“Honor Among Thieves”

Sydney M. Williams

Thought of the Day

“Honor Among Thieves”

May 10, 2012

Confidence in our capital markets has been waning for years. There has been a growing sense among individual investors that markets are rigged. As far as politicians are concerned, there is no difference between the investor class and the “one percenters.” It matters not to those bozos in Washington that several of the “99 percenters” occupying wherever or whatever they choose to occupy are trust-fund kids, or that half of all Americans have exposure to the stock market through a variety of retirement plans. Regulations, like Sarbanes-Oxley, Fair Disclosure or Dodd-Frank, have done little to change this attitude. Hedge funds are deemed by the press to be secretive, and therefore bad. High frequency traders operate in a manner totally incomprehensible to the average person, or even to the not-so-average Wall Streeter. Crony capitalism, the relationship between corporate boardrooms and Congressional offices, functions undisturbed. Yet, inherent to our democracy are free functioning markets, and critical to their success is faith that our markets are fair.

A story in Sunday’s New York Times speaks to another hurdle for investor’s confidence. Nathaniel Popper wrote of a study by Woodbine Associates that looked at rebates offered by exchanges as enticements to brokers to direct orders their way. “Best price” is the governing rule for brokers when it comes to execution of orders, but the offer of a rebate, even one as small as $0.001, may be enough to lure an order away from one exchange to another.

What makes the practice of rebates so difficult to monitor is the very small amounts of money involved on a per share basis and the very large number of shares traded each day. In spite of those difficulties, in aggregate Woodbine puts the total cost to investors last year at a little more than $5 billion. The $5 billion is predicated on an estimate that investors lost $0.004 on 1.37 trillion shares traded. It should also be noted that rebates are perfectly legal and all thirteen exchanges have rules governing the practice. Nevertheless, rebates are one of the single largest costs to exchanges. For example, in the first quarter of this year, NASDAQ paid out $306 million in rebates, or nearly half of its revenues. It is also indicative of the slim margins on which the exchanges operate

Twenty years ago almost all trades were conducted on the exchange on which the stock was listed. Today, thirteen exchanges and electronic communication networks (ECNs) compete for orders. Competition is always a good thing. Free markets operate with greater efficiency. It forces businesses to compete on a basis of price and value, allowing consumers to make a choice that suits their specific needs. When competition is curtailed, as it is for example in health insurance where companies are prevented from competing across state lines, consumers suffer.

However, it gets complicated when a third party is part of the process. Stock exchanges are a good example. Brokers are intermediaries between buyers and sellers, accepting orders and then executing them either electronically or on exchanges. Their responsibility is to get the best price for their client. The business was simpler when the New York Stock Exchange and NASDAQ held monopolies in the shares of the stocks they listed. Brokers had no choice as to where to execute their orders. But costs were considerably higher than today. In fact, most academic studies have found that the costs of executing trades are at record lows.

Criticism of rebates is not new, as Mr. Popper makes clear. Two years ago, a report from two former chief economists for the Securities and Exchange Commission (SEC) noted that “in other contexts, these payments would be recognized as illegal kickbacks.” However and indicative of the fact that often the right hand does not know what the left is doing, Edgar Ortega, writing on Bloomberg three years ago, noted: “SEC rules made it easier for marketplaces to compete for trades.”

High-frequency trading firms argue, according to Mr. Popper’s article, that rebates increase the level of trading; thereby creating greater liquidity, so lowering overall trading costs. That seems a self-serving argument, justifying their business which is, using very high speed computers, to pick up a penny or two on millions of trades each day, sometimes in front of a real clients order.

While investors should be diligent that their brokers are in fact getting the best price, and punishing those who do not, the bigger issue, in my opinion, is to worry less about fractions of a penny (tax intraday trades at exorbitant rates – that should slow down high frequency traders!) and be more concerned with dollars. Long term investing is in need of repair. Fiscal policies should be directed toward encouraging long term investment and savings, and deemphasizing intraday trading and consumption. The internet has allowed a quantum increase in the number of new businesses around the globe offering ideas that can be converted into products and services. Entrepreneurs have need for capital. Millions of people in this country have need to increase their investments. In the interest of Main Street, putting the two together should be the focus of Washington and Wall Street.

Since commissions became negotiated on May 1, 1975, broker’s margins, at least those in the agency businesses, have been squeezed. An unintended consequence of that event has sent brokers scrounging for pennies, or even tenths of a penny. As long as there is pressure on commissions there is no reason to expect the situation to change. Mr. Popper’s article was interesting and illuminating, but it was also incendiary, in that it adds fuel to an anti-Wall Street movement already in place. It may not sell as many papers, but I would rather see the press focus on issues that would help lift confidence in our markets.

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Whenever I see the words that title this essay, my mind turns to Wall Street, my home for forty-five years, and the characters in Washington whose antics my tax dollars support. The words “honor among thieves” goes back many years. As a source, Cicero and Shakespeare have both been cited, as has been John Clavell, in his play The Soddered Citizen, first produced in 1630. My preference, though, is for the anonymous person who wrote: “The meaning of ‘honor among thieves’ is the idea that lying thieving bastards can trust each other.” That pretty much sums up the business I know and have known, love and have loved for so many years, and our cronies in Washington to whom I owe a debt for the fodder they provide for my Thoughts of the Day.