In a bombshell dropped at a congressional hearing yesterday, top executives for the NYSE and the Nasdaq proposed – to borrow from humorist Dave Barry, we SWEAR we are not making this up – that you pay them fees, small-cap companies, which they will distribute to market-makers to incentivize trading in ETFs that trade your shares.

 Exchanges already incentivize most trades, but in the hundred most liquid names there’s great profit in the data off the consolidated tape. You small-caps offer no profit. So in addition to charging you listing fees, they now want to charge you market-making fees – but in the ETFs that hold your stocks.

 Congresspersons unfamiliar with how arbitrage works and how ETFs are principally one-day investment vehicles won’t see through this self-serving and patently ridiculous proposal. The SEC may also overlook the glaring contradiction to well-functioning capital markets and approve it. Public companies don’t read exchange proposals as they should and don’t comment on them.  No opposition? Approved.

 For more, we’ve asked permission to re-run a blog post today by Joe Saluzzi at Themis Trading:

Yesterday, representatives from the NYSE and NASDAQ essentially admitted that the current fragmented market structure has been a failure for most US companies.  Before a House Committee on Oversight and Government Reform, Eric Noll from Nasdaq had this to say:

 “The unintended consequences of the market fragmentation has been a lack of liquidity and price discovery in listed securities outside of the top 100 traded names and a disturbing absence of market attention paid to small growth companies by all market participants including exchanges.”

 Joe Mecane from the NYSE added that even though spread compression has happened in the most liquid, largest stocks where HFT is present, the unfortunate reality is that those same trends have not occurred in the small to mid-cap part of the market.  He said these stocks do not have sufficient liquidity for the HFT traders to traffic in and as a result you do not see the volume and spread compression that you do in the largest stocks.

 The solution that these two exchanges have come up with is to have the corporate issuers pay a fee to market makers in the small to mid-cap sector to encourage them to add liquidity to the market.  But they had a little problem.  FINRA banned this practice in 1997 because they feared public companies may be paying to have their stock prices pumped up.  So, the exchanges came up with a creative idea.  They proposed having the corporate issuers pay a fee to market makers who make markets in ETF’s that the corporate issuer is a component of.  Here is how Mr. Mecane spun it according to a Bloomberg Article written by Nina Mehta:

 “There is a conflict inherent in a situation where a company itself is paying a liquidity provider to make a market in a stock,” Mecane said. Since the prices of ETFs “are generally linked back to the underlying securities, there’s less opportunity for manipulation”.

 Less of an opportunity for manipulation?  They have to be kidding.  When we first read this, we couldn’t believe it was true.  We could not believe that exchange executives would be trying such a financial gimmick.  So we viewed the hour and half congressional hearing (View hearing here) and confirmed everything in the Bloomberg article (skip to the 33 minute mark to hear the proposal).

 Let’s think about what these guys are proposing.  They want ETF market makers to receive a payment for adding “liquidity” to an ETF that has small to mid-cap components.  Their circular logic implies that if the ETF is trading then the stock components must trade more. 

 Well, it looks like they forgot about the magic of creation and redemption of ETF’s.  This magic, which has actually suspended the laws of supply and demand for stocks, allows authorized participants to not even have to trade the underlying stocks.  They just get issued more ETF units or redeem ETF units at the end of the day.  

 According to shares, “Unless a company decides to issue more shares, the supply of shares of an individual stock trading in the marketplace is finite. When demand increases for shares of an ETF, however, Authorized Participants (APs) have the ability to create additional shares on demand.”  Take a look at this iShares video  for more information on the magical process of creation and redemption.

 Why would a corporate issuer want to pay an ETF market maker a fee?  Don’t they already pay the exchanges a listing fee each year.  What value are they getting for that listing fee?  The corporate IR folks that we have spoken to lately seem to think there is little to no value for this fee.  Many have said they do not have any information about what goes on in their stock and actually preferred the old specialist model.  Maybe the exchange should just pass this listing fee over to the ETF market makers if they are so concerned about the small and mid-cap stocks.

 But the real issue that has been exposed here is that the current one size fits all, hyper speed, short term stock market model which was born out of the 1990’s SOES bandits has been a failure and has hurt the capital formation process.  The stock exchanges have failed the American public and have now finally admitted it. 

But how do they propose to fix it…with more parlor games and financial shenanigans.  When will they finally realize that the only way to create liquidity in small and mid-cap stocks is to stimulate INVESTOR interest.  This is done by bringing back the economic incentives for brokers to once again properly research, support and distribute their analysis to the investment community so that institutional investors can INVEST in small companies.   

 For years, the for-profit exchanges have tried to protect their own financial interests by promoting the current fragmented model as efficient for all companies.  We are glad that they finally admitted that it’s not working but we are saddened that they are still putting their own financial interests ahead of the investment community.

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.