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 "Stop the bleeding" was a refrain often employed by a late mentor of mine, legendary Wall Street trader John Mulheren, who invoked that lesson in his booming voice, whenever the P&L became just an L, and traders who worked for him were wedded to losing positions. This was accomplished by forcing these traders to close out those losing positions. "Take them to a price where they trade," he would say, no excuses, and he meant it. Common sense but uncommonly hard to do. During my first face-to-face interview, John promised that he would "never stab you in the back, [he] would only stab you right in the chest." He was the perfect boss and I miss him dearly. Now that we are facing a crisis of confidence, my mind turns back the years and I try to imagine what Mulheren would do during these times. He was a man of action, embodied with clarity of vision that few ever possess and tremendous insight into the motives of people and markets. I can assure you that he would not have frozen out of fear; rather, he would embrace the challenges we face today as opportunities, recognizing the pressing need for change in the fundamental structures of our markets.
Today, those feeling the greatest pain are suffering from self-inflicted wounds—having embraced exotic financial structures, priced in a shadowy, nontransparent environment—that have ultimately proven to be their undoing. Now that the pain has shifted from shareholders and their corporate parents to taxpayers, it has become a matter of concern for the rest of us. The sins of a few have been foisted onto the backs of the many, and it is our duty to address the core issues underlying the current crisis.
While it is exceedingly tempting to cast blame for the problems that befell Bear Stearns, AIG, Merrill Lynch, Lehman Brothers, Fannie and Freddie, and other once-rock-solid institutions, I think a fresh dose of foresight will be of greater value than an equal measure of hindsight. America's financial system desperately needs an unencumbered vision for a new market structure, but perhaps one based on some traditional values.
Markets need to serve the function for which they were intended—the raising of capital. And those who create financial products and funds need to think foremost about their investors. The truth is, all of the broker-dealers, investment banks, traders and market makers exist to serve Main Street investors—not the other way around. A realization of that truth among market participants will be the first step to restoring balance—and integrity—to our capital markets.
In practical terms, the next step for regaining investor trust is requiring greater transparency in our trading systems. Without transparent markets, valid price discovery and accurate risk assessment are impossible. We are forced to rely on models and accounting practices that have failed time and again. If products cannot be listed and traded on an open exchange, they should not be available for margin. Banks and brokerages will design accurately priced derivative products to trade on listed exchanges. For example, we must be wary of counterparty risk that is embedded in certain structured products—like some nonasset-backed ETFs—that is not fully disclosed. Sponsors of listed note products should be required to disclose exactly what counterparty risk is being taken at any given moment. This will aid in real-time risk assessment by creating mark-to-market pricing for tradable assets.
Second, exchanges must be encouraged by the Securities and Exchange Commission to create market environments that attract liquidity. The jury has spoken and the New York Stock Exchange's current market structure is failing: They have lost 70 percent of their market share and the stock price is reflective of their outlook. In 2004, I delivered testimony to the U.S. House Financial Services Committee warning about the risks of new trading rules whose chief virtue seemed to be to accelerating trading speed.1 My view then—as now—was that speed would inflame both price and temporal volatility in the marketplace, in the process scaring off individual investors and destroying confidence in the marketplace.
I concluded my remarks with this statement, which seems worth revisiting in light of recent events:
Individual investors buy and sell based on price. When millions of investors get home tonight and check on their 401(k) programs, they will carefully watch the prices of their stocks and mutual funds. I can't believe a single one of them will wonder whether their shares traded in five seconds or eight. Moreover, most will have no knowledge of which exchange traded their security or under what rules they were traded. Can the NYSE move faster? Yes, and it should. But price and transparency are equally important principles [and] this committee and the SEC must not abandon [them].
Mistake Of A Generation
Sadly, since 2004, the markets have moved away from protecting the investor and toward enhancing the power of professional traders. Execution of orders is now routinely done in nanoseconds, and price protection is impossible in an era of dark pools and fragmented markets. That's why the SEC must realign its rules to favor the investor over the professional trader.
On June 13, 2000, then-Chairman of the SEC Arthur Levitt spoke to the Subcommittee on Finance and Hazardous Materials, recommending the following:
Currently, the United States securities markets are the only major markets not to price in decimals. As the security markets become more global, with many stocks traded in multiple jurisdictions, the U.S. securities markets need to adopt the international convention of decimal pricing to remain competitive. And the overall benefits of decimal pricing are likely to be significant. Investors may benefit from lower transaction costs due to narrower spreads. Moreover, the markets will be easier to understand for the average investor, who is used to dealing in dollars and cents for everyday transactions. It is time for the U.S. securities markets to make this change.2
This was the beginning of the end of the stable equity markets. To be fair, many others wrongly shared Mr. Levitt's opinion. In reality, the foreign markets could trade in decimals (why not 1/1000 of a penny? It is completely arbitrary to stop at a penny) because of the fact that during times of stress, they had the U.S. markets to rely on for liquidity—the NYSE-established price to stabilize the world markets. By regulating that our markets mimic the foreign exchanges, the SEC unplugged the last stable market. This change was rolled in slowly over the course of years, and today we are watching world markets fail the first major test without a profitable liquidity provider model on the NYSE. I cannot help but wonder what our markets would have looked like after Sept. 11, 2001, without Goldman Sachs, Bear Wagner (Stearns), LaBranche, Bank of America and others providing forced liquidity. I pray that we will never be tested like that again.
The SEC did pilot tests while rolling out decimals. Why not try nickels on 50 or 100 stocks and see if volatility is dampened? I would bet that many companies would gladly participate by placing their stocks in a pilot program where they traded only in nickels.
In addition, exchanges should (and one or more will) contract with liquidity providers by offering rule structures, such as parity—giving the provider a percentage of the fee on each trade (20 percent), if the liquidity provider is at the inside of the market, up to a disclosed amount of shares. The SEC should mandate that orders flow to the national best bid and offer (NBBO) based on price—and if price is equal, then on size. This additional test would encourage deeper markets and help concentrate liquidity and dampen volatility. And this will encourage liquidity providers to participate in more transactions and also allow for a reasonable return on capital. Furthermore, by auctioning off the right for a highly capitalized entity to act as a well-regulated liquidity provider, the exchanges would receive desperately needed revenues.
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