Warping the loom

THE controversies that beset America’s financial markets extend to even the most basic activities, such as trading a security. What was once the preserve of a stockmarket duopoly of the New York Stock Exchange and NASDAQ, and a handful of narrow commodity markets, is now a bewilderingly complex tapestry. It is also subject to incessant reweaving: take this week’s announcement that Bats Global Markets, an operator of four stock exchanges, will be sold to the CBOE, an options exchange, for $3.2 billion.

Bats was founded in 2005 in Kansas by a man whose background was in trading shares from his bedroom. In 2012 it famously botched its first attempt to list its own shares, completing the job only this year. The price it now commands reflects its success in expanding to become America’s second-largest equity market, with a growing presence in options. It brings to the relatively long-established CBOE, founded in 1973, what is seen to be better, low-cost technology. The CBOE said that Bats will also play a role in developing new “tradable products and services”.

This is a crowded field. More than a dozen exchanges deal in equities alone, to say nothing of scores of “dark pools” of liquidity for private trading and countless trading firms that fit into neither category. Then there are the markets that offer options or futures linked to shares. Exchanges now rely less on straightforward commission income—eg, from trading a company’s shares—and more on designing products that encompass a variety of financial instruments. Bats, for example, is popular for trading exchange-traded funds (ETFs), often themselves tied to options or futures. Among the CBOE’s most valuable products is an option contract tied to the S&P 500 index that tracks the American market.

Trading volumes may have grown and innovations proliferated, but there are concerns about how much companies and long-term investors have benefited. The Securities and Exchange Commission (SEC) this week trumpeted a $12.5m settlement with Bank of America Merrill Lynch for “ineffective trading controls” that enabled “erroneous orders” to provoke a series of “mini flash-crashes” between 2012 and mid-2014, and, said the SEC, dented faith in the financial markets.

Worse than such highly visible glitches are ones that steadily call into question the efficiency of the market. Such concerns have contributed to a drop in the number of companies willing to publicly list their shares. Charles Royce, who has specialised in small-company investments for decades and manages about $17 billion in various mutual funds, says it has become harder to buy and sell. Even though prices are displayed, the volume of shares available and demand for them is becoming more opaque. That is widely blamed on high-speed traders who put out a vast number of tiny buy or sell orders to gauge interest and then get in ahead of slower investors on larger trades. Mr Royce says it is hard to say whether these traders provide liquidity (as they claim) or rather make profits at the expense of long-term investors.

In an effort to improve trading to help small companies, Congress inserted into a 2012 law known as the JOBS act a requirement that the SEC should consider tinkering with its rules about how bids and offers are denominated. Currently all offers are priced in pennies. It has taken the SEC four years to come up with a plan (despite the law’s 90-day stipulation). From October 3rd the shares of 1,200 companies with market capitalisations below $3 billion will be traded with quotes priced in five-cent gaps, in a two-year experimental period—a so-called “tick pilot”.

It seems odd to expect higher spreads to lower the price of transactions. But the idea is that the large gaps create risk for high-speed traders. They will no longer be able to lay down a minefield of small orders without risking large losses. Mr Royce, and several other fund managers, are curious about the possible benefits from the study, though their expectations are limited. Two years in trading is a lifetime. Even if the plan works, by the time it is over the entire tapestry may once again have been unwoven and transformed.