Streetwise Professor

The extremely democratic, open access aspect of incorporation and limited liability in the modern US is hard to exaggerate. I set up an LLC yesterday.  It took less than an hour with a lawyer and a three figure sum to set it up.  Much of the time with the lawyer was spent yakking about UH and personal history and other chit-chat. I am sure I could have done it cheaper online, but the cost of doing it old school was so low I figured-why take the chance of making a mistake?  It was easier to set up an LLC than picking up a prescription.

It is easier and cheaper-by far-to incorporate than to become a fricking barber or beautician.  I defy you to identify anything that the state has erected fewer obstacles to obtain.  Anything.  There are few things that are so equally accessible to all Americans.

One should be suspicious of entry barriers, and embrace the things that are accessible to all.  The anarcho-libertarians who demonize corporations overlook this.  The open access corporation represents a triumph of open access and small-d democracy. Anyone can be an owner.  Anyone can be a CEO.  Do you anarcho-libertarians have any idea how rare that is? Do you really think that circumscribing or proscribing the ability to incorporate and limited liability will constrain elites and empower the ordinary?  If so-think again.

A certain sort of libertarian-anarcho-libertarians, is probably more accurate-goes apoplectic about the corporate form, and in particular, the limited liability conferred on corporations.  There are Twitter hashtags #limitedliability and #moralhazard where you can get a flavor for this apoplexy.

They seem to harken back to Adam Smith, who was skeptical of corporations:

The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

I yield to no one in my admiration for Adam Smith, but believed it or not, economics has made progress since 1776.  And one of the areas in which progress has been greatest is in the economics of organization.

The watershed paper is by Jensen and Meckling from almost 40 years ago-and ironically, exactly 200 years after the publication of Wealth of Nations. Jensen and Meckling, and the literature that follow it, address many of the phobias of the #limitedliability crowd.

Jensen and Meckling note that the limited liability is not perfect.  There are agency costs associated with it.  There is the “separation of ownership and control problem”, whereby it is costly to incentivize managers of corporations to act in the interest of shareholders.  There are risk shifting problems: equity has an incentive to increase risk at the expenses of debt holders.

But the key thing is that those contracting with corporations know these things.  They know them better than economists, most likely, because they have a very strong incentive to do so.  Meaning that these costs are internalized: the costs of equity and debt reflect these agency costs.  If the costs of the corporate form exceed the costs of alternative forms of organization, greedy individuals have no incentive to adopt this form.

This means that if costs are internalized, choice of the corporate form and equity finance will be efficient, relative to possible alternatives.  To paraphrase Churchill, the corporate form and limited liability are the worst forms of organization, except for all the others that have been tried from time to time.

Put differently: showing that there are costs associated with limited liability and the corporate form and equity finance does not imply that these are inefficient. Many of the critics of the corporate form succumb to the Nirvana fallacy.

The survival of corporations-indeed, their dominance-strongly suggests that they are less costly in most situations than alternative forms of organization.  Nobody compels incorporation.  People choose it.  They choose it in many circumstances-but not in all circumstances-because it is the least costly form of organization.

One under appreciated benefit of limited liability is that alternative forms can greatly inflate the cost of raising capital.  As one example of an alternative, under unlimited liability, any investor in a corporation cares about the wealth of other investors, because his (or her) costs under joint and several liability would be greater, the less wealthy other investors.

This sharply limits the ability of non-limited liability entities to raise capital, and raises the costs of this form of organization.  Investors will invest resources in investigating and monitoring the wealth and risk exposures of other investors.  This inherently limits the number of potential investors.  This, in turn has two deleterious effects.  First, it limits the scale of enterprise, meaning that scale and scope economies cannot be realized.  Second, it limits the potential for diversification.  Remember that diffuse ownership and diversification that are facilitated by the corporate form, public equity, and limited liability, are analogous to insurance: risk is more cheaply insured under the corporate form and limited liability.  Yes, moral hazard is a cost of insurance, but despite the existence of moral hazard, insurance markets exist nonetheless.

Where could externalities arise? Corporations provides something of a shield to equity holders from legal liability from costs imposed on third parties, or with parties with whom it contracts, but somehow deceives or defrauds.  This could conceivably result in an externality, but its practical significance is limited.  Limited liability shifts costs to third parties only to the extent that a corporation’s legal liabilities exceed its equity.  The large corporations that attract the greatest ire typically sufficiently capitalized to pay fully legal judgments assessed against them.  The Johns Manville’s of the world are the exception, not the rule.  Again, costs are almost wholly internalized.

Another criticism leveled against corporations is that they influence government to adopt policies that transfer wealth from taxpayers (or other third parties) to the owners of the corporations.  This criticism has some merit, but this is not sufficient to justify raising the costs of adopting the corporate form.

First, it is again necessary to consider: “what would happen under the alternative”?  Those who think that outlawing corporations will reduce corruption, or will reduce incentives to importune government for favors, are sadly deluded.  That is, the corporation is not a necessary condition for the existence of corrupt influence of government

Second, and relatedly, the fundamental issue here is the discretionary power of government.   If government’s power to redistribute wealth is unconstrained, the politically connected will importune it to provide them benefits.  No corporations? That doesn’t mean there will be no redistribution.  Individual proprietors or partnerships will attempt to influence government.  Indeed, in a world without limited liability, they may have an even stronger incentives than corporations to seek bailouts.  With limited liability, owners’ personal wealth is not at risk beyond their initial investment.  Without limited liability, personal wealth is at risk. This strengthens the incentive to secure government rescues.

It should also be emphasized that in the US today, incorporation is truly democratic.  Anyone can incorporate, and obtain the protections of limited liability.  Incorporation is not a privilege: it is almost a right, and states have liberalized laws to make it extremely easy and cheap to incorporate. Anyone can do it.

This is in stark contrast to Adam Smith’s time, and even in the US until the 1830s.  Early on, corporate charters were special privileges granted by the Crown or legislatures.  In those days, corruption and influence were indeed almost synonymous with incorporation.  Only the favored received corporate charters, and corporate charters conferred special privileges that enriched those that obtained them.

In sum, the anti-corporate types, anarcho-libertarian or socialist, usually fall prey to the Nirvana fallacy.  They obsess on the costs relative to some ideal of a frictionless world.  But that’s not the relevant standard of comparison.  We have to make choices between flawed alternatives.  Limited liability, public equity, and diffuse ownership have costs.  Duh.  But that’s not the issue.  The issue is whether these costs are higher are lower than the costs of alternative ways of organizing economic activity.  The dominance of the corporate form and limited liability, despite the absence of notable externalities, provides compelling evidence that these costs are in fact lower for most economic activities. Not all, but most. And “not all” isn’t important: the fact that people can -and do-sometimes choose other forms means that they choose the corporate form when it is less costly, and don’t when it isn’t.  That’s exactly what we want.

Many of the putative costs of the corporate form identified by the anarcho-libertarian types represent government failures, not market failures.

So spare me the shrieks about the costs of limited liability and corporations. If you want to have a serious discussion, show why corporate form is sometimes-nay, often-chosen despite the fact that it is more costly than the alternatives: again, compared to the real world alternatives, not perfection. Nirvana is still just a band.

This is the funniest freaking thing I’ve read in a long time.  “No chance for Sochi 2014 corruption-Audit Chamber.”  “It is practically impossible.”  Seriously.  That’s what Sergei Stepashin says.

I’m dying here.  But it gets better.  Want to know why there’s no chance for corruption?

“The Olympics are pretty expensive, this we know,” he said. “But the sports facilities cost about the same as in Europe. We conduct quarterly checks. … It’s practically impossible to simply steal just like that, I give you my honest word.”

“Rises in expenses are linked with infrastructure.”

Because of course, there is no corruption in the construction of infrastructure in Russia.  None.  The country where it costs about 6 times as much per mile to build roads than in the US.

For its next joke, the Audit Chamber will investigate Gazprom.  I can’t wait.  I can always use a laugh.

The good news: Gazprom is under increasing pressure from weak demand in its primary market-Europe-and growing gas production.  A couple of interesting data points.

First, in the first 9 months of 2012, Gazprom paid its European customers $4.4 billion in price adjustments as the result of contract renegotiations.  (h/t @NoGazprom).  Moreover, additional renegotiations are ongoing.  The customers demanded Gazprom refund some money because the oil-linked price in the contracts was well out of line with gas values (as indicated by spot prices).  Although Gazprom continues to cling to the oil linkage, the trend is clearly away from these traditional contracts due to burgeoning spot volumes.  This renders increasingly hollow Gazprom’s claims that spot markets are insufficiently liquid to make spot prices reliable benchmarks in sales contracts.

This is not a trival sum.  It represents about 7 percent of Gazprom’s 9M2012 revenues, and more than 15 percent of its 9M2012 profits.

Second, Norway is rapidly taking away market share from Gazprom.  (Could this have anything to do with Norway’s movement toward spot pricing?)

Norway, Russia’s closest rival in the European gas market, seems to overtaking Russia’s Gazprom. Norway boasted record high exports in 2012, while Gazprom suffered the worst numbers in 10 years.

Norway increased its exports 16% in 2012 to reach 107.6bn cubic metres, according to Europe’s key statistics office Eurostat. This is “a record level, close to the Russian gas exports to Europe,” Michael Korchyomkin, head of East European Gas Analysis, told Kommersant daily.

During the same period, Russia’s gas giant Gazprom cut sales to Europe and Turkey by 8%, according to the company’s head Aleksey Miller. That’s the lowest export level for the last decade, Korchyomkin said.

At the moment Norway is breathing down Russia’s neck in its key European market – Germany. In 2011 Gazprom supplied 30bln cubic meters out of the total 80bn cubic meters of gas Germany consumes annually. Norway sold just a bit less – 28bn cubic meters. Norway’s Statoil accounts for about 70% of the country’s exports and in 2012 signed a 10 year contract to supply gas to Germany’s Wintershall.

These are present pressures.  Future problems potentially loom even larger.  Most notably, the likelihood that world gas supplies will grow dramatically.  Initial hopes for rapid output increases in Poland and Ukraine appear to be overoptimistic, but eventually it is likely that these countries will start producing in commercial quantities.  If political obstacles can be surmounted in the US, large and increasing volumes of LNG exports will be looking for markets-including Gazprom’s current European markets, and the Asian markets it hopes to serve in the future.

One of the potentially most dangerous threats, though, is the huge offshore gas resources in the eastern Mediterranean, off Cyprus, Syria, and Israel.  Some analysts think that gas has the potential to turn Cyprus from financial basketcase into a prosperous and self-sufficient country.

The eastern Med gas is a particular threat to Gazprom because of its proximity to the company’s largest markets-Europe and Turkey.

Which is exactly why Gazprom and Russia have a tremendous incentive to make sure the underwater gas stays underwater.  Russia’s tentacles reach deep into every aspect of Cyprus’s economy and government.  Thus, not only does it have the motive, it has the means to impede Cypriot efforts to develop its gas resources.  Not to mention  that Russia has little incentive for Cyprus to escape basketcasedom.  A financially secure Cyprus would not need to provide a haven for dirty Russian money (but I repeat myself), which is about all that keeps the island afloat right now.  And oligarchs and corrupt  bureaucrats desperately want such a haven.

Given the instability and geopolitical fissures in that region Russia has other levers it can pull to stymie development of gas in Syrian and Israeli waters.  This article from the Economist gives just a few of the geopolitical obstacles in the way of commercializing the offshore gas.  It should be child’s play for Russia to get Turkey, Lebanon, Syria (or even an Alawite rump state conveniently located on the coast), and Israel embroiled in all kinds of squabbles that will delay considerably the development of the gas resources-perhaps forever.  There is plenty of animosity and mistrust to go around, which can easily be manipulated by an opportunistic Russia to ensure that not one molecule of Med methane makes it to mainland Europe.

Which means that the strains on Gazprom have more than economic relevance for Russia.  They have geopolitical ramifications as well. And those ramifications are not good. Russia has a vital economic stake in keeping the Levant in turmoil-and in keeping a client in power there.  It has shown no compunctions in the past about fomenting trouble, or interfering with attempts to solve it, when its economic interests are at stake.  Given the huge dependence of Russia-and the Putin model in particular-on the Gazprom rent stream this is a matter of survival to the Putin regime.  And that’s the bad news: Gazprom’s troubles give it and Russia a strong incentive to make trouble in the Levant.

One of the most ambiguous, and often damning, phrases in a school or performance review is “works to his potential.”  Left unsaid is just what that potential is, and the comparison of performance to personal potential, rather than to the performance of peers, is often a polite way of communicating that that potential is rather low.  The quintessential way to damn with faint praise.

This came to mind when reading about a spat between Medvedev and a high ranking official at the Russian central bank.  Medvedev is pushing for 5 percent growth:

“The government’s main aim is to reach steady economic growth of at least 5% [a year], and achieve stable growth of Russian citizens’ wellbeing,” Mr. Medvedev said

But Central Bank first deputy chairman Alexei Ulyukayev rained on that parade, and delivered the devastating “works to potential” performance review:

We at the central bank of the Russian Federation assume that in Russia… economic growth roughly matches its potential.

That growth, mind you, is in the 3.5 percent range.  4 pct would be a major achievement.

This is rather pathetic for a country at Russia’s stage of development, and is a far cry from the pre-crisis growth rate.  In part, this reflects moribund world economic performance.  Europe is continuing to stall. China is on another sugar high, but the pressing need to transition from an investment-and-export-driven model will result in a decline in growth rates there as well.  The US is bumping along, and the impending Health Care Cliff and continued fiscal policy uncertainty will serve as drags on growth.

But it also reflects Russia-specific factors, and is in fact a damning verdict on Putinism.  Two other speakers at the conference where Medvedev and Ulyukayev spoke, Alexi Kudrin and my friend Sergei Guriev, pointedly said that Russia’s institutional deficit were the major drivers of its mediocre potential:

But Sergei Guriev, an influential economist and government adviser, warned in an op-ed Wednesday in the Vedomosti daily newspaper that the Kremlin is in danger of falling short of its targets for improving the investment environment because of slow progress on privatization and other moves to liberalize the economy.

Former Finance Minister Alexei Kudrin, who was also at the conference, warned that lack of reforms means “there are no grounds to achieve economic growth of more than 4% for the next five to seven years.”

Mr. Kudrin, who lost his job September 2011 over a disagreement with Mr. Medvedev over a sharp rise in social and military spending, blamed the lack of reforms on the government, which prefers “to throw in money to resolve problems and rely on oil prices,” he said.

Putin’s purgatory, indeed.  The mania for stability, the fear of change, the vested interest of the elites in the existing system, and the stasis that inevitably occurs with an aging leadership will conspire to throttle any “moves to liberalize the economy” and to encourage throwing oil money at problems.

Meaning that Russia’s potential for growth is nowhere near 5 percent.

One of the first Russia-related posts I wrote on SWP was titled “The New Oprichnina“?*  This article, written more than 6 years later, argues that the analogy holds in Year XIII of the Age of Putin.

The article discusses the travails that Russian businesses suffer at the hands of the new Oprichniki.

I was talking with a forensic specialist who conducts investigations for companies who suspect violations of the Foreign Corrupt Practices Act.  This regularly takes him to what he calls “seven shot [inoculation] countries,” hardly the world’s garden spots, or the paragons of economic and legal institutions.  I asked him if he did work in Russia.  “Not if I can possibly avoid it.”  I asked why: “It’s not a country. It’s a criminal enterprise. The only places that compare are the worst places in west Africa.”  He described the host of official parasites that descend on everyone who attempts to set up a business-and the fearsome intimidation visited on anyone who pushes back.  Once upon a time it was mouth breathers in track suits.  Now it is “officials”.

So no.  Calling it the New Oprichnina is not too far fetched.

*Apologies.  The SWP archives got corrupted somewhere along the line, and the Russian/Cyrillic version of the title appears as gibberish.  Hopefully that’s not true of the rest of the post 😛

Further my last.  Europe may be out of sight for now, but that’s only because it’s not out of the woods.

Draghi be damned: Spain still in a debt death loop.  And that doesn’t even take into account the fact that 90 percent of the Spanish state pension fund is invested in Spanish government debt.  Or that Spain has long leaned on its banks to buy its debt, meaning that Spanish banks buy the bonds of the government that is supposed to bail them out if they get in trouble.  There’s a financial Escher etching for you.

So what does Spain do? It begs Germany to increase growth. As if it’s like turning on a faucet.

And if there is such a faucet, the handle has come off in Germany’s hand: the economy contracted more in 4Q12 than at any time since the depths of the financial crisis.

Meanwhile, France is getting deeper into Mali.  IMO, best outcome: something like the American Punitive Expedition to Mexico in 1915, which futiley chased Pancho Villa around the deserts of northern Mexico for a year. Worst case: British army in Afghanistan, 1842, or Islawanda.

US support-per the linked FT article-is lukewarm at best.  We (and the Brits) are supplying airlift.  A telling illustration of the lack of sustained expeditionary capability in NATO outside of the US.  Given the extreme logistical challenges of operating in the Texas-size wilds of northern Mail it is hard to imagine a force of a few thousand frenchies doing anything but getting swallowed up in the vast, desolate expanses.

And as I noted yesterday, France is approaching economic zombiedom.

So yeah. Everything is just hunky dory. Maybe as long as Draghi’s paper lasts.  Or more accurately: as long as the bond markets believe in the magic of paper.

Europe seems to be challenging Alfred E. Newman-“What, us worry?” Draghi and the EU have papered over-I am tempted to say “literally”-the immediate financial issues pressing on Spain and Italy.  Given the respite from panic, the Europhoria seems to have taken over.

But the fundamentals are still abysmal.  European unemployment hit all time highs-over 11 percent across the Eurozone, 20+ percent in some countries, and 50+ percent in some demographics-notably younger working age individuals-in countries like Spain and Greece.  Greeks are reenacting a Mediterranean version of post-WWI Vienna, venturing into the forests to collect firewood.  Spain has stuffed its banks and pension funds with government debt-they have no capacity to absorb any more. Given the parlous state of the banks (Bankia is apparently billions of euros underwater), and the dire straits of the Spanish economy, it’s hard to see all of Draghi’s paper keeping out the gales of reality for long.  Add to that the continuing move of Catalonia towards independence, or at least greater autonomy, it is evident that the downside risks are huge.

Meanwhile, France is sputtering-to put it generously-under Hollande’s socialist government.  Growth is moribund-French economists have opined the the government’s point 8 percent growth forecast is overly optimistic.  Capital is fleeing.  The tax-and-spend approach is almost certainly going to condemn the country to stagnation, at best.

Meanwhile, with all going so well at home, France is intervening aggressively in Mali, with mixed results at best.  I shall pass over in silence French hypocrisy regarding foreign intervention.  The initial French air attacks apparently halted the Islamist rebels’ momentum, but not for long.  Within 24 hours the rebels had regrouped and recommenced their advance.  On the opposite end of the continent, in Somalia, a French commando raid to free a hostage-an intelligence operative who had been half for several years-turned out badly, resulting in the death of the hostage and one French soldier, and the capture of another.  Today the Somali Islamists announced the death of the captive, but boasted they had obtained much information from him.  Draw your own conclusions.

In the UK, Cameron is walking a tightrope, threatening to renegotiate Britain’s relationship with the EU, but refusing to put Britain’s membership to a vote.  His position is infuriating the French (go figure) and threatens his position atop the government in the UK, as splitting the difference just serves to get both the Europhiles and the Europhobes furious at him.  And Obama has told Cameron to get his mind right, and get on with the EU program-or risk the special relationship with the US.

And Germany?  Germany is being strangely quiet.

In sum, I think Europe is living in a fool’s paradise.  The ECB has staved off the imminent crisis, but the fundamental economic weakness remains, especially in Greece and Spain.  Moreover, France is in a dicey situation-at best-and socialist nostrums can only make things worse. Military action-and in particular, a protracted military engagement in a place as wild and sprawling as Mali-can only stress the French polity.

Yields are down, and there is a sense that the crisis has passed.  But the ECB can only levitate things for so long, especially if France struggles-or worse.  Greece and Spain are in extremis. In my opinion, it is only a matter of time before the bond markets get a serious case of the yips again.   So enjoy the what-me-worry? moment while it lasts.  I don’t think it will last long.

The “boys” being the Dropkick Murphys. Their new CD, Signed and Sealed in Blood, came out earlier this week. I liked every tune a lot. Track-for-track the best DKM disc yet, which is saying something. Maybe not any tunes as good as their best, but every track is very, very good.

They will be in Houston at HOB on 28 February. I’ll be there, up close. Not that close. I’m only a little crazy, and the DKM mosh pit is for those bigger, younger, and a lot crazier than me. And the much more wasted.

Here’s a live version of the single release from the CD, “The Boys are Back”:

There is an I-told-you-so tizzy going on about the revelation of the BATS exchange that a system (or programming) error had resulted in the execution of about 450,000 orders at prices worse than the best bid/offer (BBO).  Oh, the humanity!

A little perspective here.  According to BATS, the total loss (which is a wealth transfer, mind you) totaled . . . brace yourselves now . . . $420,000.  Excuse me.  $420,360.

There seems to be some presumption that there was a Golden Era of trading, before the invasion of the dreaded machines, when intermediaries had hearts of gold rather than a hunger for it.  When bids and offers were never violated.  When there were never trading errors.

Wrong.  There was no Golden Age.  Nirvana is still just a band.

Think that the BBO was never violated on exchange floors?  Think again.  Sometimes this was inadvertent in the chaos of the pits/trading posts during active markets.  Sometimes it was very advertent (is that a word?)  May I remind everyone of the FBI sting on the CME and CBT, which discovered that some brokers would collude with locals to execute customer orders at off-market prices, and split the proceeds, sometimes delivered by bagmen-literally, guys passing paper bags of bills.   Given the relatively crude time stamping of trading cards, it was very difficult to construct an accurate audit trail.  Trades couldn’t even be sequenced with precision, and since the bid/offer were not recorded continuously or time stamped, it was impossible to see whether  a trade violated the BBO.  There were pit monitors who tried to keep an eye on things, but no human monitoring was capable of detecting all violations.  Indeed, the sociology of the floor and the member domination of exchanges (a subject I’ll turn to shortly) meant that social pressure discouraged cracking down too aggressively, particularly on the most powerful.

Enforcing the BBO on the floor was in many ways constrained by a lack of data.  If anything, current market monitors have the exact opposite problem: they are drowning in a sea of data.  But as BATS shows, it is possible to go back through years of this data and pick up mistakes that cost customers about $1 per error.

Then shall we discuss out-trades?  Out-trades-trading errors, where trade terms submitted by the buyer and seller didn’t match-were common on the floor.  Brokers were on the hook for errors, and there were stories of brokers writing six figure checks to make a customer whole for a loss.  I would not be surprised that on an inflation adjusted basis, a single broker wrote a check to a customer that exceeded $420,000 in 2013 dollars.

But this reality of the way things were doesn’t stop the hue and cry about the fallen state of today’s computerized markets.  The biggest huer-and-crier (emphasis on the crying) is Jackass Joe Saluzzi of Themis Trading.  Here Joe outdoes himself, by suggesting that we need to go back to the days of non-profit exchanges in order to restore public confidence in broken markets. (h/t Blivy.)

JJ apparently believes the old mutual non-profit exchanges were freaking charities, like the March of Dimes or something.  Uhm, no.

Let’s look at the facts.  The old mutual exchanges were cartels of intermediaries.  They restricted membership in order to enhance the rents of those members.  For decades, most of them ran brokerage cartels that fixed commissions.  Some created monopoly privileges for some members (e.g., NYSE specialists).  Others (NASDAQ comes to mind) had order handling rules that basically precluded public customers from competing with member market makers in supplying liquidity: NASDAQ was also the nexus of a flagrant conspiracy among market makers to fix spreads at supercompetitive levels.

Non-profit status had nothing whatever to do with the charitable urges of old time brokers and market makers.  As I showed in research done just as the transition from non-profit to for-profit status was occurring, exchanges chose the non-profit form because the non-distribution constraint inherent in that form prevented the exchange from choosing pricing policies that transferred wealth among heterogeneous members with very specialized human capital.  (An abbreviated version of the argument is here.  The full version was published in J. Law & Econ. in 2000.)  Electronic trading undermined the rents and the specialized assets that drove the choice of non-profit form, so the move to electronic trading in turn impelled the transformation of exchanges to for-profit entities.

In other words, non-profit form was chosen by very greedy, profit-driven individuals to protect their profits.  And a good chunk of those profits resulted from the exercise of market power and the adoption of collusive arrangements by exchanges.

So spare me nostalgia.  Indeed, methinks that a good deal of the nostalgia-and the related criticism of modern electronic markets-is a shriek of rage by those who profited under the old system, and are furious that someone ruined their racket.

Joe does get one thing right (cf. blind hog, acorn).  He attributes the specific BATS problem, and the increased complexity of the equity markets, to RegNMS.  This is correct.  The information-and-linkages approach chosen by the SEC led it to adopt regulations that socialized order flow.  This was done with the explicit goal of encouraging competition among trading platforms.

Another example of “be careful what you ask for: you might get it.”  Pre-RegNMS, NYSE executed about 85 percent of the trades in its listed stocks, and the bulk of the remainder was executed in Third Markets which did not contribute to price discovery.  NYSE was essentially the natural monopoly supplier of price discovery.  Now, NYSE market share is in the low-20s, and executions are shared pretty much equally among a handful of platforms.

But this socialized order flow model requires linkages between the execution venues.  It is that necessity that accounts for the complexity of the current equity markets.  The interconnection imperative is directly responsible for the proliferation of order types that many find so vexing, and which indeed give advantages to specialized electronic traders.  Note that the BATS error was in an order type designed to ensure compliance with RegNMS rules relating to the BBO.

You can criticize this market structure.  But if you do so, you have to grasp the nettle of the fundamental trade-off.  The choice is binary.  You can choose to socialize order flow, or not.   If you do, you get something like the current equity market structure, with intense competition among execution venues linked by a complex web of fragile connections and a proliferation of order types.  If you don’t, you get something like the pre-RegNMS market structure, or futures market structure past and present.  A market that tips to a single execution venue that exercises market power, either by restricting access (the old mutual model) or by charging supercompetitive prices (the new for-profit exchange model).

Those are the choices.  But the debate is almost never framed that way.  Instead, bat sh*t crazy people like Saluzzi (enabled by folks like the CNBC talking head in the BATS Hit video) take up all the oxygen screaming about how bad the current market structure is and retailing myths about some Golden Age that never was.

Political economy considerations almost certainly ensure that the SEC is not going to go back on RegNMS, and it is truly invested in the information-and-linkages approach it chose.  So we are likely to see a continued series of controversies over problems that are inherent in the socialized order flow model.  The SEC will pull its chin, and deal with each problem as it appears in an ad hoc way, just adding to the complexity as the new games are devised to exploit the new rules implemented to stop the old games that exploited the old rules.  This will make for never ending media appearances for the likes of Joe Saluzzi, but  don’t buy his line about the good old days.  The good old days that existed when regulation effectively opted for the other binary choice (no socialization of order flow) weren’t all that great.  There was a different set of problems, and a different set of people and firms profiting off the inefficiencies that inhere in the network nature of financial trading.