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March 30, 2016

Financial Reform Newsletter: A market solution to a market problem and more..

A market solution (the Investors Exchange or IEX) to a market problem (predatory high frequency trading) is bottled up at the SEC: Our public securities markets are essential for companies large and small to access capital and for our economy to grow.  That requires investors, also large and small, to have faith and confidence in our markets and trust that they are relatively fraud-free and fair.  Without that, people don’t invest in stocks, companies don’t get funded, jobs don’t get created and everyone’s standard of living declines. 
That’s why the Securities and Exchange Commission (SEC) was created after the massive frauds and crimes that lead to the Great Crash of 1929 and the Great Depression of the 1930s: to protect investors and markets while facilitating capital formation by policing the markets with disclosure and enforcement.  The SEC is supposed to be the cops on the Wall Street beat.
But, too often, the interests of investors, markets and capital formation – the public interests – are subordinated to the private interests of incumbent financial firms with political connections, lobbying might, an army of high-paid lawyers and lucrative jobs offer.  An example of that problem is the current pending application from the upstart stock-trading platform Investors Exchange (IEX) to become a public stock exchange.  That application has sparked a ferocious debate about market structure, high-frequency trading, predatory conduct and the overall state of the equity markets.
Today, those markets are highly fragmented among 13 major exchanges and 40 or so private trading platforms (dark pools, internalizers, etc.).  This has set off an arms race among financial firms seeking to develop the fastest technology, which is being used too often to exploit time differences of microseconds (one millionth of a second) and soon nanoseconds (one billionth of a second) between and among those many trading venues.  This all exploded into the public consciousness in 2014 when some of these practices and IEX were featured in Michael Lewis’ bestselling book, “Flash Boys: A Wall Street Revolt” and when Mr. Lewis, in promoting the book, described the markets as “rigged.”  This one word was like lighting a match in a gasoline factory: it ignited a long-overdue debate about our markets that continues to this day, exemplified by IEX’s exchange application awaiting action by the SEC.
For those unfamiliar with the IEX saga, you can find background information here (in addition to Mr. Lewis’ book) and, if you’re unfamiliar with the market structure issues, this terrific book explains them: “Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio.”  Those who have been following the story know that IEX is currently an alternative trading venue where investors can trade without being scalped by predatory high-frequency traders using high speed technology to prey on their orders.  If you don’t think this is happening, why are nearly 99% of all orders cancelled before filled?  If you want to see this happening, sit next to an independent trader trying to execute an order of just 50,000 shares of a highly liquid stock of a fortune 500 company for a few minutes.  You will be amazed at the amount of work, effort and time it takes to prevent that order from being picked off as multiple market venues are manipulated time and again by computer programs that detect, decipher and trade around your every move.
Given the damage to investors, markets and capital formation, what has the SEC done about this?  Very little and certainly not enough.  Its principal response to the furor set off by Mr. Lewis’ book was to do what bureaucracies do when they want to look like they are doing something when they are really doing nothing: set up a committee to “investigate.”  Rather than ramping up enforcement or writing rules to stop the predatory practices, the SEC instead formed the Equity Markets Structure Advisory Committee.  Adding insult to injury, the SEC stacked the committee with industry insiders who benefit from maintaining the status quo.  And it even included some representatives from firms who have been sanctioned by the SEC for egregious violations of the very laws and rules the committee is supposed to review.
In the midst of all this, a private company, IEX, developed a market based solution to the problem of predatory high frequency trading, which is complicated to explain but suffice it to say it outwits the predators by eliminating their time advantage by imposing a 350 microsecond delay, called a “speed bump.”  If you don’t think it works, again, sit next to an independent trader trying to execute the same order described above and watch what happens. 
IEX has operated as a dark pool for a few years now, but wants to become an exchange. If its solution works, it will attract investors and market share.  That is a direct threat to the (tens of) billions of dollars currently siphoned off by predatory high frequency traders and their market enablers like exchanges selling co-location and direct feeds.  Thus, the IEX application has become ground zero in the war over market structure and fragmentation and predatory high frequency trading with those profiting from the current system lobbying all out to get the SEC to deny the application.  This is little more than an attempt to kill the competition and prevent investors from having the marketplace option of choosing an exchange that stops predators from picking off their orders.
The original deadline for the SEC to act on IEX’s application was last December, but that was extended until March of this year-and just delayed again for an additional ninety days.  This postponement commits the SEC to a hard deadline to approve or deny the application on June 18, 2016, but it also opened up a new public comment period, which ends on April 14, 2016. As the deadline approaches, you can expect the fight to reach a fever pitch, which you can join by filing a comment letter (discussed here).  

Should mutual funds use derivatives and, if so, what should be the rules to protect investors and promote systemic stability – read our latest comment letter to the SEC to find out: Better Markets recently submitted a comment letter to the SEC that evaluates its proposed rule on the use of derivatives by mutual funds. During the financial crisis, the $16 trillion mutual fund industry suffered enormous and destabilizing losses due to their reliance on swaps and other derivative instruments -highlighting the urgent need for change in this market.
The proposed rule contains a number of sensible provisions that require funds to take extra care in managing the serious risks associated with transacting in derivatives, but it fails to tackle the key threshold question of whether it is legal for such funds to engage in such transactions in the first place.  The rule is proposed purportedly under authority from a statute (the Investment Company Act of 1940) that actually bars funds from engaging in many types of derivatives transactions.  The SEC’s proposed rule fails to directly address these very serious issues and, even assuming such derivatives use was legal, the SEC must otherwise strengthen the rule, as detailed in the comment letter.

Are egregious conflicts of interest about to be ended for advisers giving retirement advice?  Are advisers finally going to be required to put their clients’ best interest first and above their own economic interests? Rumor has it that the final release of the Department of Labor’s (DOL) proposed rule ending conflicts of interest is quickly approaching – perhaps as early as next week.The DOL’s proposed rule will protect Americans from the “Retirement Advice Loophole,” that allows financial advisers to provide investment advice that puts their own interest ahead of what’s best for their clients. The proposed rule will not only put a stop to financial advisers disguising sales pitches as investment advice but it will put billions of dollars back into the pockets of American retirement savers, where it rightfully belongs.  Many advisers already act in their clients’ best interests, but too many do not and that it why it is so important to update this 40-year-old rule and protect hardworking Americans struggling to save for retirement. 
Thinking about transformational ways to end the problem of Too-Big-to-Fail financial firms that threaten our financial system and economy: Federal Reserve Bank of Minneapolis President Neel Kashkari recently announced in a speech at the Brookings Institute that the Bank was undertaking a year-long review of too-big-to-fail and would be considering transformational changes to end it.  April 4, 2016 marks the first in a series of symposiums to consider these issues. The event will include a town hall discussion hosted by President Kashkari and will include presentations by notable advocates such as  Anat R. Admati, co-author of The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (and the George G.C. Parker Professor of Finance and Economics at the Graduate School of Business, Stanford University), and Simon Johnson, co-author of Thirteen Bankers: The Wall Street Takeover and the Next Financial Meltdown (and the Ronald A. Kurtz Professor of Entrepreneurship at the Massachusetts Institute of Technology’s Sloan School of Management).
The Minneapolis Fed’s #EndingTBTF initiative will explore various proposals from expert researchers and incorporate input from a wide range of thought leaders, with the goal of producing an actionable plan to end too-big-to-fail, which will be released by the end of the year.
The event will be live-streamed. Stay up to date with the initiative by following @MinneapolisFed and follow the conversation with the hashtag #EndingTBTF.


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