Poisoning the Goose while Taking its Alpha Eggs

The authors of Broken Markets are the founders of Themis Trading LLC, an agency trading firm headquartered in Chatham, New Jersey. These authors, Sal L. Arnuk and Joseph Saluzzi, believe that some seemingly innocuous regulatory changes (and other changes which never perhaps seemed quite so innocuous) have contributed to make the system of capital investment in the United States quite dysfunctional.

It may not come across either from that title or from the longer subtitle (“How High-Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio,”) but this is very much a book about regulation and its consequences.

Savers, Entrepreneurs, and IPOs

The point of a well-functioning capital system, as the authors see it, is mediation between the savers who want to make a profit on their capital and the entrepreneurs who can make good use of it. The frequency and success of initial public offerings are obvious tests of whether that job of mediation is getting done, and though this had been foreshadowed throughout the book, the significance of IPOs is driven home near its conclusion, in a “guest chapter” by David Weild and Edward Kim, senior advisers at Grant Thornton.

Looking at the decade of the 1990s as a whole, the average annual number of IPOs was 520. If one makes the assumption that the number of IPOs each year should increase in a manner proportionate to the growth of the broader economy, then in 2011 the United States should have had 950 such offerings. In fact, it had roughly one sixth of that number. The average number of IPOs annually since 2000 has been only 129, Weild and Kim observe.

The U.S. stock market is shrinking. The number of companies that leave it each year since 1997 has exceeded the number entering via IPOs. The Weild-Kim chapter in this book is accordingly titled, “Killing the Stock Market That Laid the Golden Eggs.”

One might paraphrase the message of this book in terms of the fable to which that title alludes. The “goose” consists of the body of retail investors, also known as savers. The hedge funds and others who can trade using the full resources of cutting-edge hardware and software co-located can gain alpha thereby, they can get a lot of golden eggs, in a manner encouraged by recent regulatory changes (not by “deregulation,” that customary scarecrow!). In doing so, though, they are undermining the system that makes their success possible. They are, perhaps, profiting from the final days of their benefactor goose.


But let us leave Weild-Kim to return to the material written by Arnuk and Saluzzi themselves, and especially to the consequences of regulations. One fairly straightforward sort of regulatory move was decimalization: in the 1990s that the Securities and Exchange Commission decided to press the exchanges to abandon price points such as 9 3/8, in favor of 9.37. Let us look at this in some detail as a sample of the universe of regulatory changes this book surveys.

As Arnuk and Saluzzi say, it seemed tough at the time to make a contrary argument, since nearly everything one calculates in contemporary life is in decimals. There was no obvious reason to adhere to the anachronisms of the buttonwood tree. Thus, in August 2000 the exchanges began phasing in decimals.

What happened? Spreads did fall, but “displayed liquidity at the National Best Bid and Offer” also fell, at least in part because there were 100 price points for each dollar now, where once there had been eight or 16, so limit orders no longer come in clusters. This in turn made “pinging and sniffing for order flow” a lot easier, heralding the rise of the sort of algorithmic trading that is to the ordinary retail investor what a hawk is to a mouse.

Why did the SEC under Arthur Levitt press for decimalization? This might be a case, familiar enough to historians of regulation in any event, of good intentions gone wrong. To revert to the goose of fable: the poultry farm manager may generally have believed that the retail investors who have long laid our golden eggs would gain from the new additive in their feed. He may be innocent of any intention to poison. Yet poisoning there may have been.

Arnuk and Saluzzi dismiss the idea that Levitt was deliberately assisting high-frequency traders who were trying to create a lot of new price points that they could arbitrage. They think, rather, that he was “trying to tilt the playing field toward the individual investor” against his own bête noire, the mutual fund industry. Still, intentions are not consequences. Only consequences are consequences.

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