Speaker 1:
From the library of the New York Stock Exchange, at the corner of Wall and Broad Streets in New York City, you're Inside the ICE House, our podcast from Intercontinental Exchange on markets, leadership and vision, and global business. The dream drivers that have made the NYSE an indispensable institution of global growth for over 225 years. Each week, we feature stories of those who hatch plans, create jobs and harness the engine of capitalism. Right here, right now at the NYSE and at ICE's 12 exchanges and six clearing houses around the world. And now, welcome Inside the ICE House. Here's your host, Josh King, of Intercontinental Exchange.
Josh King:
We've all seen what looks like today, like newsreel footage. Back in the 1980s, trading stock seemed from all appearances, a glamorous business. On the floor of the NYSE on any given trading day, you could see up to 5000 navy jacket cladded stock traders converging like an international rugby convention in a massive scrum, to buy and sell blue chip stock Solas. Those were the days. In the decades that followed, stock markets around the globe have undergone an almost total metamorphosis. The introduction of technology, electronic trading and greater regulatory scrutiny have, by and large, been a great thing for global investors. But behind the scenes, markets today are far more complex and complicated. There are now around 13 stock markets operating in the United States and an additional 50 or so off-market venues called alternative trading systems. Today's trader is more likely to have a PhD in mathematics and access to state-of-the-art computers and algorithms to execute millions of trades in milliseconds.
Josh King:
Despite this complexity, US markets remain the envy of the world. Investors benefit from the lowest cost to invest in the stock market in any time in history. Those stock quotes, which you used to wait to see in the next day's broad sheet, are free at your fingertips, delivered in real time. And the strong regulatory oversight from bodies like the Securities and Exchange Commission, means that markets are also more efficient, transparent and trustworthy than ever before. Is this path sustainable? Is everyone being treated fairly as progress marches on? Recently and historically, as our guest today, Justin Shack, would be quick to point out, differing views have arisen for the best path forward to continue to transform trading for the benefit of all. Our conversation on the evolution of stock trading and the key issues impacting the business of markets right after this.
Speaker 3:
Cushman & Wakefield is one of the premier brands in the commercial real estate services space. We have 48000 professionals around the world in 400 offices, in 70 countries. This company, a hundred and one years old. If you can imagine, it's never been public.
Speaker 3:
There's a reason they call the NYSE, "The Big Board". It's a great home for companies like us. Big companies with big ideas. Cushman & Wakefield, now listed on the NYSE.
Josh King:
Our guest today, Justin Shack, is managing director and partner at Rosenblatt Securities. A New York based equities brokerage firm, which serves institutional investors. Justin heads up the firm's market structure analysis team, a group that helps their clients, mainly asset managers and proprietary trading firms, to understand and navigate the highly complex and rapidly changing equity market landscape. Justin, is as much a storyteller as he is an analyst. Prior to joining Rosenblatt, he spent 14 years covering markets as a reporter for Institutional Investor Magazine, a role which gave him a unique insight into the mechanics of modern markets and equity market structure. It also gave him a unique and historical perch for explaining today's landscape. In addition to his role at Rosenblatt, Justin has become a prolific market commentator in the press and his analysis is held in high regard in the industry for his thoughtful views. Justin, thanks for joining us today.
Justin Shack:
My pleasure to be here. Thanks for having me.
Josh King:
I haven't checked in, in the last 15 minutes. How's the market doing today?
Justin Shack:
Well, it's funny you ask that question, because I have no idea how the market's doing today. People often ask me that and I usually have a similar answer for them, because I'm focused more on the structure, and the rules, and the regulations, and less on minute to minute performance.
Josh King:
So you heard in my introduction, I want to start with a clip from a speech that your boss, Dick Rosenblatt, gave a while back, painting a picture of the exchange of old.
Dick Rosenblatt:
I went down to the New York Stock Exchange in 1969. By the early seventies, senior traders were telling me, leave. This place is finished, get out while you're still young. Believe it or not, I was once young. And somehow, I know they were sincere and they were very experienced, but it didn't seem right. My first boss was an odd lot broker. He'd come into work a little before were 10 o'clock when the market opened, and we're at 11, he'd say "Dick, I'm going up to lunch." Well, lunch for him was the bar on the seventh floor of the exchange. When the market closed, I would go out to the member's lounge, where my broker was sleeping off lunch in his favorite chair and I would nudge him a little bit and I'd say, "Excuse me sir, market's closed. Time to go home." "Oh. Thanks Dick. Have a good night. I'll see you in the morning." Well, he was a nice enough guy. But I figured if the markets continued to grow, they would actually need people who worked.
Josh King:
That actually need people who worked, Justin. The seventh floor of the exchange still exists. We are on the sort of complex of the sixth and seventh floor, as we speak today. They're not serving booze up here during the day. It's given over to listed companies, often laying out their investment thesis and their companies for Wall Street analysts. A very different scene from what Dick pointed out back at the end of the sixties.
Justin Shack:
I mean, absolutely. Things have changed a ton, and I've heard Dick tell that story quite a lot. And the point is, don't necessarily write off the floor of the New York Stock Exchange. I think that's one of the points that... The floor has continued to evolve as the markets have evolved, and right now the floor is still very relevant and very vibrant. And people are doing different things there, they're certainly not having three drink lunches and sleeping them off and requiring somebody to wake them up, so that they can leave at the end of the day. But you know, the markets are constantly evolving, and most of the time it's for the better.
Justin Shack:
One of the things I remember too about the sixth and seventh on the floor was, there was no lady's room, a long time ago. The first time I ever come up here, the ladies' room, I actually was with my wife, and it was like a little closet. She was like, "Oh my God. What is this?" And I said, "Well, there aren't a lot of women members." And obviously, things have changed dramatically now with Stacy running the entire show.
Josh King:
Can you explain how the company started with Dick and how it's developed to its current offering?
Justin Shack:
Yeah. I think the period of time that Dick was talking about, in that little clip that you just played, was probably about 10 years before he started what is today Rosenblatt Securities, as Richard A. Rosenblatt & Company. And he was one of the early, what we're called, independent floor brokers. He really was one of the pioneers of that business. Where instead of just being what was then called a $2 broker and relying on overflow business that the giant investment houses couldn't handle themselves when things got really busy, he went direct to the buy side, to asset managers, and said, "I'm going to represent you on the floor of the New York Stock Exchange and get you the best possible prices for your orders, so that your investors do well and your clients keep more of the alpha that you have in your strategies and in your investment decisions."
Justin Shack:
So we built on that business over a long period of time. Obviously, as you pointed out in your earlier question, the New York Stock Exchange has changed dramatically during that period of time. I mean, market share used to be 90%, 80 plus percen, and obviously the market has fragmented since then. And the floor is still the biggest liquidity pool for these names, but market share is more like 20% to 25%. So there was a lot of pain in those intervening years, where a lot of firms like ours no longer exist or were weakened dramatically. Dick had the foresight to always be on the lookout for, "How can we diversify? How can we adapt?" So we started an upstairs trading business as agent, not as a dealer, the way that market used to work, for what were then called over-the-counter stocks, a long time ago.
Justin Shack:
Sort of fast forwarding to my involvement with the firm over almost the past 11 years. As market structure started changing a lot in the late 1990s and early 2000s, Dick was always a guy who had a very acute grasp of the rules and how to use those rules in our clients' favor when trading. And so he observed very astutely and paid a lot of close attention to how market structure started to change when there were scandals in the market that resulted in new rules. There was decimalization of what were previously 1/4 wide, or 1/8 wide, or 1/16 wide quotes in fractions, and a lot of stuff that started to happen.
Justin Shack:
He and Joe Gawronski, our president, started just writing email essays to our customers about, "Here's what's happening with market structure." And they found pretty quickly that our clients loved it and couldn't get enough of it, but they didn't have the time to actually write all this stuff while they were also running the firm. I'd gotten to know them through my days in journalism. I wrote a little something about when Dick and Joe were trying to actually start a crossing network, in cooperation with the New York Stock Exchange, to kind of take it in a new direction.
Josh King:
What is a crossing network?
Justin Shack:
So what you referred in your introduction, to dark pools or alternative trading systems, crossing network is kind of the early iteration of a dark pool. Where you have a buyer and a seller, and instead of meeting on an exchange where there's a displayed quotation, they might meet in a crossing network where they're not stating what their stated price is, they're not displaying a quote, but they can still match in the dark without pre-trade price transparency. So they were working on starting this business and I had covered it for Institutional Investor, got to know them, and they said, "Well, why don't you come on and write all this stuff, so we don't have to." And that's been a big part of our evolution over the years, is that we've become market structure experts. We were one of the first firms to really carve out that niche, where we were analyzing market structure for our customers.
Justin Shack:
As things have gotten a lot more complex, it's something that asset managers, proprietary traders, even exchanges and regulatory agencies around the world really appreciate and turn to us for. We have a lot of other businesses that we've been getting into more recently that aren't as relevant to this particular discussion, like fundamental research. So we're always on the lookout. We're kind of this entrepreneurial kind of "boutiquey" firm. We're not one of the big Wall Street shops, even though we are the biggest firm on the floor of the New York Stock Exchange. We're, in the grant scheme of things in the brokerage industry, pretty small and nimble and always looking for new places to diversify into.
Josh King:
So Dick being an innovator, Dick looking out for new things that would be additive to the firm, you'd think he'd look for math experts and quants. But in you, he found really a history student, a storyteller. You started out as a journalist working across the river from Manhattan. What brought you to Institutional Investor and the financial beat in the first place?
Justin Shack:
Yeah. I never dreamed in a million years that I would be sitting in this seat in the New York Stock Exchange, talking about what we're talking about right now. I had an interest in humanities and in history, and my original career track was to become a college professor, a history professor. I had an undergraduate degree in history, went to grad school for a master's and-
Josh King:
At UConn. Right?
Justin Shack:
Yeah. And I was thinking that I was going to get my PhD and be an academic. In the course of getting my master's degree, I learned pretty quickly that that was not really a future that I would be comfortable with. And I'd always had an interest in journalism, was lucky enough to get my resume into a daily newspaper across the river in Jersey City, where I had an internship, and then spent a couple of years doing kind of a just general cops and courts type of reporting. Then, on a lark, responded to a classified ad, back when those things existed in the New York times. I'm dating myself of how old I am. With Institutional Investor. And they were an organization where they wanted people who... They ran a bunch of newsletters that people paid a lot of money for. There were weekly newsletters that were sent out through the mail, again, dating myself.
Justin Shack:
But the idea was, break news for people on this industry and they'll pay what the newsletter costs. So they didn't necessarily want people who knew about finance, they wanted people who were kind of news hounds and could break news, and I fit that description. I kind of learned on the job there when I left the Jersey Journal, where I had been, to go to II newsletters. And the very first beat I had, in November 1996, was cover the exchanges. Someone handed me a source list, "Here's all the people your predecessor talked to." A lot of them are people on the floor of the New York Stock Exchange who were specialists and floor brokers. Dick Rosenblatt might have even been on the list, who knows. And just sort of dial and smile, and get stories and get news.
Justin Shack:
That was very fortunate and played a big role in sort of where I am now and why I'm talking to you about this topic, because that was when market structure really started changing in dramatic ways. Right about then, there was a big price fixing scandal in the over-the-counter dealer market for stocks like Intel and Microsoft, that were traded and known as NASDAQ stocks, over-the-counter stocks that weren't listed on an exchange. And that was really the beginning of this 20 plus year cycle, that we find ourselves leading to an evolution of a completely new market structure.
Josh King:
I want to take you back to actually the late nineties, November 12th 1999. We're in the White House, President Clinton is there, Treasury Secretary Larry Summers is there. Here's a clip from the event. Senator Phil Gramm, the Chairman of the Senate Banking Committee. The reason for the gathering, the signing of the Gramm-Leach-Bliley Act, and thus the repeal of Glass-Steagall. Here's chairman Gramm.
Speaker 7:
The world changes, and Congress and the laws have to change with it. Lincoln used to like to use the analogy that old and outmoded laws needed to be changed, because it made about as much sense to continue to impose them on people, as it did to ask a man to wear the same clothes he did when he was a child. In the 1930s, at the TRTH of the depression, when glass Stegel became law, it was believed that government was the answer. It was believed that stability and growth came from government overriding the functioning of free markets. We are here today to repeal Glass-Steagall, because we have learned that government is not the answer. We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom.
Josh King:
Just in the turn of the last century, was a transformative period. Not just for the markets, but for the entire financial industry. How has Wall Street changed at the time, from your perspective with your notepad and pen at II, including the impact of the repeal of Glass-Steagall? It opened up competition between the commercial and the investment banks.
Justin Shack:
Yeah. I mean, I remember speaking with Phil Gramm around that time about market structure, and he said something to me to the effect of, "Well, my philosophy is, first, do no harm." You know, the Hippocratic Oath of markets, if you will. It's interesting. To think about that in the context of the words we just heard him saying, because one could certainly argue-
Josh King:
Did a lot of harm.
Justin Shack:
That act let loose forces that did quite a lot of harm to the world, let alone our economy and our society. So it's interesting to think about that in the context of market structure though, because one of the things that I think getting rid of Glass-Steagall and Gramm-Leach-Bliley did, was to encourage size and scale in financial services. And that's, in and of itself, not necessarily a bad thing.
Justin Shack:
One might even argue that we need more of it now, because a lot of the complaints that you hear from some of those firms today about market structure, are directed at places like the New York Stock Exchange or NASDAQ or CBO. To say, "Well, they have too much power. They have too much power over us to charge us prices for goods and services that we have to have." And we can't really argue with what the fee is, because we have to have them to compete. I'm not so sure I agree with that argument. I think there are choices that a lot of these firms make to compete at the very highest level in the industry. And there have been lots of other points in our history. I think back to 1975, when I was only three years old. But having studied it, there was a huge step that's often referred to as May Day, May 1st of that year, when commission rates for the New York Stock Exchange...
Justin Shack:
Previously, all the members charged the exact same commissions to all customers. They were deregulated and people like Charles Schwab came in and Muriel Siebert came in, and started charging lower commissions. And investors benefited greatly from that, but it was tremendously painful for the brokerage industry. There were a lot of white-shoe firms, that were among the biggest in the industry at that time, that either went out of business or had to merge with larger rivals to survive the immediate impact of that revenue being damaged in the wake of May Day. And I think about that today, one could argue that, well, maybe we need more scale in the brokerage industry.
Justin Shack:
Maybe we don't need... I don't know how many there are. Maybe there are 30 or 40 firms that kind of pay for the best of everything, to be able to serve their customers in what they feel is the most effective and possible way. Maybe we need some smaller number than that, and then that would be a way... Market forces would be a way to relieve that pressure, rather than appealing to the government for help. Which, kind of to bring it back to what Senator Gramm was talking about, is the opposite of letting market forces work. To say, "Well, we need reforms now that are going to be geared towards relieving pressure on one segment of market participants at the expense of another."
Josh King:
So a few months after Gramm, Summers, Clinton and the gang signed Gramm-Leach-Bliley in OEB 450, in the White House Complex made those remarks that we just heard... January 2000, Justin, you wrote a 17 page piece for Institutional Investor that you recently unearthed from the old time capsule, the Shack House. "Trading Meets the Millennium." What did you say in 19 pages that stands up in today's scrutiny? Yeah.
Justin Shack:
I mean, I think I started thinking about that story, because increasingly what we hear today, the past year or so, particularly of action that we see out of Washington focused on market structure, is the exchanges are being targeted and the exchanges are looked at as a source of what's wrong about market structure and that they created it. And I hear the phrase a lot, today's market structure was created before the exchanges quote unquote "became public companies". There are conflicts of interest now, because they are public companies and they have responsibilities to their shareholders and not to their members. Well, it wasn't the exchange's idea to do that. I think Dick would've been very comfortable to continue to have the system that was created in the 1790s, where what would become the NYSE's members founded the NYSE.
Justin Shack:
And then for centuries after that, it was run by and for the members as-
Josh King:
Call it the club.
Justin Shack:
Yeah. Essentially a non-profit, but to maximize its members' profits. And the members exerted the ultimate control over the exchange. And I think, if you go back and you read that story, what becomes very clear is it was not the exchanges that started this process that gave us this market structure that a lot of people find objectionable and in need of reform, it was the big Wall Street firms that decided for various reasons that that system was not working for them anymore. Part of it, when I went back and read that story, was there was a scandal on what was then called the NASDAQ side of the business. It was really over-the-counter trading. NASDAQ was not yet in exchange.
Justin Shack:
And there was a dealer marketplace that worked a lot like the way fixed income markets or FX markets work today. Where you had a lot of big dealers that were quoting prices, and there was an academic paper that said, "Hmm, we've noticed something very interesting. The minimum trading increment is an 1/8 of a dollar, but none of the dealers ever seem to quote the odd 1/8 increments. They're only quoting the even 1/8 increments." And there was a gentleman named Schultz, another gentleman named Christie, who unearthed that and published this paper. Then the Justice Department investigated and found that wasn't just an accident. It was collusion by the dealers to keep the spreads artificially wide, because that was the source of their profit. So there was this major investigation and a settlement in 1996 with, I think a couple dozen of the biggest dealers, including the biggest household names on Wall Street.
Justin Shack:
I don't want to name any individual firms, even though it was 20 plus years ago. I don't want to seem like I'm picking on anybody in particular. But that got the regulators to say, "Well, how do we keep this from happening again?" Because clearly, that was a bad outcome for investors. And we weren't just talking about thinly traded securities. This was the late 1990s, this was internet 1.0 bubble being inflated, and a lot of trading activity in companies like Intel, and Microsoft, and Cisco Systems, which a lot of people owned and a lot of people traded. The spread, effectively, was a 1/4 for every dollar. If you think about that in the context of today's markets, spreads in companies like that are typically only a penny.
Josh King:
Yeah.
Justin Shack:
And the commissions that investors pay, in what's now not a dealer market anymore but more of an agency market, are tiny fractions of a penny per share. What the regulators did at the time, was say, "Well, we have to keep this from happening in the future, because it's costing investors lots and lots of money.
Justin Shack:
So let's force the dealers to publish that order. If a customer says, "I'll give you an order that narrows the spread" you now have to publish it. This started just an array of unintended consequences. 20 years of building up, what I like to call, a Jenga tower of market structure. And that was kind of one of the first blocks that we started building on. There was this thing called the limit order display rule. Long story short, Wall Street complied with that rule in a way that I don't think the regulators anticipated, and it led to the growth of a lot of new systems called ECNs, which later became called ATSs. Because the government said, "Well, now the dealers are publishing their quotes. But they're not doing it on the NASDAQ screen, they're doing it in all these little systems."
Justin Shack:
The first one was called Instant and it existed for a while. Then there were a bunch of new ones that just sprung up and said, "Wow. This is an opportunity for us. We can be the place that gets all these orders." And within a few years, by 99' when I and my colleagues Hal and Mike Carol wrote that story, they had a 1/3 of the trading in OTC stocks. And then Wall Street firms started to fund those ECNs. They started to take equity stakes in them. I think they did that in large part, because they were worried that Wall Street was getting away from them. Remember, this was the time when online brokerage became a thing for the first time. Right? So firms, I'll name some of them now. Like Merrill Lynch, Smith Barney, Paine Webber... Doesn't exist anymore, it's now part of UBS.
Justin Shack:
You know, they were the big retail brokerage houses and they charged hundreds of dollars per trade, in commissions. And all of a sudden, you have E-Trade and people have access to the internet, TD Ameritrade and some of the others, that really started to take a lot of that business away from those big Wall Street firms. The combination of the ECNs taking away all that business and over-the counter-trading, and then the online brokers taking away a lot of the retail brokerage business, I think had Wall Street scared. And the New York Stock Exchange, even though they controlled it, some of the big firms wanted to change it. But then, there were 1366 seats on the New York Stock Exchange and a lot of those folks kind of liked things the way they were.
Justin Shack:
So it was very hard for someone like Dick to say, "Oh yeah. We'll adopt electronic trading. We'll do all these things to modernize ourselves.", because he had to get 1366 votes. Well, he didn't have to get that many votes, but he had to get a majority and it was never going to happen. So Wall Street started pushing the exchanges to change by funding competitors to them. And that really led to the situation that we have today, where they demutualized, they went public and led to a lot of the complexity that people find objectionable today.
Josh King:
Based on what we had talked about earlier, and thinking about the repeal of Glass–Steagall and if that was beginning to sow the seeds of what would come later. You are in your seat now at Rosenblatt, just a couple months, and you're starting to see the mortgage crisis begin to unfold, Lehman, begin to come apart. Were there parts of that didn't surprise you at all?
Justin Shack:
Oh, absolutely. And it wasn't as if people did not see it coming. I mean, even though I didn't write about the crisis per se, because the crisis did not yet exist, there was plenty of questioning and I think even some articles. I can't remember any that I wrote particularly, but there was certainly a lot of talk in 2006 and 2007. There was some of the sort of tremors that you started to feel, and at the end of 2007, that precluded the crisis, that things were just... It was only a matter of time before the reckoning was going to occur.
Josh King:
What was Rosenblatt's rationale for creating this position to serve their institutional client base? What kind of things were you doing from day one using the skills that you had, in furtherance of the firm's goals?
Justin Shack:
Yeah. So what appealed to me about doing something like this... And it was a position that Dick and Joe created, it wasn't something that existed before in the firm and the firm was like less than half the size than it is today, when I joined. But what appealed to me is that, it would allow me to continue to do basically what I was doing before, which is gathering information, analyzing that information and using that information to tell a story about a topic that I loved the most.
Justin Shack:
Of all the things that I covered when I was a journalist, I was covering asset management and equity research and investment banking, but market structure was really the thing that I cared about most and found most interesting. And really, the only thing that was different was the audience. Well, the other thing that was different was the way people sort of look at you as a member of the industry, rather than a journalist who's trying to find out things that maybe they don't want to tell you or they don't want to see splashed all over the front page of a magazine or a newspaper, at some point in the near future.
Justin Shack:
So I found that my access to that information and what I could learn really just went up by a huge factor. The reason that I think Rosenblatt did it, I alluded to this a little bit earlier when we first started talking about when I made that move, was Dick and Joe were providing some of this and felt very rightly that this was something our clients were interested in quite a bit. They wanted more intelligence about... At that time, I think Reagan MS had just gone into effect, but there were a few years before that where it was being debated. I think it was proposed in 2004 and then not implemented or started to get phased in until 2006 and 2007. So there was just a long period of time where market structure was sort of becoming a thing that people cared about.
Justin Shack:
And they found that our clients really wanted to know about that, they needed to keep up with it and they needed somebody who could do that full time while they were running the firm. So one of the first things when I came in was... Then the interesting thing for us too is, we're a trading firm, but we don't have... A lot of the biggest brokerage houses out there have their own order routers, they have their own algorithms, they have their own dark pools, they have this whole suite of electronic trading tools that they use to take really big institutional orders, and their customers chop them up into small pieces and then route them around to where all the liquidity is. We don't have any of that stuff. We have people on the floor, obviously, and then we have a high-touch trading desk that uses other people's tools.
Justin Shack:
We are actually customers of some of the other big sell side firms. One of the things that we discovered in using a lot of those tools was, our orders that we're getting from our customers and using these tools to route to different places, we're winding up in these things called dark pools. Tons of them were being created in 2006, 2007, 2008 and 2009. And we didn't really have a lot of information about them. The volume in them since 2008 is more than doubled.
Justin Shack:
So for our own selfish purposes, we started gathering a lot of this information, saying, "Well, okay. How much volume is in this pool? Why is my order being sent there? Who else is there? How does it work? What are the rules? What are the order types?" And we pretty quickly found that our customers would be interested in that too. So we developed a report called "Let There Be Light". You know, not the most clever pun I guess, but it seems to have worked. It became kind of the industry standard for information about what was going on in the dark pool. So it was stuff like that, where we were just shedding light on areas that were changing very rapidly, and that were pretty opaque.
Josh King:
2018 began on a very volatile note and it looks like it will end on a very volatile note. In this run that we've been on since 2009, is it sputtering to an end over things like tariff fears and Brexit votes? Are they propelling us to more uncertainty now? Or are we sort of at a speed bump and sort of continued the trajectory as we go into 2019?
Justin Shack:
Yeah. So again, I'm always reluctant to comment on issues like that, like what's making the market move the way it is. But I can make some general observations. I think one thing that we've noticed is, volatility plays a pretty big role in elements of market structure, like how much volume there is or how much of that volume is done on exchanges, as compared to off exchange. And much of the period that you just described was an extraordinarily low volatility environment. I mean, I think it was in the middle of 2010 that people started to feel comfortable again that the world was not going to end, financially. You know, some of the worries that had spread to Europe around that time started to calm down, and pretty much since that point, we saw volatility as measured by the VIX come down dramatically and stay down very low.
Justin Shack:
I mean, last year I think it was record lows, as a year and at various points throughout the year. And then the interesting thing that one of the analysts on my team, Alex Kempsey, has discovered a couple of years ago looking at data on interest rates, was that there is a relationship there. And the other thing that we saw during most of that period, was there was zero or close to zero interest rates. More recently, we've seen the feds start to raise. If you look historically, volatility and the fed funds rate mirror one another, there is a relationship there. When fed funds start to go up, volatility starts to go up maybe months or a small amount of years later.
Justin Shack:
So I think... I don't know whether the market... I was shocked that the market wasn't reacting to a lot of the geopolitical issues that have developed over the past couple of years, until recently. So I can't really predict what's going to happen there, but I think it's interesting to look at the next few years as potentially a period of returning to a more normal interest rate environment. Then we may see more volatility in the marketplace and an end to that period where we saw a really low record of low volatility.
Josh King:
After the break, Justin Shack and I discuss how market structure has changed over his career and how the past laid the ground work for today's most contentious issues around equities trading. That's right after this.
Speaker 8:
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Josh King:
Welcome back. Before the break, Justin Shack, managing director and partner at Rosenblatt Securities was reflecting on his experience as a financial journalist covering a rapidly evolving market structure. Let's go back just a few months now, Justin. October 25th 2018, the Securities and Exchange Commission in Washington DC, their roundtable on market data and market access. Chairman Jay Clayton is presiding over the meeting. I'm down there. It's a pretty full house. You have around the table many of the important players in the market structure today. Doug Cifu of Virtu Financial, Chris Concannon of CBOE, Brad Katsuyama of IEX and others. I want to play an extended clip of our own Stacy Cunningham, President of the New York Stock Exchange, trying to make some sense of it all.
Stacy Cunningham:
So, one thing I just wanted to say, is that I think what I'm hearing a number of times happen, is we're pulling out one aspect of fees and focusing on just that. And stripping market data out of the overall ecosystem. I don't believe that I've heard any of the exchanges up here say that market quality that is good in the market is a result purely of the exchanges. It is an ecosystem and we recognize that. And it is our all in cost that matter, because there is a relationship between transaction fees, and market data fees and connectivity. So I think that's why it's important to look at that relationship and not try to just isolate one component and say, "Fees are rising over here, and we're going to ignore the fact that fees have come down in other places". Because that definitely seems to be what's happening.
Stacy Cunningham:
We heard an impassioned response from Brad, but it is cheaper to trade on NYC than it is to trade on IEX. And so, I think if you're looking at just one aspect of fees, yeah, you can talk about some of the things in isolation. That's very different than what the overall landscape is. And so, I think it's important to look at that holistically, and there is competition. The facts are... Despite what we hear from Doug and from Met, the facts are not all brokers take all products, not all brokers exhibit the same behavior on all markets. So there is a competitive landscape and they're choosing what's right for them. It doesn't mean that we can't make improvements. Just to address some of the cost concerns that have come up, I don't believe that investors or any market participant is expecting to pay the cost of the product, the cable, the seat on the New York Stock Exchange.
Stacy Cunningham:
When people spend a million bucks to buy a seat on the New York Stock Exchange, they weren't thinking, "Well, how much wood went into creating this seat?" Or Doug, when a Florida Panthers fan buys a ticket, I don't think they're thinking about the paper the ticket was printed on or what that costs or even the chair that they're sitting in the stadium. They're thinking about the ecosystem that they're walking into and what they're about to experience. And for exchanges, that's capacity, that's access, that's the exchanges processing information that's coming in, sequencing orders, putting them together. And it's not just aggregation.
Josh King:
I submit to our listeners that a six hour round table cannot be encapsulated in a two minute clip, Justin Shack. But you recently wrote an article entitled "Who created this mess anyway. Hint, it wasn't the exchanges." Can you unpack what Stacy said in the context of what you wrote. What's going on here? Help us clarify some frequent myths that circulate about markets, and can you explain who all the players are in this story?
Justin Shack:
Yeah, sure. I'm happy to take a stab at that. I think that that market data round table was one instance or one flash point in whats become a much broader war between, on one hand the major exchanges, and on the other the major banks and broker dealers who do business on those exchanges. And the reason for the tension, is that the brokers no longer own the exchanges. As I said earlier, for a very long time, for most of our history in trading, the exchanges were owned by and operated for the benefit of the sell side, and that has not been the case for the better part of 20 years now. It was the brokerage community, as we talked about earlier, that really forced that issue and made it happen for various reasons. I think now they're coming to the realization that that system that they helped create or set in motion is no longer working for them.
Justin Shack:
There's a lot of cost pressures that they're dealing with, regulatory issues that they're dealing with and their margins are compressing. And I think there's a natural desire, you can't blame them for it, to say, "Look, something has to give here." There's a lot of money at stake here. Right? That round table was very heated at various points and I think the reason is that there's a lot at stake. Quite frankly, there's hyperbole on both sides. Right? People are talking about, "I can buy this cable on Amazon for $5 or whatever it is, and you're charging me multiples of that." And then the other side is saying, "Well, they're looking at the entirety of a bank's revenue." Which isn't really quite applicable to just equity market structure.
Justin Shack:
So there's definitely a lot of spin going on all around. But I think it all comes down to that fundamental break that happened between the exchanges and the brokers, where they were no longer at a commonality of interests. And now, you have the brokers standing on the outside who don't own the exchanges anymore and the exchanges are for profit. They're owned by public shareholders and they have a duty to those shareholders to maximize their profits. So if you're a broker or dealer and you have to trade, you not only have to trade because of the way our regular regulatory system works, you need to connect to these major exchanges for best execution purposes. You need to take their data. If you're a serious provider of electronic trading services, you need the full depth of book data, sort of the direct feeds, and all that stuff is expensive. Taken together.
Justin Shack:
I think that's what Stacy's trying to say, is that all that together, there's a certain table stakes. Right? If you want to be a tier one electronic broker dealer, you have to pay those table stakes. And it's sort of like squeezing a balloon a little bit, like what you pay and which components. Right? The trading fees have come down to the point where the margin of error is ridiculously small for the exchanges, and I think they've compensated over the years by charging more for things like access to the order book or for the market data. But I think it's important to look at it holistically. I don't think it's... I wouldn't say that we shouldn't be looking at the broader issues of exchange power. Or do we want publicly listed exchanges? Are there conflicts of interest there? I think that's perfectly legitimate to look at. But I also think that there's a whole other side to that debate, which prompted me to write that article that you cite on social media. "Who Created This Mess, Anyway?"
Justin Shack:
There's a whole other side to this debate that isn't really being talked about, in places like the market data round table or some of the other items of regulatory focus. Like the transaction fee pilot that the SCC proposed recently that would impose a lot of new restrictions on Exchange's ability to set their prices for trading, which are already quite low.
Josh King:
Why is that side of the story not being told as much?
Justin Shack:
I mean, I think it's partially just a function of which issues are being talked about and discussed. What's on the regulatory docket right now? You have a transaction fee pilot that was proposed, I believe back in March. You have the focus on market data. And in both of those cases, there are a lot of market participants who believe that things need to change on the exchange side. So I think naturally the focus is on, what can the exchanges be doing different? What can we change about the way they work that would make things better? There're complaints about an unlevel playing field and I think one of the things I said in that article was, yeah, the playing field is definitely unlevel, but it's unlevel in multiple directions. It doesn't just tilt toward the exchanges.
Justin Shack:
There are a lot of competitive advantages, very powerful competitive advantages, that brokers have over exchanges. That competitive advantage that they have when they're trading off exchange, they have lighter regulation that leads to a lot of the market structure complexity we see today, that a lot of critics find objectionable and are saying that we need reforms to fix. So all I try to get at, by raising these issues, is yeah, maybe there's a whole bunch of issues we need to be looking at, where exchanges might need to change their behavior or we may need to change the rules around the way exchanges work. But let's look at everything, let's not just look at that. Let's look at maybe a more balanced set of reforms
Josh King:
Because, in some respects, all these alternative trading systems, dark pools, you have something like the transaction pilot go through focusing purely on what happens on the public lit exchanges. Taking the publicly traded companies, putting them into three buckets. What's happening in the dark pools? Very little examination at all.
Justin Shack:
And look, the one thing that I know for sure... There's a lot that I don't know and I'm usually quick to point out what I don't know. But the one thing that I do know for sure, is that there are always unintended consequences to major regulatory actions. There are always unintended consequences to major regulatory actions. I mean, that's the biggest major lesson you can really take away from having studied market structure as long as I have.
Justin Shack:
And so, I worry if we're in this mad dash to pass the transaction fee pilot and to change the way the market data system works, those will undoubtedly have unintended consequences. I can think about what some of them might be, but even I or the smartest people at the SEC or in Congress or elsewhere in the industry are not going to be able to predict all of them. Those unintended consequences might be bad for investors. So far, in 20 years of evolution, we've had tons of unintended consequences, but investors have done really well. And I worry that we start a whole other cycle now where investors don't do well and I want to be careful that we don't do that.
Josh King:
What might some of the unintended consequences be from the transaction fee pilot?
Justin Shack:
So when you think about how the transaction fee pilot would work, it's weird. There's a couple of different threads here. I think the big broker dealers who want just the access fee to come down, when they need to access a quote on the New York Stock Exchange or NASDAQ or one of the CBO markets, you need to pay a fee to access that limit order, to access a quote, to hit a bid or lift an offer. And there's a cap on that, under regulation NMS, at 30 cents per one hundred shares. I think since that was set, they've wanted it to come down. So that's one thread, and then there are a bunch of people, a lot of them on the institutional investor side, who think the rebates that are on the other side of the equation, for the people who are posting those quotes, those create a distortion in the market.
Justin Shack:
They create conflicts of interest for brokers. They tend to want to route to those, to reap those rebates instead of routing to where the best outcome for the investor would be had. The mechanism that the pilot would use to get at the rebate, is to get the fee down. And if we think about what effect the rebate has in markets, yes, one of them is undoubtedly that it creates conflicts of interest in routing. But the other is, it incentivizes liquidity provision at the inside quote. And if you take away that rebate, there are a lot of people, a lot of big market making firms for instance, that look at that rebate as basically part of the bid ask spread or as insurance against being adversely selected. Having toxic order flow come in and kind of run them over.
Justin Shack:
So when you take that away, it removes an advantage that the market maker has. When you think about off exchange liquidity provision, there are not only ATSs, but other dark venues. They're called single dealer platforms. Increasingly, there are things called central risk books that banks are investing a lot of money in now, where they have liquidity that's available, there's no price quote on it, but usually it's at the same price that the exchange is advertising. They don't get a rebate. So right now they're at a disadvantage. If you're a market maker in one of those venues, you're at a disadvantage to an exchange. With the pilot... But one thing I should say, is they do have an advantage, which I mentioned earlier, which is they have lighter regulation than the exchanges. So they can segment order flow. If I wanted to trade just with you for instance, in a single dealer platform, I could do that.
Justin Shack:
I can't do that on an exchange, because there are fair access rules that means whatever I do on an exchange, I have to make available to everybody. So long story short, and I know this gets a little bit complex, but when you take away the rebate or you make the rebate de minimis, you take away the disadvantage for the off exchange liquidity provider, but you're not attacking the advantage. So they still have an advantage being able to segment order flow, but now the disadvantage of not having the rebate is not there. And I think... I've talked to people who operate some of these platforms or route orders to some of these platforms, and they think there's a pretty good chance that you might see in the test groups, where the rebate gets either removed or made really small, a lot more off exchange trading, a lot more dark trading that is not contributing to price discovery and is just using the exchange quote, basically. Kind of what some people have called the "Best Buy problem". You come into the showroom, you look at the price and you buy it elsewhere.
Josh King:
We've been focused so much in our conversation, Justin, on the implications for institutional investors. Let's just pivot a little bit to the retail investor. I want to listen to one of those classic television ads of the era in which trading was democratized with the discount brokers, that you mentioned earlier. The Schwabs, the Sieberts... This is that famous spot from Ameritrade in which Stewart, an office flunky, guides his boss through his first $8 trade.
Speaker 10:
Stewart. Can I see you in my office, please?
Stewart:
That kid is sick.
Speaker 10:
Get in here.
Stewart:
Hey Mr. P.
Speaker 10:
Stewart, I just opened my Ameritrade account.
Stewart:
Let's light this candle. Let's go to ameritrade.com. It's easier than falling in love. What do you feel like buying today, Mr. P?
Speaker 10:
Kmart.
Stewart:
So research it. All this stuff is provided for you free of charge.
Speaker 10:
No cost?
Stewart:
Yeah. That's synonymous with free.
Speaker 10:
Looks like a good stock.
Stewart:
Let's buy.
Speaker 10:
Let's buy a hundred shares.
Stewart:
All right. Click it in there.
Speaker 10:
Okay.
Stewart:
How about 500?
Speaker 10:
100 Stewart.
Stewart:
You feel the excitement? You're about to buy a stock online.
Speaker 10:
Oh. Fabulous. I'm thrilled. How much did that cost me?
Stewart:
$8, my man.
Speaker 10:
My broker charges me $200.
Stewart:
You're riding the wave of the future, my man.
Speaker 10:
Listen-
Stewart:
I got to get a soda. I'm sorry, Mr. P. I'm having a party on Saturday night. If you really want to go...
Speaker 10:
I'm going to try and get there.
Stewart:
Happy Trading!
Speaker 10:
Thank you.
Stewart:
Rock on.
Speaker 10:
All right, Stewart.
Speaker 12:
Call toll free, (800) 573-9914. Visit ameritrade.com. Ameritrade, the way to trade period.
Justin Shack:
I always wondered if Mr. P actually showed up to the party at Stewart's house on Saturday night.
Josh King:
Oh. He looked like he was raring to go as I rewatched that ad the other day. You know, at the SEC, at the market data round table, it was not lost on me that I think chairman Jay Clayton and several members of both exchange and broker panel brought up this sort of fictitious couple. Mr. And Mrs. 401k. Who, I guess we ascribe as the retail investor, the person who's either buying and selling stocks on their own, or just expects that they have a bucket of equities in their 401k plan and it's going to grow in 2019 through 2030 the way it grew from 2009 to the present. Is this sort of a smoke screen, all this talk about Mr and Mrs. 401k from the SEC chairman and the members of the panel? Is this really sort of as... Several members of the panel, Stacy Cunningham included, saying this argument is really about Wall Street versus Wall Street and who's going to divide up the remaining profits.
Justin Shack:
Yeah. I tend to agree more with the latter viewpoint. But I don't think the concern with Mr and Mrs. 401k... Or I think John Fallon when he was the chairman of the New York Stock Exchange ages ago, used to say "Ain't many in Kansas. Right? Like there's always been this concern and that's why the SEC was created. Right? We need to protect the unsophisticated investor. I think that's a very important thing. And chairman Clayton has made it clear that that's a priority of the SEC, and I think very appropriately so. That really, I think is more relevant, when you talk about things like cryptocurrency or fixed income markets, where there's a lot less efficiency and there're big markups and a lot of vig going to the dealer community. When you talk about equity market structure and market data, there's not no effect, I don't think you can say this doesn't affect the everyday investor, because it absolutely does. But it's more of an indirect effect.
Justin Shack:
Really, when we talk about whether it's make or take or fees, or the fees that people pay for that brokers pay for market data, that's a cost that they absorb in their PNL. Now, does that affect what they then charge their end customer? Absolutely. But it doesn't determine it, it's a factor. Right? It's sort of like saying every gas station in the United States would charge the exact same price for regular gasoline that's benchmarked to the price of Brent Crude. That's not what happens and I don't think that's what happens in the brokerage industry either.
Justin Shack:
There are certain raw materials that the brokerage industry needs to buy from the exchange community and elsewhere, and then they can figure out, "Do we have the scale? Do we have the efficiency to maybe take that raw material and charge a lower price to our customer than our rival might?" And that's competition. It's kind of what I was alluding to before, that you have reforms that are investor friendly and might be painful for intermediaries, but the intermediaries, market forces, can work there in ways that maybe lead to consolidation among some of those intermediaries and relieve some of that pressure without having to go to public policy, to accomplish that.
Josh King:
And finally, as our conversation wraps up. Justin, using the wisdom that you've gleaned from over two decades of observing markets, what do you think markets will look like 20 years to come?
Justin Shack:
You know, I think one of the things I've learned, is there's always unintended consequences to regulatory changes. But the other thing that I've learned is, in the 10 plus years I've been at Rosenblatt, there have been a lot of people agitating for change in market structure and very little actual change in market structure. So betting on no change is a winning bet. And so, I would say in 20 years, the basic roles, the fundamental jobs and functions we see today are probably going to be very similar to what they are today. Maybe some of the technology's going to be better, maybe there'll be little changes, but the system is probably going to look a lot like the way it does today.
Josh King:
And we shall see. Come back in 20 years, we'll have another conversation.
Justin Shack:
We'll see. Hopefully, I'll be happily retired and playing my guitar somewhere by then. But yeah.
Josh King:
You and me both. Thanks a lot for joining us in the ICE House.
Justin Shack:
My pleasure. Thanks for having me.
Josh King:
That's our conversation for this week. Our guest was Justin Shack, managing director and partner at Rosenblatt securities. And if you like what you heard, please rate us on iTunes so other folks know where to find us. And if you've got a comment or question you'd like one of our experts to tackle on a future show, email us at [email protected] or tweet at us at NYSE. Our show is produced by Kristin Cause and Pete Ash, with production assistance from Ken Abel and Steven Portner. I'm Josh King, your host, signing off from the library of the New York Stock Exchange. Thanks for listening. Talk to you next week.
Speaker 1:
Information contained in this podcast was obtained in part from publicly available sources and not independently verified. Neither ice, nor is affiliates, make any representations or warranties, express or implied, as to the accuracy or completeness of the information and do not sponsor, approve or endorse any of the content here in. All of which is presented solely for informational and educational purposes. Nothing here in constitutes an offer to sell, a solicitation of an offer to buy any security or a recommendation of any security or trading practice. Some portions of the proceeding conversation may have been edited for the purpose of length or clarity.
