Market Microstructure and Capital Formation

In an earlier post I argued that recent changes in technology have altered the distribution of trading strategies in asset markets, with information extracting strategies becoming more prevalent at the expense of information augmenting strategies. Specifically, there has been a dramatic increase in the market share of strategies based on rapid responses to market data using algorithms and co-location facilities. One consequence is that the data itself becomes less reliable over time, resulting in greater price volatility and occasional severe disruptions. The flash crash of May 6 was a striking example. 

While my focus has been on market stability, this kind of transformation in microstructure probably has a number of other important effects. In recent testimony before the joint CFTC-SEC committee on emerging regulatory issues, David Weild has argued that one of these consequences is on the size distribution of publicly traded companies, and on capital formation more generally:

There has been a computer arms race unleashed on Wall Street by changes in regulation and technology... [This] is displacing fundamental investing with computer‐trading based strategies and has created new forms of systemic risk, a loss of investor confidence, and a disastrous decline in primary (IPO) capital formation and the number of publicly listed companies in the United States.

From 1997 to Year End 2009 there has been a 40% decline in the number of publicly listed (i.e., NYSE, AMEX and NASDAQ) companies in the United States. On a GDP weighted basis, we have seen a more than 55% decline in the number of publicly listed companies. Today’s market structure has lost the ability to support small capitalization companies and initial public offerings (IPOs) on the scale necessary to help drive the US economy. The U.S. now annually delists twice as many companies as it lists and this trend has been going on since the advent of electronic trading... the unemployment crisis in the United States has been partly caused by changes to debt and equity capital market structure and the events of May 6 may give us an opportunity to come to grips with the notion that we have entered into an era where trading interests are eclipsing fundamental investment and economic interests.

Fundamental investing, or so‐called “information increasing” activities, are being displaced by trading, or so‐called “information mining” activities. The growth in indexing and ETFs may be exacerbating this problem.

In addition, stock market structure today is geared for large‐capitalization stocks with typically symmetrical order books but disastrous for the vast majority of small‐capitalization stocks with asymmetrical order books (where there is not naturally an offsetting buy order to match against a sell order and vice versa)... The “Flash Crash” was an example of where even normally liquid securities went to a state of “asymmetry” and price discovery broke down...

[Until] all trades, quotes and other messages in all interrelated markets are tagged and traceable to the trading venue, broker and ultimate investor, and disclosed to the market, markets will not be perceived as fair... With full tagging, tracking and reporting and the application of posttrade analysis and test bed techniques such as Agent‐Based Models, regulators and market participants will... once and for all be in a position to judge the impact of other participants and to regulate and plan accordingly...

It may be time to admit that what works for large, naturally visible companies, is the antithesis of what is needed by small companies and it is these small companies that are essential to grow our markets, reduce unemployment, restore US competitiveness and drive the US economy.

I am not aware of any academic research that links market microstructure to the size distribution of publicly listed companies in the manner suggested here, and I am grateful to David for for bringing his testimony and supporting documents to my attention. The issue is clearly of considerable importance and deserving of greater scrutiny.

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Update (7/2). In an email (posted with permission) David adds:

I did a presentation to the ISEEE (International Stock Exchange Executives Emeriti) at the end of April.  The audience consisted of about 25 mostly former senior stock exchange executives... I was taken aback by the reaction of people from places like the Zurich Stock Exchange, Australian, New Zealand, Bovespa and others who were of the opinion that these electronic market structures (specifically, compressed spread-trading centric electronic continuous auction markets) are hurting primary capital formation in many of their countries as well.

For me, having run strategy for investment banking, research, institutional sales and trading at a major Wall Street firm, it is pretty simple - If one can't make money supporting small cap stocks, one won't support small cap stocks...

This has had two effects:

1. The investment banks tell issuers that they have to do a much larger ($75 million) IPO; minimum IPO sizes have increased at much faster than the rate of inflation.   
2. Aftermarket support for IPOs has withered because issuers lose money providing it (unless the companies are much larger).

It is commonly argued that the rise of algorithmic trading has resulted in increased liquidity, although this claim is by no means universally accepted. David (if I understand him correctly) is arguing that even if liquidity has increased for some classes of securities, it has declined for others, with detrimental net effects on capital formation.