They Call It Innovation
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Two sessions at the CFA annual conference typified the nature of the discussion of “innovation” in the investment world.
The first was a plenary session that featured Harold Bradley of the Kauffman Foundation, Bill Hambrecht of WR Hambrecht, and Duncan Niederauer of NYSE Euronext. It was titled, “Has Innovation Helped or Hurt the Integrity of Markets?”
Niederauer had his PR hat firmly on throughout the session, urging attendees to “take a balanced view of accomplishments and pitfalls,” and chastising critics of the industry, saying, “Quit being negative; we’re trying to solve problems.” By and large, he gave a defense of the status quo — other than warning about the growing share of dark pools. In other words, he talked his book, and did not address issues related to the upheavals caused by new business models at the exchanges.
As Hambrecht noted, the changes in the industry have led to much lower transaction costs, at least in equities. (You can still get mauled trying to sell a muni, for example.) That’s the one shining benefit that gets pointed to as evidence of progress. But at what cost in other ways?
Hambrecht summarized my point of view when he said, “Much of what we call financial services innovation is dealer bookmaking.” That’s where the action has been. Bradley stated it this way: “The foundation of the business relies on prop trading.” He also expressed concern about the explosion in the notional value of OTC derivatives that has resulted. Certainly, the game of cat-and-mouse with the regulators will continue, but sometimes it seems like the regulators are the mice. As always, those with the most power to change market structure for the better are on the buy-side, and Niederauer believes that they will “have a lot more to say” going forward, but it really hasn’t happened to date.
Partially because of the JOBS Act, Hambrecht thinks that there will be a shift away from technology as the driving force of change in the business, to “content.” He sees a flowering of research information ahead. (I am less sanguine, for a variety of reasons. By the way, I wish that the conference had been held this month so that I could hear Hambrecht talk about the Facebook IPO.)
While that panel didn’t provide much in the way of fireworks, that was not true of one at a breakout session regarding high-frequency trading held later the same day. The panelists were Kevin Callahan of AX Trading Network, Manoj Narang of Tradeworx, and Joe Saluzzi of Themis Trading. Narang and Saluzzi squared off repeatedly about the benefits and detriments of HFT.
Narang believes that firms like his provide the liquidity that is the lifeblood of the market, saying that “without HFT, there is no market,” that they are the “natural counterparties...trying to take the other side of your trade.” Saluzzi sees not liquidity providers, but liquidity takers, and decried abuses by HFT firms. Narang acknowledged some “inadvertent [quote] spamming behavior,” but Saluzzi scoffed at that characterization.
All the panelists agreed that Rule 611 regarding “locked markets” is problematic and needs to be reviewed, which is saying something, since there wasn’t much agreement on anything else.
As far as I’m concerned, the bottom line was expressed by Callahan, who said, “The buy-side needs to wake up.” He thinks it’s time for those investors to have “a holistic view toward trading costs” and realize that “they have a choice” regarding the market structure in which they operate. On a trade level, Saluzzi sees the VWAP orders and other algorithmic trades from institutions being “picked off all day long.” But, as Callahan indicated, the larger question is whether those buy-side firms will take the lead in dealing with the pressing issues of market structure that have resulted from “innovation.”
Yes, it’s hard for me to use that word in this context without the quotation marks. They call it “innovation,” but in the investment business, that usually just means that “we figured out how to make some more money for a while.” True innovation involves a rethinking that adds value over time, not just speeding things up to clip basis points for today—and in a business where we are stewards of the capital of others, it should lead to benefits for the many rather than for the few. As an industry, we’ve failed to make that happen.
This posting originally appeared as part of a series of postings on various aspects of this year's CFA Institute annual conference. See the PDF index on the research puzzle for the complete series.
–Tom Brakke, CFA
Tom Brakke, CFA, provides consulting services to investment organizations on decision making and the communication of ideas. For more, visit his blog, the research puzzle.