Former US Federal Reserve Chairman Paul Volcker has famously asserted that the only financial innovation that has improved society is the ATM machine. Reuters finance blogger Felix Salmon has made a similar argument: Working from a list of financial innovations compiled by the World Economic Forum, he recently argued that the only “unambiguously good” advances were point-of-sale terminals, automated clearing houses, and the Clearing House Interbank Payments System — all related to the financial plumbing of the banking system.
Are they right? The picture is arguably far more nuanced than that. In finance, as in so many other disciplines, innovations that offer tangible value to customers and to society can be easily bent to serve harmful ends by greed, poor incentives, and lax oversight — to name just a few factors.
The complicated legacy of financial innovation is a subject we return to frequently at CFA Institute — most recently, at our Equity Research and Valuation Conference, where three leading practitioners — Theodore Aronson, CFA, managing principal of AJO; William Hambrecht, the founder, chairman, and CEO of WR Hambrecht & Co; and Gus Sauter, the former chief investment officer of The Vanguard Group — assessed two of the most widely debated innovations of our time: high-frequency trading and dark pools trading venues. They also discussed the failings of the traditional underwriting model and the benefits of the Dutch auction model for initial public offerings pioneered by Hambrecht’s firm.
What follows are highlights of the discussion. You can watch the entire 59-minute session below, in which the panelists also cover the future of the brokerage business, the “flash crash,” and exchange-traded funds, a financial innovation that recently celebrated its twentieth anniversary.
Vanguard’s Sauter noted that high-frequency trading is not a monolithic strategy. There are “hundreds if not thousands” of such strategies, he explained, some of which are likely manipulating the market just as critics contend. Such behavior is illegal and should be stopped. Still, Sauter argued that high frequency trading is largely beneficial, because it helps link markets together by arbitraging away price discrepancies. Investors should not begrudge high-frequency traders for making money if they provide liquidity, he contended. “The vast majority are working in their own interest and providing a social good” in the form of tighter spreads and more efficient markets.
Hambrecht argued that some high-frequency trading contributes to market volatility that can make it more difficult for companies to raise capital. He said one of the reasons that the IPO market is so quiet is that company founders are spooked by market gyrations. A third of all registration statements that have been filed in the last few years have been withdrawn, he noted, adding: “An efficient market is a very violent market.”
The panelists offered begrudging acceptance of dark pools, which according to a recent CFA Institute study contribute to improved market quality up to a certain threshold of trading activity, after which the quality declines. Hambrecht linked the rise of dark pools to the actions of trading desks, which he said used to take advantage of order knowledge to trade against their clients. Having a system in which investors could trade without giving up the value of their orders has been beneficial to investors, he noted.
Vanguard’s Sauter said his biggest objection to dark pools is the fact that investors can’t see all the bids for a given stock, so there is no opportunity to trump the highest order, a move that would tighten spreads and benefit the entire marketplace. In effect, the rise of dark pools ensures that there is no price-time priority in trading. If you are the first person willing to pay a given price for a stock, he argued, then you should be the first person to execute the trade. “If I was designing a system from scratch, it would not include dark pools,” he said. Still, Sauter acknowledged that investors can cut transaction costs by using dark pools. They may be bad market structure, but since they are already out there, “you’d be crazy not to use them.”
Or as AJO’s Aronson put it: “Are dark pools all good? No. But they are mostly not bad.”
Initial Public Offerings
Hambrecht said that the Facebook IPO cast a spotlight on the “disfunctionality of the traditional underwriting business” and laid out a three-point critique. First, he argued that a negotiated deal (versus an auction) does not provide true price discovery, a fact that became quickly and painfully apparent to investors in the Facebook deal. Second, he bemoaned the selective disclosure of information to investors. “The single most important item when any analyst looks at a company is the forward 12-month estimate, which is not in the prospectus and is delivered through the sales force of the underwriter in whisper form.” As a result, “part of the market gets the estimate and part of it doesn’t.” This erodes confidence.
The underwriting process is also rife with conflicts of interest, Hambrecht said. During the dot-com bubble, he argued, pocketing a healthy after-market premium created an obligation on the part of the buyer — typically mutual funds — to return as much as 50% of the profit to the underwriting firm in the form of commission flow. These days, he said, hedge funds have replaced mutual funds in this “reciprocity scheme.” Case in point: The only way to sell a stock short is to borrow it, and the only way to borrow stock in an IPO is from the underwriter. That creates the potential for conflicts.
Is there a better mousetrap? Hambrecht praised the virtues of his Dutch auction model — in effect, a declining price auction in which the price offered for the last share becomes the clearing price for the entire offering. This model provides “remarkable price discovery,” he said. In roughly 23 auctions over the past 12 years, first-day trading in his firm’s IPOs was up an average of 3%, compared to an 18% jump in a typical non-Dutch auction IPO.
And in case you are wondering, Hambrecht’s firm doesn’t lend out shares to short-sellers. “We say sorry. That takes care of it,” he said.
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