Low Frequency Disclosure

If you think stock prices are irrational, Flash Boys proves why you’re right. And the craziness makes perfect sense.

Now that the initial furor over Michael Lewis’s Flash Boys has subsided, the commentariat seems to have missed the most significant and troubling systemic malfunction the book reveals.

Curiously absent is any notion that manipulative stock trades are related to anything the companies attached to those stocks actually do. Nowhere in the book is a relationship between a company’s stock price and its operating fundamentals even suggested.

Why does a millisecond of trading speed matter to a trader who doesn’t know what the companies underlying the stocks do? Is it possible that milliseconds only matter because the traders don’t know what the companies do? Why don’t they know?

Since the Securities Exchange Act of 1934 introduced the rules of the modern public secondary market:

• The time it takes to get a stock quote has dropped from 20 minutes to 25 microseconds.
• The time it takes to execute an order has dropped from 30 minutes to 200 microseconds.
• Government-mandated release of financial data for U.S. public companies has gone from once every 90 days to… once every 90 days. (And no exceptions, please — improper disclosure can come with subpoenas or worse.)

“Quarterly disclosure” actually begins weeks after the quarter’s end, and itself can take weeks. Companies report results piecemeal in a morass of legacy formats: first the marketing-style press release, then the Kabuki analyst conference call, and finally the dense, legalistic SEC filing.

Of course management gets the numbers daily or in real-time (the actual metrics, by the way, not the lawyer-ized and GAAP-ified reduction) and the board gets them monthly. What did the owners do to deserve such shabby treatment?

The disclosure is slow, and it’s lousy. A dive into Twitter’s recent 232-page IPO prospectus — to choose a particularly outrageous example — reveals that U.S. public-market investors were asked to hand over almost $2 billion without knowing anything that a half-competent venture capitalist would demand of a private company before considering even a meeting, much less an investment.

These are the same things a parent would ask a child before financing a paper route: “How many customers do you have and who are they? How will you get the customers to pay you? How much will they pay you? Do they pay in advance, in arrears, on credit?”

Undisclosed — all of it.

For all of its low frequency and low fidelity, public-company disclosure is at least no worse on an absolute basis since the New Deal. Historically Wall Street’s robust information function helped investors understand fundamentals beyond the SEC filings. So many analysts published research on stocks that Institutional Investor built a publishing franchise ranking them and FIRST CALL built a data business collating their estimates.

Then three major things happened:

1. The 1999 repeal of Glass-Steagall enabled a great consolidation of securities firms into commercial banks that, by the end of the financial crisis — and as the action in Flash Boys takes place — left only the “nine big Wall Street banks that controlled nearly 70% of all stock market orders.”
2. In 2001, the exchanges did away with the quaint custom of quoting stock prices in fractions (a half, a quarter, an eighth) in favor of pennies, or Decimalization. The tightening of spreads reduced commission costs for investors, and destroyed the business model for Wall Street research by dramatically reducing the money available to pay research analysts.
3. Then the 2003 “Global Settlement of Conflicts of Interest Between Research and Investment Banking Information” imposed on the industry by Eliot Spitzer (yes, him) left Wall Street research as a legacy function representing marketing cost to the mega-firms still attempting to perform it.

In the meantime, the faster computers and connection speeds driving high frequency trading (HFT) changed the nature of scorekeeping on Wall Street. The companies underneath the stocks in the equity market report their scores quarterly, but the portfolio managers responsible for managing trillions in assets tally their scores daily and report to their limited partners at least monthly. Flash Boys cites large HFT Virtu Financial’s claim that they made money every trading day but one in a five-and-a-half-year period. That’s a winning score.

And this is where the tectonic forces of market history meet the book’s protagonist Brad. The buy-side needed data on which to deliver performance on a daily basis, just as the sell-side needed a business model to replace the commissions formerly associated with research. The available data turned out to be data on other investors’ trades. As Brad demonstrates while trying to buy a stock, and watching the market thwart him by dynamically re-pricing itself, “You see, I’m the event. I am the news.”

In this way, liquidity was substituted for transparency. HFT participants seem to say, “I don’t need to know what I own, because I make a good return with no risk when I sell it a microsecond in front of the guy who unwittingly gave me the bright idea to buy it.”

And in case we are tempted to dismiss this as a niche phenomenon, Flash Boys asserts that HFT practitioners make “half of all trades in the U.S. stock market” but “submitted more than 99 percent of the orders.”

Any idea that the public equity market is priced efficiently is challenged by the crazy-but-true facts revealed in Flash Boys: The net result of all the unintended regulatory consequences has made it rational for the smartest and best-capitalized market participants to spend billions funding an arms race that is all about NOT CARING about the correct price of a stock based on its fundamentals.

The state of the art isn’t creating more or better knowledge, it’s making knowledge irrelevant.

And sadly this makes sense. Investors have been banned from knowing much of what they wish they could know about the companies they trade, even on a quarterly basis, to say nothing of daily. But since the market grades them daily, is it a surprise that some of the world’s most hyper-educated, tenacious, and competitive people — with a resource base as large as all outdoors — literally tunneled under mountains (and built microwave towers on top of them) to produce data-driven ways to win in the new daily-grading contest?

And why are investors so motivated to outperform? That’s what we (all of us who have money managed for us in the equity market) pay them vast sums to do. The capital they manage on behalf of pensions, endowments, mutual funds, banks, insurance companies, families, individuals and themselves demands a return.

In a market with little or no fundamental transparency, ever-more-instant liquidity may be the most rational thing of all.

Rett Wallace is co-founder and CEO of Triton Research, a financial data and intelligence firm.