Where’s the SEC in All This?
In the 1990s, information superhighway was the popular term used to describe the Internet. You can think of the stock markets as the capital superhighway. Movement of capital on this highway from savers and investors to businesses of all sizes must be safe, orderly, and reliable for all market participants, regardless of their “speed.” If not, then the connection between Wall Street and Main Street is broken.
The Securities and Exchange Commission was created by the 1934 Exchange Act to bring confidence back to the markets in the midst of the Great Depression after the 1929 Crash. There was great fear that confidence had evaporated. If that confidence were to be reinstated, folks would buy and sell stocks again and make markets liquid. That would inspire investing, which would fuel the economy and the need for funds to grow businesses.
According to the SEC’s website, its mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” This means that in policing the markets, and in crafting rules to keep up with technological innovation, the SEC should make sure that capital formation, and the catering to investors (as opposed to traders), is always front and center. This means that the SEC must always remember to keep that linkage between Wall Street and Main Street healthy and thriving. If Main Street is left out of the thought process, if it loses faith in the stock market as an investment vehicle, investors will “take their marbles and go home.”
News flash: It’s already happening. More than a quarter of a trillion dollars have been withdrawn from domestic equity mutual funds since May 2010.5 This is horrible for two reasons. One, new and existing businesses need funds to grow, innovate, and hire. If American businesses don’t get these funds, our economy stagnates, we fall behind other nations, and our standard of living drops. Two, these longer term investors are, and have always been, a source of real stability to the market. Their bids and offers provide liquidity that, unlike that of HFT, is deep and unfleeting.
The mission statement also claims that the SEC is focused on protecting investors and maintaining a fair, orderly, and efficient market. Insider trading cases, including the recent, high-profile prosecution of Raj Rajaratnam from Galleon Group, certainly protect us from those gaining unfair advantages at the expense of long-term investors. However, the Rajaratnam case—the largest insider trading scandal in our nation’s history—centers around only $53 million in ill-gained profits. Compare that to the SEC’s failure to stop the $68 billion Bernie Madoff Ponzi scheme, despite being tipped multiple times.
Although we praise the SEC for going after Rajaratnam, we can’t help but be disappointed in the agency’s seeming lack of action around HFT and the conflicts of interests in our market structure. HFT firms generate between $8 billion and $21 billion a year in profits. Tradebot, an HFT firm based in Kansas City, Missouri, in 2008 said it had not had a losing day in four years.6 The last few years have shown quarterly earnings from big banks engaged in HFT. Several, including Goldman Sachs, have had quarters without one day of incurring a net trading loss. You might think, especially after the Madoff scandal, that these recurring, out-sized profits at the expense of investors would make the SEC call out the troops.
To appease the public, agency executives certainly appear to say the right things. In a December 3, 2009 letter to U.S. Senator Ted Kaufman, SEC Chair Mary Schapiro wrote the following:7
- Next month we hope to seek public comment, through a concept release or similar document, on a range of issues relating to dark liquidity in all of its forms, as well as the impact of high frequency trading in our markets. Among other things, we are likely to seek input on the various strategies used by high frequency traders and any special trading advantages they may enjoy, including through colocation arrangements. I am committed to pursuing the goal of improved intermarket surveillance as a means to strengthen our markets, deter and ferret out wrongdoing, and augment public confidence.
Although the SEC and CFTC have had their hands full with the post-financial crisis Dodd-Frank regulation to control risk at large banks, there is another element at play. You see, the SEC created all the regulations to “modernize” the markets over the past 15 years. It has written and revised the rules with the input of the stock exchanges and large brokerage firms—input that in many cases came from industry personnel who once worked at the SEC.
In other words, the SEC is the creator of our Franken-Market. And, as actor Colin Clive cried in the famous 1931 film about Mary Shelley’s monster, “It’s alive!”