Thursday, June 19, 2014

That "fair" specialist system

Many people with a little age on them and some experience with the stock market will remember vividly the specialist system that ran the floor of the New York Stock Exchange until the late 90's or early 2000's.  In that system each listed firm had a specialist, aided by unknown and underpaid minions, who traded their stock to the market each day.  These specialists were held to no known exact standards by the incredibly lax NYSE at the time. These specialists excelled at knowing the minute by minute ups and downs of the market in the stocks they covered, to their advantage.  They definitely provided liquidity, except in times of extreme crisis when they mysteriously vanished, and they and their specialist firms definitely profited handsomely from their activities.

With the more sophisticated trading firms they were no doubt scrupulously working with miniscule margins, but with unsophisticated corporations that did not specialize in finance they had a somewhat open playing field as long as they did not wildly overstep.  With small orders placed on behalf of retail investors by brokerage firms, they were in completely open territory for wide margins.

Talking with my firms' various specialists went like this.  First sports and stock market talk in general, then whatever Catholic charities that they were so generously supporting, and most importantly golf.  They talked like normal people through all of that.  When it finally came to talking about how they did their jobs and traded our stock, it was all complete gibberish.  I'm more than half smart, my CFO was intuitively brilliant, and our Treasurer always did a great job of pretending to be smart.  But the fact is, the specialists did not want us to have the slightest idea of how they were managing our stock trades.  The one thing I did learn over time is that they always tried to work from a short position, and except in the most unusual circumstances always ended each day substantially short stocks.

In short, pun intended, they were there to make money for themselves and their firms, not to carry out some noble mission for the vaunted NYSE.  The people that got screwed the most by far were retail investors.

I bring all of this up because of the heavily promoted Michael Lewis book "Flash Boys".  In his many promotional events, he and his interviewers suggest that he is looking our for the little guy, and that Wall Street is a scam to exploit them.  Compared to the specialist era, today is the golden age for the retail investor in individual stocks, most notably those who use the many capable discount brokerages, or those who choose to invest in the very low expense ratio index funds like those at Vanguard, Fidelity, or Schwab.

While I can't say that I fully read the relentlessly tedious and tiresome "Flash Boys" except in various parts and through constant skimming, what the at times humorous and talented Lewis is really describing is a financial competition between high speed trading firms, firms that handle such large volumes that tiny margins add up to a reason for huge expenses for fiber optic cable lines that are closer to trading centers.  That's a story of note, but not one that has much if any affect on retail investors.  If it does through pension funds, mutual funds, index funds, and the like, I would bet that the impact is much less than what the age old specialist system had.  Many union and government related pension funds in particular were notoriously naive or unscrupulous, and especially vulnerable to the specialists.

 The big unanswered question here is what having half of all equity market trading done by these warp speed searchers for tiny advantages means for the market as a whole, and whether it in any way diminishes the search for real valuation that is the hallmark of the U.S. equity market.  If that is mentioned in Lewis's book, I did not take the time to find it, and it is not a subject that shows up in any of his interviews to my knowledge.

From this perspective, "Flash Boys" is mainly a major successful act of self promotion.


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