Choking the Recovery

Harold Bradley and Robert E. Litan

Executive Summary

A strong, sustained recovery will require the formation and growth of new scale companies. These companies, in turn, often require access to equity capital as they grow. Traditionally, this has best been accomplished by the floating of shares in an initial public offering (IPO).

IPOs have been down substantially over the past decade. Many factors have been alleged to have contributed to this trend, among them, the higher regulatory cost of going and remaining public under the Sarbanes-Oxley Act (SOX) of 2002.

But a far more important, and heretofore unrecognized, deterrent to growth company IPOs is the proliferation of new indexed securities—derivatives essentially. Initially, these products took the form of mutual funds; now they are increasingly represented as "Exchange Traded Funds" or ETFs.

We show here that ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future. In the process, ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges and, in turn, when combined with the high Sarbanes Oxley compliance costs for small companies are discouraging new companies from wanting to be listed on U.S. exchanges.

That is not all. The proliferation of ETFs also poses unquantifiable but very real systemic risks of the kind that were manifested very briefly during the "Flash Crash" of May 6, 2010. Absent the ETF-related reforms we outline below in this summary, and in more detail in the text, we believe that other flash crashes or small capitalization company "melt ups," potentially much more severe than the one on May 6, are a virtual certainty.

In setting forth our thesis, we rebut the currently popular critique of so-called "high frequency trading,"or HFT: namely, that it contributed to the flash crash and continues to pose threats to market stability. Likewise, we demonstrate that the charges against algorithmic trading are without foundation.

We reach the following specific conclusions and offer the following principal recommendations:

First, although the Securities Exchange Commission (SEC) has correctly identified some problems that require remedies (such as the growing importance of "dark pools," explained further below), in other respects, the Commission appears to have fundamentally misdiagnosed the key implications of many of the recent developments in equities markets. This has led the Commission to focus on solutions that either are irrelevant or may be counterproductive.

Among the most significant of the SEC's critiques are its attacks on HFT. Although high frequency trading has dramatically increased in importance, in fact, it is not to blame for the real problems in U.S. equity markets. Regulatory attempts to level the playing field between HFTs and other traders are misguided and likely would raise costs for retail investors while benefiting old investment bank trading desks and large institutions that once received favorable treatment over lower-commission-paying competitors. Equally misplaced is the suggestion of industry insiders like Paul Tudor Jones that the Commission should encourage the use of rigid trading ranges to constrict price movements to a maximum daily range. As we show below, such limits can be gamed easily by professional investors (like Jones) in global financial markets, and actually worsen, rather than dampen, volatility.

Second, the SEC, the Fed and other members of the new Financial Stability Oversight Council, other policy makers, investors, and the media should pay far more attention to the proliferation of ETFs, and derivatives of ETFs, which we argue are introducing potential systemic risk into the markets while discouraging investor interest in new public company equity offerings. The systemic risks are twofold. One is that the ease of short selling ETFs makes them ideal potential triggers for marketwide free falls of the kind experienced on May 6 during the Flash Crash. The Flash Crash was the first electronic market crash. In previous times of market stress, as in 1987, an institution or retail investor was forced to make a phone call to place or cancel an order. The inability of phone lines to handle the calls during that human intermediated crash was widely discussed in post mortem evaluations. Today, institutional, retail and high frequency traders can cancel buy orders in milliseconds with a simple computer command when they get a sniff that something is really wrong in the marketplace. The other, less well-recognized danger is that ETFs could be caught in a "short sqeeze" should investors for any reason decide they want to cover their short positions. The sponsors of ETF's serve only as a "transfer vehicle" to agregate securities delivered by Authorized Participants (AP) into new ETF creation units. The effective functioning of secondary markets, including securities lending and trading, fall on the shoulders of the APs and brokerage communities. APs, such as The Susquehanna Financial Group, argue that short selling of ETFs does not really matter because APs can at all times easily create more units and eliminate short exposures. Claims by such market participants that ETFs pose no systemic risks simply are not credible, and we show why with a rigorous analysis of trading data at the individual common stock level.

Fortunately, there are remedies to the concerns we raise, and they all reside within the regulatory authority of the SEC:

• The Commission should require far more transparency about the liquidity of the underlying securities or instruments represented by an ETF. It may be a good idea for the Commission to ban ETFs whose holdings are not easily traded. One simple way of doing this is to preclude small capitalization companies from inclusion in any ETF.
• The Commission should compel ETF sponsors to explicitly describe ETF creation and destruction processes in product registration and disclosure documents, including hard rules that govern creation processes based on short interest as a percent of shares outstanding, with hard caps (say 5 percent) on short interest. Additionally, the Commission should require weekly disclosure by sponsors in a transparent, plain English way, such as on the company's website that summarizes compliance with the sponsors stated objectives.
• The Commission should immediately subject ETFs to the post±Flash Crash liquidity "time-outs."
• The Commission should require ETFs to obtain opt-in consent from smaller cap companies (or from the exchanges where they are listed) whose stocks are relatively thinly traded.
• The Commission should require securities holders to specifically "opt-in" to securities lending agreements rather than the current "opt-out" agreement in most account documents. As part of the opt in, the broker should disclose quarterly what the retail investor earns in "interest" for lending stocks in his or her portfolio, and the broker's share of those earnings.
• The Commission should consider, for both stocks and ETFs, prohibiting plain market orders and instead require all market and algorithmic orders to have a minimum price of sale (so-called "marketable limit orders"). This would also help mitigate the kind of free fall in prices we saw during the flash crash, which could be repeated even with liquidity "time-outs" in place.
• The Commission should compel brokers to compute a ratio of order creation to order cancellation during the trading day and report those ratios to exchanges. When ratios indicate the evaporation of orders, as occurred during the Flash Crash, markets should suspend trading for 15 minutes when a call market would be used to establish an effective clearing price. Under adverse news conditions, this should moderate the group behavior effects that contribute to systemic risk.
• The Commission also needs some help from the Federal Reserve System, which is responsible for overseeing the nation's largest banking organizations. Given their central role in capital markets, custodial banks should be required to report each week their fails-to-receive and fails-to-deliver of equity and ETF securities in an analogous fashion to the requirements imposed by the Fed on U.S. primary dealers for debt securities.

Third, two specific rule changes by the SEC would address the problem of "free-riding" on the public markets by dark pools—a legitimate problem that the SEC has correctly identified. First, the Commission should require all off-exchange trading venues (dark pools and internalized trades completed by broker-dealers) to first satisfy all publicly displayed orders at the price they intend to trade. Put differently, the Commission should prohibit off-exchange venues from processing trades at the same prices revealed in the public markets unless the public orders are filled first. In addition, the Commission should adopt one of the rules it has proposed; namely, the "trade at" rule that would require off-exchange venues to improve by one cent the best-quoted price. Together, these two rules changes would restore value to limit orders now undermined by proprietary routing and internalization techniques.

Fourth, the SEC should abandon efforts to artificially promote "competition" among exchanges or their functional equivalents (alternative trading systems) through such fundamentally anticompetitive means as compelling all exchanges to report transactions to a single entity (the Consolidated Tape Association) and setting the prices at which such tape information can be sold. In addition, the Commission should set some minimum data transparency requirements for all approved exchanges, including the prompt dissemination of last sale price and volume data; depth of book within 20 percent of market prices; and rules ensuring access to these data. More broadly, the SEC can and should promote more competition in trading, which would further narrow spreads and trading costs by allowing so-called naked access to "long-only" institutional investors who are subject to provisions of the 1940 Investment Company Act. Such firms, which use no borrowed money, are subject to periodic securities holdings disclosure, and are regularly audited by the Commission, may be more dependable counter-parties than heavily leveraged broker intermediaries.

Finally, the SEC and the U.S. Congress have an opportunity to reinvigorate the public market for equities of new companies and thereby encourage promising companies to expand internally rather than sell out to larger, generally less entrepreneurial companies. The SEC cannot encourage new companies to list in the public markets without the help of Congress. We recommend that Congress exempt small companies with a market capitalization of $100 million or less from onerous compliance regulations under the 1933 Securities and Exchange Act so that we can begin to create a true small-cap marketplace, much as existed in the earliest days of the NASDAQ market. Furthermore, shareholders of small capitalization companies of $1 billion in market cap or should be free to choose whether they wish to comply with provisions of the Sarbanes-Oxley Act.

We urge the public, regulators, elected officials, and executive branch policy makers to give attention to the subjects we outline here. In the process, we hope to shed some light on some very complicated but important topics that have a direct bearing not only on our capital markets and their performance, but also on the willingness of the new growth companies to go public and thus help power the sustained growth that our economy so sorely needs.