It will take more than recent rule enactments to raise confidence in the U.S. equity market, which was rattled following the “flash crash” two years ago, and then again after the Knight Capital Markets order-routing fiasco two days ago.
That’s the early writing on the wall. Investors are still wary, even after regulators passed a limit-up/limit-down proposal, capping off a two-year regulatory blitzkrieg of new rules and revisions designed to prevent another flash crash type event.
Just two years after the May 10, 2010 market meltdown, regulators have implemented several market structure fixes to help prevent another flash crash. Examples are revised single-stock circuit breakers, the banning of stub quotes, the approval of a consolidated audit trail-CAT- and revised market-wide circuit breakers.
Recent data from the Lipper bear out investors’ bearish sentiment on U.S. stocks. According to the most recent data, investors pulled out $3.0 billion from equity mutual funds.
For the week ended July 11, all equity funds had estimated outflows of $540 million, compared with prior-week outflows of $2.87 billion. U.S. equity funds saw outflows of $1.47 billion, following the prior week’s exodus of $3.16 billion. In contrast, foreign equity funds actually rose by $927 million during the latest week.
The limit-up/limit-down proposal was the most recent and most ambitious rule designed to assuage investors. It was put forward by the exchanges and the Financial Industry Regulatory Authority in April 2011, and approved by the Securities and Exchange Commission on May 31.
Many within the trading industry believe this rule will stop another flash crash from happening.
But is limit-up/limit-down, or the gaggle of other new regulations, enough to bring back the retail investor and get him to place his faith, and more importantly his money, into equities?
No. That’s what several industry professionals told Traders Magazine.
Industry executives said that the Average Joe retail investor doesn’t really understand these market micro-structure rules and changes. To them, these rules are gibberish. Retail investors are more concerned with macro issues, like the debt crises in Europe and the U.S. and job security. Investors have not made money in stocks in the last decade, either, which hasn’t helped matters. Market micro-structure remedies like limit-up/limit-down don’t address those issues and don’t resonate.
Chris Nagy, head of consultancy KOR Trading and former head of order strategy and government relations at TD Ameritrade and a champion of the retail investor, told Traders Magazine that while limit-up/limit-down helps the institutional investor and improves market structure, it can actually hurt the retail guy.
“Retail investors feel they don’t have a chance in the present system,” he said. “They feel like the system is rigged against them – that their broker is in cahoots with everyone on Wall Street to rip them off. While limit-up/limit-down will do the industry a lot of good, it will do little to help retail investors.”
To make his point, he noted a provision within the limit-up/limit-down regime that mandates the new price bands will be doubled to 10 percent from 5 percent during the market open and close. This is when the vast majority of retail orders are placed and executed, Nagy said, thus a doubling of the price band can work against their investment goals.
“This 10 percent limit could be huge in terms of price for the retail investors,” Nagy said. “If they waited until after the open and placed an order and it gets executed when the band is only 5 percent then they could have gotten more favorable execution.”
The addition of price limits does add a degree of stability to the market, Nagy added. However, this improvement of market structure is relatively unknown to the retail investor who simply calls his broker and places and order. Many investors, he said, don’t even know where their order is being executed.
“As far as the retail customer is concerned, they simply think their order is being executed at NYSE or Nasdaq,” he said. “This rule does little to restore confidence as retail investors don’t really understand the mechanics of how the market or limit-up/limit-down really works.”
That point is exemplified by this week’s Knight order-routing debacle, where orders intended to be executed throughout the day were sent at the market’s open on August 1. Retail investors don’t really know who Knight is and the function they serve, and limit up/limit down wouldn’t have made a difference.
Nagy said that limit-up/limit-down would not have helped with the Knight trading issue, as most of the stocks involved did not move enough to trigger the rule had it been in place. The affected stocks included lesser known names such as Wizzard Software, China Cord Blood Corp. and Molvcorp.
Limit-up/limit-down, which replaces the existing single-stock circuit breaker regime that has been in effect since the flash crash, halts trading in stocks if a trade occurs outside of a given price range. It is slated to go into effect next February.
The goal of limit-up/limit-down is to smooth out daily price fluctuations in stocks – thus preventing bad trades before they happen. It works like this – throughout the day, exchanges will calculate upper and lower price limits for individual securities, and prevent trades from occurring outside those bands. Under limit-up/limit-down, moves in the 1,400 largest securities are capped at 5 percent.
One buysider agreed with Nagy. Chip Coleman, director of trading at Thompson, Siegel & Walmsley in Richmond, Va., said rules like limit-up/limit-down and other market structure-centric changes are not enough to boost retail investor confidence. TS&W manages $7.1 billion in assets for corporate and public institutions, including retirement funds, non-profits, endowments and foundations. It also manages five mutual funds, so Coleman has a feel for what retail is doing and thinking.
He said the retail investor sees headline reports in the media about Wall Street scandals and looks for remedies to general macroeconomic issues like job security and wage growth, not price bands.
“These changes are geared towards professional traders and speculators,” Coleman said. “The average investor is in a retirement plan run by a long-only mutual fund company and these changes don’t really change the fund’s investment strategy or how they conduct themselves in the market. Headline news events aren’t covered by these rule changes.”
However, one prominent market expert thinks the price bands and other regulations are a step in the right direction.
Jamie Brigagliano, partner in the securities and futures group at Sidley Austin LLC and former deputy director of the division of trading and markets at the Securities and Exchange Commission, said there is no silver bullet for restoring confidence hurt by an event like the flash crash, but limit-up/limit-down should help.
“Limit-up/limit-down, which will prevent trades in individual stocks from occurring outside of a specified price band, is an important piece of a series of reforms designed to prevent disruptive liquidity gaps like that which occurred in the flash crash,” Brigagliano said. “Limit-up/limit-down, when combined with circuit breakers – both single stock and market wide – the abolition of stub quotes, and the imposition of risk controls on broker-dealers, definitely strengthens market structure.”
And the improved strength should bring investors back. He added that other reforms, such as the large trader rule, which requires that certain traders identify themselves, and the development of a CAT, will help regulators keep a lid on market problems, and should also assuage retail investors.
“In sum, these are all incremental improvements that should reduce market disruptions and over time increase investor confidence,” Brigagliano said.