"The Rust Belt Comes to Wall Street"

Sydney M. Williams

Thought of the Day

“The Rust Belt Comes to Wall Street”

October 3, 2011

Technology has been changing Wall Street for most of my forty-four year career. Machines have been replacing people, not dissimilar to what happened in the industrial Midwest decades earlier. There is no better example of machines replacing man than in the arena of high-frequency trading (HFT.) Wikipedia estimates that HFT firms represent two percent of the approximately 20,000 firms operating today, but account for over 70% of all trading volume. But this changing dynamic began long before the advent of high-frequency traders.

Wall Street had always been a relationship business – and that certainly remains true for smaller firms like ours and for many of those on the “buy side” of the Street who rely on personal contact. Nevertheless, rising volume on the Exchange demanded increasingly sophisticated computers to handle trades. When I entered the business in September of 1967, daily volume was approaching 10 million shares a day, double what it had been a year earlier. By June of 1968, daily volume was approaching 15 million shares, causing the Exchange to close on Wednesdays, so as to deal with the growing paperwork problem. Those Wednesday closings continued through the end of that year, when declining volume (and stock prices,) along with faster computers, allowed the Exchange to re-open on Wednesdays.

Interestingly, On “Black Tuesday,” October 29, 1929, over 16 million shares traded hands on the NYSE and the tape ran until 7:45PM. It would take thirty-nine years before that many shares traded on the Exchange – in May 1968. Volumes increased as negotiated commissions replaced fixed commissions on May 1, 1975. On August 19, 1982, about a week after the great bull market began more than 100 million shares traded and on October 28, 1997, a day during which the DJIA traded up 4.7% marked the first time more than a billion shares traded. Since those days in the late 1960s, technology has generally allowed the tape to keep pace. According to the March 2007, Quarterly Report from the Bank for International Settlements, trading in U.S. equity markets grew from $136 billion or 13.1% of GDP in 1970 to $14.2 trillion or 144.9% of GDP in 2000. Increases in volumes did not necessitate a corresponding increase in the number of traders.

About the same time technology was allowing faster trading, John Bogle of Vanguard Funds created the nation’s first index fund. That fund, now the Vanguard S&P 500 Index Fund, is the largest equity mutual fund in the country. The concept of indexing meant that larger pools of money could be managed at lower costs and with fewer people. Index products required neither analysts nor high-priced portfolio managers. The creation of equity derivative products, a symbiotic product, caused indexes to further proliferate. But it did mean Wall Street had a need to hire mathematicians capable of understanding and producing complex algorithmic trading platforms. Those employees were more technocratic in nature with little need to interact with clients. The owner of money was further distanced from any sense of real corporate ownership.

An article in Friday’s papers reported that McGraw-Hill, owner of Standard & Poor’s is in advanced talk with the CME Group, which owns the Dow Jones Indexes, about forming a joint venture. Those two benchmarks, the S&P 500 and the DJIA, are, as the New York Times reported, “just the tip of a huge business. The companies own hundreds of thousands of indexes that track stocks, commodities and more exotic investments.” There are 56 regulated exchanges around the world that, according to data from Bloomberg, list more than 46,000 companies. Additionally, exchange traded funds (ETFs,) which act similarly to an index fund, now account for about a trillion dollars in assets. The net effect is that increasingly the owners of company shares are index funds who care little for the fundamentals of the underlying business.

New funds and ETFs are constantly being created, and they are fluid – stocks get dropped and added to ETFs and index funds, often for reasons having to do with fundamentals. That creates an advantage (and opportunity for mischief) for the sponsor of such funds. The creator of an ETF has the capacity to combine an understanding of the fundamentals of the underlying stocks with an access to flows into and out of the specific ETF. That knowledge could be used for spurious purposes – the gruel on which regulators feed.

As technology improved and derivative products proliferated, the financial industry generated larger percentages of GDP, rising from 4% when I entered the business to 8% in 2006. According to an article on “Financialization” in Wikipedia, the notional value of all derivative trading in 2006 reached $1.2 quadrillion, or roughly 100 times the value of that year’s U.S. GDP of $12.5 trillion. During those years, the consumers’ role in the economy increased from about 66% to 70%, suggesting that manufacturing, trade and commodity production declined proportionately.

Technology has increased productivity in our industry enormously. With a five man trading desk, our firm trades in a day what the entire Street was doing in early 1967. Trillions of dollars are managed for investors in a variety of index products using proportionately fewer people. Obviously, there has been an increase in programmers and software engineers, but the trend is not unlike what happened earlier in the automobile or steel industries. Thirty years ago I recall visiting the Anheuser Busch facilities in St. Louis and being amazed at the size of the vats and the acres of floors on which they were located, and at the dearth of visible human labor.

No industry is immune from the advances of technology. It is part of the natural process of what Joseph Schumpeter called creative destruction. It explains, in part, the advent of hedge funds, independent money management firms and private equity partnerships; it is what has allowed smaller firms like ours to survive and to thrive; because, for all the efficiency of machine over man, their very existence allowed opportunities for creative individuals. Owners of money will always seek out those few managers who can consistently outperform markets. And those managers have a need for analytical input and judgment. In the steel and auto industries, specialized, creative manufacturers were able to add value. The same has been and will be true in the financial industry.

The Dodd-Frank Bill left glaring gaps. “Too big to fail” banks have become even bigger. Derivative products that provide insurance, such as credit default swaps, remain unregulated. If all investment banking firms were to revert to private partnerships, the growth of derivatives and “financialization” would slow markedly, for what people do when their own money is at risk is quite different than when they have access to other people’s money. In 2008, Merrill Lynch lost $28 billion, probably as much as they had made cumulatively in their thirty-eight years as a public company. Nevertheless, the general trend of machine replacing people on Wall Street is likely to persist – more indices and derivative, higher trading volumes, decreasing commission costs, and larger amounts of assets, all requiring fewer people. The asset management business, in particular, faces enormous hurdles, as the ten-year performance for most money managers hardly justifies today’s fees, and proliferating ETFs and indexes provide cheaper alternatives. Nevertheless (and ever the optimist,) from today’s problems will arise tomorrow’s opportunities.