The Future of Equity Trading

Introduction

Several points about equity markets:

  •  They are growing globally.
  • An increasing number of equity trades are computer driven.
  • A primary activity of private equity firms is to take publicly traded companies private.
  • In the US, the Sarbanes-Oxley Act passed in 2002 made it more costly and burdensome for public companies to satisfy SEC regulations.

How these factors affect equity trading, now and in the future, is discussed below.

 Global Equity Markets

Table 1 provides data on stock market values worldwide.

 Table 1.  – Stock Market Capitalization (% share)

Exchange 1995 2000 2005 2006 2007 2008 2009
Americas
US 40% 49% 40% 37% 31% 34% 31%
Other 4% 4% 6% 6% 7% 6% 8%
Total 45% 53% 46% 43% 38% 41% 39%
Asia – Pacific
China n.a. n.a. 1% 2% 7% 5% 7%
Japan 21% 10% 11% 9% 7% 10% 7%
Other 9% 6% 11% 13% 17% 14% 18%
Total 30% 16% 23% 24% 31% 30% 33%
Europe – Africa – Middle East
United Kingdom 8% 8% 7% 7% 6% 6% 6%
Other 18% 23% 23% 26% 26% 24% 23%
Total 25% 31% 31% 33% 32% 30% 29%
               
Overall Total (bil. US$) 17,124 30,957 43,069 52,963 64,468 33,731 49,146

n.a. – not available

Source: World Federation of Exchanges

Note that the lead markets in all regions (US, Japan, and the UK) are losing their dominance to other markets in their respective regions. Japan’s decline is most pronounced. China’s markets (Shanghai and Shenzhen) are now slightly larger than Japan’s, while India now ranks fourth in Asia, just behind Hong Kong. Although the US exchanges share has fallen, they still dominate all others by a wide margin.

Table 2 provides global data on the number of listed companies.

Table 2. – Companies Listed on Stock Exchanges

Exchange 1995 2000 2005 2006 2007 2008 2009
Americas
US 8,160 7,851 6,029 6,005 5,965 5,472 5,179
Other 9,337 9,261 9,988 10,057 10,151 9,682 9,762
Total 17,497 17,112 16,017 16,062 16,116 15,154 14,941
Asia – Pacific
China n.a. n.a. 1,377 1,421 1,530 1,604 1,700
Japan 3,013 3,406 2,796 3,854 3,870 3,786 3,656
Other 4,841 6,039 14,164 14,589 15,227 15,429 15,545
Total 7,854 9,445 18,337 19,864 20,627 20,819 20,901
Europe- Africa – Middle East
United Kingdom 2,502 2,374 3,091 3,256 3,307 3,096 2,792
Other 3,875 6,932 7,743 11,116 11,468 11,604 11,278
Total 6,377 9,306 10,834 14,372 14,775 14,700 14,070
Overall Total 31,728 35,863 45,188 50,298 51,518 50,673 49,912

n.a. – not available

Source: World Federation of Exchanges

It is notable that unlike the dominant countries in the other regions, the number of listed companies in the US has fallen by 36% since 1995. Perhaps some of this decline in recent years is attributable to more burdensome regulatory requirements and the activities of private equity and merger/acquisition companies.

Computer Driven Trades   

A recent Bloomberg Businessweek article “The Machines That Ate the Market” made a number of interesting points about computer-driven trading:

1.   History

  • “Historically, the NYSE and Nasdaq were nonprofits seen as utilities that served the public interest…. Beginning in the 1970s, Nasdaq, and, later, additional electronic rivals, gradually eroded the NYSE’s dominance…. Newer profit-making exchanges started explicitly to benefit the firms that ran and patronized them.”
  • “Directives from Washington have encouraged the dispersal of trading. Some 50 exchanges and other electronic venues across the country now compete for securities business. The volume of equity traffic controlled by the NYSE fell from 80 percent in 2005 to 50 percent in 2007 and then to less than 25 percent this year…. Wall Street’s extreme makeover has achieved its main goals: greater efficiency and much lower commissions for the pension and mutual funds, insurance companies, and endowment managers that invest in equities.”
  • “…the market is now dominated by quick-draw traders who have no intrinsic interest in the fate of companies or industries…. High-frequency traders (HFTs) now account for as much as 60 percent of daily volume….The most prolific HFT outfits, such as Getco in Chicago, Tradebot Systems in Kansas City, Mo., or RGM Advisors in Austin, Tex., can individually generate as much as 5 percent or 10 percent of all the stocks traded in the U.S. on a given day.
  • “HFT shops move enormous quantities of stock in fractions of a second.” They locate their computers near the mainframes of wholly automated trading venues “because the distances that their orders travel, measured in feet, can determine profit or loss.
  •  “On its Web site, Wolverine in Chicago says its servers receive direct data feeds from more than 15 exchanges and execute more than 1.5 million orders a day.

2.     Today

Amazing! What does it all mean for individual investors?

Analysis

The article documents things have changed dramatically.

The HFTs)…argue that all that extra buying and selling provide the liquidity that makes the market more efficient.

  1. There is no question that some of what the HFTs are doing keeps markets worldwide accurately reflecting value – classic arbitrage, e.g., “The quants use a range of strategies. One is simultaneously posting bids and offers for ever-changing amounts of a single stock. Prices tend to vary by minuscule amounts on different electronic exchanges, so a stock can be bought at a lower price on one, then sold instantly at a higher price on another…. They direct their mainframes to sift the information flows for minute discrepancies, such as when futures contracts fall out of sync with related underlying stocks.”
  2. But there are other computer programs the HFTs use that do just the opposite. Remember, the HFTs primary aim is to make money “with no intrinsic interest….” Suppose the HFTs are betting lots of money on markets to fall. They have carefully studied every facet of momentum quantitatively, and they know how to generate momentum, i.e., if stock prices start down, they know what sorts of trades will accelerate the downturn.
  3. Perhaps one trader does not have the clout to cause a major market disruption. But it is reasonable to assume that most of the large computer driven traders have their own momentum generating programs. What if they all try to generate momentum downward at the same time? It can be quite disruptive.
  4. The quants have also studied how market movements are correlated. They know that bad economic news in the US will cause its markets to fall. They also know a fall in US markets will have a ripple effect globally. They can get into other markets before anyone else and short them, thereby accelerating the ripple effect.
  5. Consider what has happened on global markets in the last year. Asia and Latin America are out of the recession, but their markets move up and down with Western country markets. Why?

Before answering that question, let me document my statement with numbers. The so-called coefficient of determination (R2) measures the extent to which the movement in one variable can explain/predict the movement in another. An R2 of 1 would mean the movement in one variable can completely explain the move in another; an R2 of 0 means there is no correlation between the two variables. Consider first how stock indices, funds, and ETFs from different regions have performed since 2007. In Table 3, the R2s for these variables is provided against movements in the S&P 500. In other words, how much of the day-to-day fluctuations in these other variables can be explained by movements in the S&P 500?

Table 3. – R2 of Markets vs. S&P 500

(1/31/2007 – 6/4/2010)

Investment R2
  Regions
Asia (EPP) 0.76
Latin America (PRLAX) 0.61
  Countries
UK (FTSE 100) 0.96
Japan (Nikkei 225) 0.88
South Korea (EWY) 0.85
South Africa (EZA) 0.67
India (MINDX) 0.55
China (MCHFX) 0.25
Brazil (EWZ) 0.24

Source: Yahoo Finance

To me, these figures represent markets where values are being pretty accurately represented. The banking collapse and resulting global recession was the result of problems in the US, Europe, and Japan. Note that the R2s for Asia and Latin America are much lower than for Europe and Japan.

But now look at what happened since worries about the four weak sisters of Europe started affecting the markets. As I have been writing for some time, Europe, Japan and the US are still mired in the recession and debt. In contrast, Asia and Latin America are fundamentally debt-free and emerging from the recession. In light of this, one would expect Asian and Latin American markets to be performing much better than Western markets.

As Table 4 indicates, this is not what has happened. Movements in the FTSE 100 are more highly correlated with market movements in Asia and Latin America than the US or Japan.

Table 4. – R2 of Markets vs. FTSE 100

(4/23/2010 – 6/4/2010)

Investment R2
  Regions
Asia (EPP) 0.90
Latin America (PRLAX) 0.93
  Countries
US (S&P 500) 0.86
Japan (Nikkei 225) 0.81
South Korea (EWY) 0.88
South Africa (EZA) 0.75
India (MINDX) 0.84
China (MCHFX) 0.89
Brazil (EWZ) 0.89

Source: Yahoo Finance

Table 5 provides data on what has happened to stock markets since the European worries started. Asian and Latin American markets have fallen more than Western markets.

Table 5. – Stock Market Performance

(4/23/2010 – 6/4/2010)

%
Investment Change
  Regions
Asia (EPP) -18%
Latin America (PRLAX) -13%
  Countries
UK (FTSE 100) -10%
US (S&P 500) -12%
Japan (Nikkei 225) -11%
South Korea (EWY) -16%
South Africa (EZA) -13%
India (MINDX) -8%
China (MCHFX) -11%
Brazil (EWZ) -16%

Source: Yahoo Finance

Why is this? Does it have anything to do with the HFTs, or is it just the result of the relatively small markets of Asia and Latin America being more affected by Western liquidations than the underlying strength of their economies?

Conclusions

What can we expect? The only thing I can say with certainty: the emergence of HFTs as dominant global players will mean more stock market volatility.

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
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