Thursday, June 28, 2012

Congress Looks at Minimum Tick Sizes to Help the IPO Market

On June 20, 2012, the House Committee on Financial Services held a hearing to review issues affecting the performance and utility of the securities markets.   A major item on the agenda included a review of what additional steps could be taken to improve the quiet state of the Initial Public Offering, or IPO, market.  The Committee had earlier this year exercised a leadership role in the passing of one of the only bipartisan bills in recent memory - the JOBS (“Jumpstart Our Business Startups”) Act.   The JOBS Act represents a significant rethinking of securities laws to create a new path for nascent  pre-IPO companies to raise seed capital from public investors without meeting many of the reporting and other requirements previously in place. 

The Financial Services Committee is now considering the role that minimum trading increments, or price ticks, have in building a new public company’s ability to enjoy a liquid secondary market.  A price tick is the minimum difference between the price for which a stock can be bid to be purchased and the price at which it can be offered for sale.  Certainly, the confidence that a would-be reporting company has in being able to attract investors - not only though its business plan and financial performance – but, also in the efficiency of entering and exiting an investment in the company’s stock, is a critical consideration for a corporation making the decision to “go public” or not.   Thus, it is an important issue for the Committee’s consideration.

New public companies face a daunting road. [1]  How important is it for the pendulum to start swinging back to encourage more companies to use the public markets?  In the House Committee’s recent hearing, Jeffrey M. Solomon, Chief Executive Officer of Cowen & Co., cited in his prepared testimony statistics that showed a 28 percent decline in the number of U.S. public companies from 1991 to 2011, a drop-off from 6,943 to 4,988.[2]

For the United States to lose more than a quarter of its public companies in the span of a generation is eye-popping.  However, based on Congress passing the JOBS Act legislation and showing an ongoing interest in additional positive steps like modifying tick sizes for some companies, Congress is showing meaningful concern about the role of securities regulation on capital formation.  These actions are a very welcome step in beginning to address the problem. 

The focus on tick sizes for smaller and new public companies may seem like a small matter, but having Congress examine how the market structure of securities trading can be either a catalyst or a drag on capital formation is extremely worthwhile.  For select stocks, whether new or thinly traded, the goal of wider ticks is to attract market makers to provide greater liquidity by allowing them to make a profit on the bid/ask spread of a security.  New issues of securities that are developing a following, or stocks that have been listed for some time but “trade by appointment” – a polite way to say they are illiquid – can benefit by drawing the participation of liquidity providers who would otherwise not make markets in that stock because of a lack of trading opportunity. 

Whether the tick difference is a nickel, a dime or a quarter can be left to the exchanges or to the issuers, but Congress must assure that there is a mechanism to make tick sizes for affected stocks consistent across trading venues.  In addition, sub-penny pricing should not be allowed to infiltrate the trading in stocks with wider tick sizes as has been the case with securities listed in the broader market.  Sub-penny pricing, once thought to be a means to bring price improvement to investors who place market orders, namely retail investors, has become too often a means of confusing and disadvantaging the retail client rather than helping him. 

Appropriate changes in regulation to foster capital formation can have a profoundly positive effect on the confidence business has in the government’s economic stewardship of the economy.  Hopefully, the current focus on the state of capital formation will continue.


[1] See my opinion pieces e.g. “Sarbanes-Oxley Is a Curse for Small Cap Companies,” Wall Street Journal, August 15, 2005,,,SB112406088194912851,00.html, and “America’s Regulations Are Scaring the Sox off Small Caps,” Financial Times, August 1, 2006,

Thursday, June 21, 2012

Oil Below $80: Where Have All the Speculators Gone?

The price of crude oil has fallen more than 20% in three months, from $106 in March to below $80 per barrel on the NYMEX as of June 21, 2012.  On the minus side, the rapid fall indicates a pronounced and sudden weakening in the world economy.  As nations and businesses slow down, less oil is consumed and the price falls; oil is a pretty good indicator of economic health.  On the plus side, every dollar fall in the price of oil translates to an extra $20 million a day or so back in the pockets of U.S. consumers.  It is hard to imagine a faster and more targeted economic stimulus plan, and the federal government didn't need 60 Senators' votes to make it happen.

Such a dramatic price decline after a relatively stable period of $100 oil may teach us some important lessons about the market structure of listed energy contracts.  Oil is a volatile commodity, and a volatile investment should one look at tracking its price as part of a portfolio.  Oil surpasses almost all, if not all, financially traded products in normal volatility.

While the question gets asked in times of rising prices whether rising oil prices are caused by artificial factors like "excess" speculation, you rarely hear the regulators and pundits who complain of artificially high prices discuss whether lower prices are also caused by excessive speculation.  In fact, in cases of falling energy prices I have never heard the claim that they were the direct result of speculation.

I spent over 20 years as an attorney and operations officer of the NYMEX, and I have no better idea why prices go up than saying "more buyers than sellers."  What I find hard to believe is that speculators cause high prices but supply and demand causes lower prices. That just seems silly.

The point is, why do the advocates of strong position limits and intrusive controls on market participants not emerge when prices fall to explain how speculators affect pricing?  I say that speculators have the same role they always have: providing liquidity. I'll say that at $100 or $70.  Not just $70.

Monday, June 11, 2012

Will Nasdaq Face Liability for the Facebook IPO?

When a publicly listed for-profit  exchange handles the initial public offering or IPO of a legendary company, should it be held responsible for investors’ losses if the offering goes badly because of trading glitches caused by the exchange’s technology?  

Intuitively, the answer appears to be yes, because companies of all stripes have had to compensate victims who suffered losses caused by the corporation’s negligence.  However, since 1934 the securities markets have operated in large part as surrogates for the federal regulator, the Securities and Exchange Commission, in maintaining fair and orderly markets and upholding principles of just and equitable principles of trade.  When they operate under the mantle of surrogate of the SEC, exchanges are called Self-Regulatory Organizations, or SROs, and they are given wide latitude to act, or not act, in the best interests of the investing public.  The courts have held that SROs when performing the quasi-governmental role as an SRO in regulating the marketplace have the right to be protected, just as the regulator would be, from lawsuits and damages resulting from a regulatory decision under a doctrine called “absolute immunity.” In re NYSE Specialists Securities Litig., 503 F. 3d 89, 90-91 (2d Cir. 2007); Mandelbaum v. New York Mercantile Exchange, 894 F. Supp. 676 (SDNY 1995). 

The question of whether Nasdaq was acting in its SRO role when it made various decisions surrounding the Facebook IPO may determine whether it will face the consequences of having to repay angry investors their losses – now totaling hundreds of millions of dollars - or be able to escape from any court imposed damages.

The basic details of what went wrong with the launch of the Facebook IPO have been broadly reported: the opening was delayed from the announced time, and after the first print was published by Nasdaq , investors and brokers began complaining that they did not know if their orders had been executed. 

The opening of trading in the IPO of Facebook shares went awry quickly because of technology failures, and questionable decision-making in the face of those technology issues.   In the days that followed the IPO several companies revealed that they and their customers had suffered losses of about $200 million.  This weekend UBS upped the ante for injury caused by Nasdaq’s handling of the IPO by revealing a whopping loss of an additional $350 million above what had been reported earlier by other market participants.

Nasdaq has apologized several times, and acknowledged the specific technical glitches that created that first day havoc  (a “race condition” where the matching engine never enters a stable state was the root of the electronic havoc).  Nasdaq has proposed a compensation pool of approximately $40 million, about a third of which would be paid in cash and two thirds in reduced or waived fees for future business.  The exchanges that compete with Nasdaq have derided this offer serving up another helping of negative press to reinforce the view of Nasdaq as something of a bumbler.  The competing exchanges complain, and with some justification, that using a compensation pool as a way to lock customers into using your market, thus helping your own market share numbers at the expense of your competitors, is against the SEC’s rules for fair and competitive markets. 

Normally, when a public company performs badly in its business and causes damages to the public or other companies the question of liability is one of calculating the damages and determining whether the misstep was the result of intentional misconduct where punitive damages might apply, or negligence where the company must repay the injured person for the harm it caused.  Certainly no one in this matter claims that Nasdaq intended to botch the Facebook IPO, but botched it was.  Leaving a marketplace full of investors and brokers wondering for hours whether they bought stock or not while the market was gyrating wildly is a failure by a market operator to perform its basic function.

Securities and futures exchanges operate in a strangely different world from other corporations, and thinking that normal rules of liability apply to them can be misleading to the extreme.  Under normal rules of liability, Nasdaq could be facing damage claims of more than $500 million because investor losses can be tied directly to its systems failure.  However, under the rules governing exchanges it is quite possible that Nasdaq will escape any liability, or at least significant liability, because it benefits from the legal doctrine of “absolute immunity” in performing the regulatory functions it must perform as a surrogate of the SEC.  If Nasdaq was acting in its capacity as a regulatory body when it was making decisions about the Facebook IPO  in order to protect the public interest, then Nasdaq will be able to say that it is absolutely immune from paying damages, even if its decisions were flawed.

Nasdaq realized early on that something was amiss with the technology supporting the Facebook IPO.  It tried to assign an opening price manually while fixing what it believed to be the bug causing the problem.  Nasdaq was empowered to halt  the market under its own Rule 4120(a)(7), and cancel all trades that had occurred prior to the halt (remember the BATS IPO where BATS experienced system problems handling its own IPO after the market had started to trade, and reversed course to cancel all trades in order to preserve a fair and orderly marketplace).  Or, Nasdaq could have halted the market, resolved the issues, and confirmed all trades occurring before the halt, and then moved forward with new trades.  Should Nasdaq have been in doubt about actions it could have taken in the face of a halt, Nasdaq could have relied on Section 19 (b)(3)(B) of the ‘34 Act and implemented an emergency rule without prior public notice or SEC approval in order to maintain “fair and orderly markets.” 

In hindsight, notwithstanding the misguided criticism heaped on BATS after its IPO fizzled, a trading halt could have resolved the technical issues before too much damage was caused.  Yes, a halt during the biggest IPO of recent years would have been embarrassing, but not on the scale of 500 million reasons to be chagrined.  BATS, by contrast, chose to be embarrassed over flubbing its own IPO rather than risking the consequences of a technology failure during its IPO.  Nasdaq on the other hand decided to plow forward, thinking at the time that its actions would solve the problems and preserve a fair and orderly market and just and equitable principles of trade.  In hindsight, plowing forward only made matters worse, sowing confusion among investors and maximizing the losses that they incurred as systems issues plagued investors and the exchange during the day.

However, at the time it made its decision, Nasdaq officials believed that the best course for them to take to protect the interests of the market was to issue an opening price manually, fix the technology issues on the fly, and continue with public trading of Facebook shares.  With 20/20 hindsight that may not have been the wisest or best decision.  However, if Nasdaq made the decision not to halt as the best means to provide the public with a fair and orderly market,  then Nasdaq can claim that it acted in its capacity as a Self-Regulatory Organization to provide and protect a fair and orderly market, and were thus protected by the absolute immunity doctrine that applies to exchanges performing quasi-governmental regulatory actions.

I expect that the question of absolute immunity for exchange actions taken during the Facebook IPO will receive much attention from the courts.  Arguments will be made that Nasdaq acted primarily in its corporate interests, or that a for-profit exchange does not deserve the protection of the absolute immunity doctrine that arose when exchanges were not-for-profit membership owned organizations; instead its shareholders should bear the risk of loss.  Those arguments have some appeal, and may prevail ultimately as the inevitable cases go through the courts.  But, rules that are specific to the unique regulatory roles played by exchanges may well insulate Nasdaq from facing the consequences of significant damages from its handling of the Facebook IPO. 

Thursday, June 7, 2012

The Core Principle 9 Debate

Core Principle 9 governs the requirement for CFTC regulated futures and options transactions to be executed in an open and competitive fashion.  Requiring futures and listed options to meet the open and competitive standards makes perfect sense: the purpose of a futures market is to allow for price discovery and hedging of market risk to occur. 

CP 9 is intended to assure that prices determined on regulated exchanges fairly and accurately represent the value of the underlying commodity or financial interest.  If a market is competitive – open to many different interested users all looking to have the market reflect their personal opinion of value – and open, so that all of these interested competitors can see at all times what price his competitor believes is true value, then the market will function effectively as a mirror of value.  

Placing a numeric threshold on whether the market is competitive threatens to move such important products as Crude Oil (LO), Gasoline (OB), and Heating Oil (OH) Options and Nasdaq 100 (ND), Palladium (PA), and S&P 500 (SP) futures off of regulated exchanges.   Natural Gas (ON) and Gold (OG) Options as well as Gasoline (RB) and $10 Dow Jones (II) Futures have between 10% and 15% of their volume executed off-exchange, and are threatened with removal.

The first issue is what is the public benefit of removal?  To place such products alongside a medley of swaps that have no real bearing on the price discovery function of markets seems to lessen the price discovery function of these important products. 

Once a product is labeled a swap, or ineligible for trading on a Designated Contract Market (DCM), it is not formally subject to the full “open and competitive” requirements of DCM Core Principle 9.  However, by proposing large block trading sizes, and mandating electronic execution and immediate reporting of trades, the rules for swaps are moving fairly close to the CP9  standards, a kind of CP9 "lite" approach. 

It appears to me that products that have traditionally traded as futures contracts likely serve an important price discovery function, and ought to be left on highly regulated DCMs.  Products that are typically unimportant to price discovery (swaps) do not require CP9 lite or any other prescriptive trading regime. 

Is there a benefit to treating important products for price discovery as swaps, and treating swaps as important products for price discovery?  I don’t think so.  The trading rules for swaps are moving closer to the standard for CP9 without a good reason to impose a standard meant for instruments that have a pricing function in the economy.  The fact that a highly complex swaps trading regime, is in the works does not make it an appropriate venue for futures contracts that are economically important to pricing of key goods and services. 

Having essentially taken the Pink Floyd approach to futures regulation:  “…Regulator, leave those futures  contracts alone…” I also believe that applying open and competitive trading requirements to swaps - CP9 “lite” - also makes little sense to me.

The vast majority of swap transactions have little or no impact on the price of the underlying good or service.  Oil swaps derive their value from the price of oil futures; same with natural gas; same with interest rate swaps relying on U.S. Treasury cash and futures prices as well as the Eurodollar futures market; agricultural swaps depend on the price of benchmark agricultural futures; metals swaps rely on cash and futures gold and silver futures markets.  These are derivatives that have little independent  impact on the price that the public cares about such as gasoline at the pump or home mortgage rates.  If 85% of the swap trades occur openly in the public square rather than over a phone, the public good will not be improved even marginally. 

The traditional function of futures exchanges has worked well, and continues to do so.  DCMs should be granted broad discretion to determine which products affect price discovery, and to offer them discretion to meet the open and competitive standard of CP9 as has always been the case.

Swaps, on the other hand, do not need a futures-like trading regime.   The problem with swap trading is not the lack of price transparency, which is important in pricing core goods.  Rather, swaps have lacked risk transparency.  Knowing how many have been issued, who holds them, and how are they  valued and collateralized are issues of broad public importance.   Uncleared swap transactions, as opposed to swaps executed according to one set of rules or by private means, actually pose a threat to the public interest.   How they were executed does not have much significance in protecting the public, however. 

Threatening to displace important products from DCMs is unsettling to the market.  Creating a CP9-like set of trading requirements for swap markets does not lessen the threat to the public’s ability to get price discovery benefits from these products.  Indeed, focusing at all on the pricing mechanism for swaps that do not impact the price discovery process is time better spent on applying trade reporting and clearing to the swaps world.

Tuesday, June 5, 2012

Thoughts on the June 4, 2012 report of James Giddens, Trustee for MF Global, Inc.

I have followed closely the aftermath of the MF Global bankruptcy and the failure to meet customer asset custody obligations.  My reaction over time has been generally a cynicism at the ever lengthening course of what appeared to be a very quiet investigation.  I have expressed anger at the various U.S. Attorneys for a prolonged, silent inquiry while assets were being used for trials of John Edwards and Roger Clemens, two figures who were already beyond redemption in the public eye.

I do not have any personal assets at stake in the MF Global matter, however, because of my belief in the system of segregation, I also tweeted my assurance the week before the bankruptcy filing for customers to stay calm because of the protection of the law.  This assurance was based on a 30 plus year career at exchanges and clearinghouses.  I don't know if anyone acted differently because of my tweet, but the outcome of MF Global has forever shattered my trust in the reliability and honesty of any brokerage firm anywhere, and of any size.  To be clear, I still have complete trust in the sanctity of funds on deposit at the major U.S. Clearinghouses because there is no commercial conflict with the Clearinghouse's proprietary interests.  However, funds that are deposited at a broker, but not turned over to a clearinghouse are in my view unprotected until I see reforms to the system, and an accounting of what happened at MFG, before I even begin to approach the level of regard for their safety that I held previously.

I have now read the report of June 4, 2012 by James Giddins, the SIPC Trustee overseeing the bankruptcy and related investigation of MFG.  Clearly, silence has not equaled inactivity.  The Trustee has written a compelling narrative and explanation (although at times the failure to name the counterparty to important emails is frustrating, most likely at the request of U.S. investigators) and answers a number of questions.  Clearly there was confusion in the final 10 days of MFG's existence because of numerous customer redemptions and the insistence of virtually every counterparty for additional cash, which quickly drained liquidity.   Recordkeeping responsibilities for the financial and custodial functions of the firm were divided between MFG's offices in Chicago and New York  A key employee with financial experience was on vacation.  The Treasurer was new.

It is possible that every wrong action occurred without anyone actually knowing for a fact that the action was wrong.  Knowledge, I suppose, is the burden that any criminal investigation would need to meet.

However, the fact that MFG seems to have adopted a policy that allowed for intraday invasions of client funds to meet the firm's myriad obligations in itself to me is wrong, and places what would normally be merely a negligent decision with an unintended outcome in a highly suspicious light.  In other words, funds in trust cannot be invaded, even temporarily, and once a firm decides to ignore that basic rule of a trustee's obligation, any mistake in repaying the funds comes on the heels of knowingly misusing trust funds in advance.

I can now understand why Edith O'Brien is not receiving immunity from prosecution so quickly.  She may indeed be guilty of a crime or crimes.  Others in the "New York Operations" area, as the Trustee calls them, may also have knowingly participated in this breach of trust.  Whether higher level officials knew of the practice to borrow from segregation is unclear, and I'm sure a key topic of the ongoing investigation.

The Trustee also reports on the interactions between the firm and the regulators, including a report that circulated internally that was edited before being shared with regulators, omitting a likely red flag from regulatory review.  Following directives not to transfer segregated funds with regulatory approval, it appears from the Trustee's report that transfers of that kind occurred.  False reporting and misleading regulators are serious, perhaps criminal offenses, and I am also sure they are now the subject of intense scrutiny.

Were the senior officers of the firm knowingly involved in misdeeds?  The report is certainly more exculpatory than indicting - there are no reported smoking guns - but there are several very serious open questions.  Who knew what facts when different facts were being reported to regulators? Who knew that intraday transfers from segregated funds  for the firm's own benefit were fairly routine? And, if someone senior knew, would he have a greater duty to inquire about certain transfers lest he turn a blind eye - also the potential basis for criminal culpability?  These are open and fascinating questions.  My guess is that with this report as a basis for where the investigation sits, we will have the answers to these questions in due course.  I am advising myself: Patience.  This trustee has done commendable work, and we can only wait for the next report or some other action for more answers.