares need no liquidity to achieve a low beta and high institutional retention. So is trading activity in liquid names investment – or something else, such as statistical arbitrage?

Second, understand how ETFs work. To meet fluctuating supply and demand, ETF sponsors create and redeem units daily through authorized participants (APs) consisting of broker-dealers and large institutional investors like Vanguard and Fidelity.

Setting aside that unfair advantage (and stat arb opportunity) for APs, can you create and redeem your shares daily? No. What does incentivizing trading in small-cap ETFs create, then? Arbitrage. Statistical calculations of fluctuation in a set of securities. That’s not investment, it’s noise. Worst, the Nasdaq wants you small-caps to pay for it in your stocks – so it can generate more data and transactional revenue.

Lesson: Exceptions to rules always foster arbitrage. Apply it to any scenario, from taxes, to trading, to regulations.

So express yourselves. If or when this proposal reaches the SEC, go here, find the rule filing, and comment. One public company can change outcomes.

Here’s proof. The letter from ModernIR is referenced in the SEC’s decision to extend discussions about extraordinary market volatility. We were just one voice (none from public companies!) – but every voice counts.

We’ve opined again on market-volatility rules. Please read it. In two pages, we summarize how market rules are depriving public companies of what they want most in trading markets: Differentiation.

Your company should comment, too. So be heard, be seen, and be counted.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea.

Now suppose instead of one bouquet you want a thousand? In the market, what happens if someone suddenly wants not a hundred but ten million shares of your stock? Supposing such a trade were even possible today, the impact on your market would be extraordinary. But what if you could instantly issue ten million shares – poof, out of thin air? Your stock price would stay the same, because supply would swell to absorb demand.

That’s what ETFs do. They create shares. They must specify the methodology in their prospectuses. For instance, the iShares Telecom ETF “IYZ” says “Creation Units” are blocks of 50,000 ETF shares that it will issue to certain “authorized participants.” Some are brokers, some institutional investors. In turn, these participants supply the ETF sponsor with the designated set of assets – the mix representing the ETF’s constitution. In the case of IYZ, it approximates the Dow Jones US Telecom Index.

Redemption is the reverse. The ETF sponsor “redeems” shares by taking back units and returning constituent shares. The elemental concepts of supply and demand are neutralized. Prices of components miraculously stay the same even as tens of billions of dollars flow to ETFs. It’s almost…perverse.

The ETF sponsor as God and creator of the ETF charges authorized participants a licensing fee and buyers of ETF shares a management fee. This seems a good business – charging fees both directions while you work your ETFs like bellows.

But there’s more. ETFs can only be created and redeemed in blocks – 50,000 shares in the instance we cited above. Beyond the obvious inclination for brokers and institutions to “manufacture” units of ETFs from discretionary liquidity as a way to offset portfolio risk without paying for it, the arbitrage opportunities around assembling and disassembling Creation Units stagger the imagination.

You can short ETFs. You can buy, sell and short options and futures on the underlying indexes. Buy, sell and short the components of indexes, and of ETFs, and the options on components. You can buy, sell and short ETF options. You could buy, sell and short closely related ETFs and all their components and related derivatives. You can swap them all, spread-trade them, buy, sell and short the volatility among them.

And how about trading ETFs long or short in small increments and then creating or redeeming units inversely in large chunks if you’re an authorized participant? Institutions and brokers are doing this with highly sophisticated algorithms. Software providers like Tethys Technology abound for maximizing outcomes.

The key to this kingdom, this arbitrage nirvana, is that one entity, through creation and redemption, is stable, while all the others vary.

No wonder ETFs are responsible for some 35-40% of daily market volume. No wonder everything is massively correlated. If ETFs drive demand for components, and ETF units expand and contract to stabilize prices, then price movements of individual securities become volatile intraday, yet major measures come rapidly back into correlation.

The problem is apparent: If the medium of exchange adjusts to fit supply and demand, how do you buy value, or growth? Prices revert to the mean, irrespective of value or growth prospects.

Yet value and growth are the pillars of capital-formation.

What’s more, ETFs are one-day life cycles for industries, sectors and groups. They are only truly effective as investment vehicles for a day. What existed yesterday has been redeemed and what will be tomorrow has not yet been created. From air ye came and to air ye shall return.

EDITOR’S NOTE: The same concept backs the “maker-taker” trading model, in which exchanges pay high-frequency traders to swell and fade around supply and demand fluctuations. Create and redeem liquidity to stabilize prices. It’s behind global central banks too: create and redeem currencies to stabilize prices. Eradicate market forces from outcomes. It’s…unnatural. No wonder everybody is looking for a miracle.

First this on equity markets: Last week we noticed a surge in “volatility trading.” We’ve written before about these tactics that capitalize on volatility as the asset instead of the direction of the markets or a given security.

You should know about them because they’ll impact your price even if you trade less than 100,000 shares per day. We can find these things in market structure because certain firms specialize in it. When they show up, we watch what happens around them, thus discovering who else does it and what effect they have on market structure.

Under normal circumstances there wouldn’t be much. But we’ve woven such a tight risk-management net around algorithmic execution that everything reacts to everything else. Volatility traders who previously were using the VIX and similar measures perhaps have lately discovered that they can nudge risk-management algorithms around and produce volatility. It’s another unintended consequence of “systemic risk,” which can only exist when something artificially impedes natural failure.

Back to small caps. The average trade size in US markets today is less than 300 shares. We find in our pool that it’s closer to 200 shares. That’s partly due to the way the SEC measures “best execution,” or the quality of trades under SEC Rule 605. Broker-dealers must be within standard deviation of broad industry measures or they’re subject to fines. Naturally, over time executions become similar: about 186 shares per trade, regardless of market cap.

Say a multi-billion-dollar stock trades 26,000 times per day (and prices millions of times), while a stock with $500 million in market cap trades a thousand times. Both average 186 shares per trade.

A value institution is constrained by market structure from owning the smaller company. If they execute 100 trades, or 18,600 shares, high-frequency systems front-run and price them out of the market. Over time, the most efficient and compliant mechanism for owning small-caps are big risk-averse ETFs and algorithms cutting across hundreds or thousands of stocks, such as Renaissance Technologies or AXA or Dimensional Fund Advisors might run (through big prime brokers), or which Vanguard or Barclays iShares or Deutsche Bank Powershares might continually direct through their prime brokers and direct-market access channels.

Thus, small-caps become quant holdings. The problem is that small-caps and large caps alike need rational holders who stay the course through market swings and business cycles, the sort of thing that emotionless execution just won’t do.

This is a regulatory issue, IROs and execs. Structure is screening out your fundamental holders. How do we solve it? Speak up! Voice your opinion! Rules are supposed to create level playing fields, not advantage the dispassionate.