The Answer Is Transaction Costs
"The real price of everything is the toil and trouble of acquiring it." -Adam Smith (WoN, Bk I, Chapter 5)
In which the Knower of Important Things shows how transaction costs explain literally everything. Plus TWEJ, and answers to letters.
If YOU have questions, submit them to our email at taitc.email@gmail.com
There are two kinds of episodes here:
1. For the most part, episodes June-August are weekly, short (<20 mins), and address a few topics.
2. Episodes September-May are longer (1 hour), and monthly, with an interview with a guest.
Finally, a quick note: This podcast is NOT for Stacy Hockett. He wanted you to know that.....
The Answer Is Transaction Costs
The Innovation is the Exchange Itself!
Chris Cornette, a longtime securities trader who grew up in the business, reveals how the most important innovation that made US capital markets preeminent in the world was the exchange itself.
• Cornette's father worked in the P&S (Purchase and Sales) department on Wall Street, eventually becoming the controller of an American Stock Exchange specialist unit
• The original Buttonwood Agreement from 1792 created exclusivity among traders that helped establish trust in the market
• Exchange specialists subsidized trading in small-cap stocks using profits they made from large-cap stocks
• The phrase "your word is your bond" wasn't just a saying but the foundation of the trading system. Exclusion from the exchange was enough of a threat to discipline bad actors
• Specialists would ensure market liquidity and "continuity" in pricing, preventing wild price swings
• The transition to electronic trading and decimal pricing in the late 1990s fundamentally changed market dynamics
• High-frequency trading firms don't have the same ethical obligations that floor traders did
• The number of publicly traded companies has declined significantly since the move to screen-based trading
• Self-regulation through the exchange helped create trust that made markets function effectively. Not perfectly, but effectively.
If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !
You can follow Mike Munger on Twitter at @mungowitz
This is Mike Munger, the knower of important things from Duke University. This is the first of the monthly long-form interview Tidy C episodes for the 25-26 school year. These will continue through the end of May. A reminder there will also be one or more bonus episodes as I work my way through Adam Smith's Wealth of Nations in collaboration with Adam Smith Works at Liberty Fund. One quick program note I should acknowledge that I am recording this on a new Shure microphone that was provided by David and Jack at Pain Oil in Graham. They also gave me the other microphone that I use most of the time. I rather pathetically said that I was away from the other microphone, had to record it on a bad one In this case. It's an interesting illustration of the provision of public goods privately. They were so disgusted by the sound that they said we would rather listen on a decent microphone and will pay for it. So, david and Jack, thanks so much. This microphone's from you.
Speaker 1:Today's episode is a discussion with Chris Cornetti, a longtime securities trader who grew up in the business. Chris contacted me a while back about the problem of transaction costs in markets. Markets he's interested in particularly are for exchanging securities, equities and other financial assets, and Chris posed a great question what's the most important innovation that made US capital markets preeminent in the world? Well, it was a trick question. According to Chris and I think he's right the innovation is the exchange itself. He'll tell us why and give some pretty great inside accounts of the American and New York stock exchanges. In New York there's two new twedges this month's letter plus book it a week and more Straight out of Creedmoor. This is Tidy C.
Speaker 2:I thought they'd talk about a system where there were no transaction costs. It's an imaginary system. There always are transaction costs. When it is costly to transact, institutions matter and it is costly to transact.
Speaker 1:Well, my guest today is Chris Gornetti. Chris asked me to remind everyone that he's speaking only on his own behalf, not for anyone else. Well, chris, can you tell us about your background, where you grew up and how you first encountered the Wall Street financial markets? I was born on Staten Island, so it was a short ferry ride to Wall Street financial markets.
Speaker 2:I was born on Staten Island, so it was a short ferry ride to Wall Street. My father worked for different firms in the P&S department and eventually he made it to an American Stock Exchange specialist unit and he became the controller of that firm. You know he worked in P&S as the head cashier and so that's a pretty big job because you know, basically you're in charge of the transaction. Part of what happens with us on the floor it's the purchase and sales department. If you looked up P&S on your computer you wouldn't even get AI waiting on it. They have no idea what it is because it probably hasn't been around. No one even refers to it anymore.
Speaker 2:And then in my little warm-up email, like I mentioned that back in the day, I can remember my father sending the guys out with briefcases that were handcuffed to their wrists. I'm like, why is that? Because it was filled with cash and certificates and they would give cash to pick up certificates and they would drop certificates off to get cash. My father would give them a slip to make sure they got this much cash for this security. And that was very time-consuming at the time because the trading had picked up and these firms didn't really have the ability to expand these departments quick enough and so back in the day, they would take off Wednesdays so they could catch up. I remember when I got there they were still using punch cards to report. The reporter would hit the punch card and send this to the machine and then we reported the tape well, you're not that old how?
Speaker 1:when was that when? When were they using punch cards?
Speaker 2:I started. I started in 1989 yeah, but my father my father. My father was down there um with the with the specialist unit in 1978 so I would visit them, and then, oh, I see, yeah, yeah yeah, so I would go.
Speaker 2:So I would go to my dad's office yeah they really never really ventured to the floor, except, except occasionally. I'd go visit my dad for lunch when I was working downtown, and and then you would see these, these guys come up from the floor at lunchtime and uh, they were. They were a whole different breed of man. You're not going to find these guys out there anymore. You know Well what were they like.
Speaker 2:Well, I can tell you one story. You know these guys, they would take enormous amounts of risk sometimes and you know, god bless his soul. But my dad's boss was named Frank Santangelo, francis Santangelo, francis Santangelo and he was larger than life. When he would come up to the office you knew he was there. And one day it was kind of a slow trading day and he wandered into the XMI pit, which is the major market index, which was designed as an option to follow the Dow Jones Industrial Average, and he didn't really know how to trade options. He was a stock trader, although he had hired some of the best guys around him to trade options. They had the most successful option books on Wall Street. He went in there and took a huge position I think he might have been position limit long in the XMI and he came up and he goes, carmine.
Speaker 2:I did something bad because my dad's name was Carmine and he threw the tickets on us. He goes. I don't think we're doing too good. And I think he was down like two or three million and he had this guy, joe Ricci, that was running the options department at the time and he called up Joe he goes. He got us into trouble. He goes. What did he do? So my father said that this guy, joe Ricci, was an unbelievable trader and he whittled this position down and I think they lost like maybe $550,000 instead of $2,000 or $3,000, which was a success.
Speaker 2:But at the time he did that he created a capital requirement problem and they were clear on Bastard. So my dad had to call up ace greenberg, who was, you know, very famous wall street guy, and say ace, he was. What did he? And then he said to him, what do you do now? So you know the story was you know he goes. You know carmine will give you whatever you need to get him out of the mess, just let us know what we we have to put in your account. You know, and that's the sort of things that would happen now if you hurt a regulator heard me say this they're like well, you can't borrow the money for your capital, but you know he goes. I know you're good for it. You know, because his wife was a trust trust one baby and she had plenty everywhere new with the money she had in the in the kid. So they were just lending the money. So he didn't have to go to his wife and ask for the money, and so there's stories like that.
Speaker 1:I mean, I could tell thousands of stories of crazy stuff. Well, can we talk for a minute about the way that the exchange was set up, the set of rules? There was a you had sent me. I had never seen before there was a constitution.
Speaker 2:Is that right when you go back to the exchange's constitution that we have from 1817, they put in that document what the commissions for certain stocks and options would be. So I think they had banked stocks at. Everything was a quarter of a point actually, and then if you trade the commercial paper or the bond, we get a quarter percent of the nominal value. They were evolving into this thing where they had to organize it better from the time that they were in Well, but let's go back there.
Speaker 1:What was it? The exchange was organized. What was the problem that the exchange was an answer to, and why did it need a constitution? Why don't you just have a place where people buy and sell?
Speaker 2:Well, they did. And so Wall Street evolved into two tiers. There was a tier that these men from the Buttonwood Agreement that goes back to 1792, the star of the New York Stock Exchange they pledged each other to do business, and exclusively with one another. And that exclusivity basically cut out all the guys who were already just trading out on the street. Like you said, they were just getting together and approaching one another just like an open-air flea market. You know. They were like what do you got? Well, I got this, I want that. And they would trade haphazardly.
Speaker 2:Well, these guys said look, we're going to create our own little exchange, we're going to run out of the Tontine coffee shop and we're only going to deal with each other.
Speaker 2:We're not going to deal with all these other hooligans. We'll call them or them, or undesirables, we'll say. And so they stuck to that. And then at some point it was maybe growing too fast where they need to organize it better. And so they decided that they were gonna, uh, rent a room at 40 wall street, which was in the constitution, uh, for 200 a year. And they rented the room, uh, to, you know, just to organize themselves better and to and in and out of the cold and the rain which I started my career on the American Stock Exchange, which was affectionately known as the curb market, and those guys didn't come inside until 1921. So they were out in the street for a long time and it was said that JP Morgan wanted them off the street because they were, you know, they were like, like I said, hooligans, and they were on Wall Street and they would hang out the windows of these what they would call high rises, but my five story or six story buildings, you know all of this sounds like.
Speaker 1:it sounds like the red light district in Amsterdam. So the prostitutes want to get off the street, they want to get up into a building, but they're hanging out the windows, yelling.
Speaker 2:Yeah Well, they wore a headpiece, you know, and they had the microphone around their neck because they need to be hands-free, because they used hand signals to signal their broker on the street on what to do. But these guys trafficked in what we would call penny stocks now, stocks that were not as desirable or worth it to trade in because of your reputation. So the New York Stock, know, founded themselves to separate themselves from this and they wouldn't list these stocks and even even to now, if you don't qualify, you're not getting a listing on the new york stock exchange, you know. And so you say they'll say go to the nasdaq for a while, if you want to come back, come back, you know, and um, and that's how they did it. And so back at the time that they were in the Tontine coffee shop before 1817, what they did was what I would call a negotiated market where you would go for the guy that you knew had certain stocks or certain paper to trade, and there wasn't a lot of different stocks at the time. This was probably a handful of quality stock, which is us government bonds, banks. There was no railroads, there was no telecommunications companies, it was basically insurance companies, banks and sovereign debt that they traded and you could have a buyers on two different tables and you would go to the one. Maybe you have a friend, you go to him and look in better terms. You know so, even when I was on the floor, you know I I worked in an open, uh outcry auction market and so what would happen is we would, we would do what everyone knows as the stock exchange, up until we went to screen-based, which was the bekelling and screaming and what you see in the movies Little pieces of paper. Well, you would write your trades. You would have to mark the trades down and report them so that the P&S department could process them and then get the cash and move the certificates. And that would be how we did it.
Speaker 2:Now I mean to stay back on 1792 to 1817, they moved indoors and they created a call market where the secretary or the president or whoever they nominated for the day I think most of the times those two guys nominate someone else. I just know them from those the big shots always wandered off. You know like, okay, you take care of it, I'm going over to the launching club. So I always said the chair, you know, would call the trading in order. And then they would go down a list and say we got city bank and we got bank of new york and we have, you know, two-year treasury notes and we have you know uh, bills and and you know something, maybe they do uh, some insurance companies or some insurance debt, but whatever it was, they went down the list and they called these markets and, and the members would put their, their interest in if they had any interest, and and, and he would do what I call would be almost like a Dutch auction and match the buyers and sellers to optimal price. And so if you had someone who had an $86 bid for 2,000 shares and someone who had an 85 seller of 1,000, he might set that at 86, the 1,000 trades into 86, and then there's an 86 bid for 1,000 more, and 1,000 was actually too much. It was probably like 100 or 10 shares back then. 1,000 is nothing today. But what happened was then that 86 bid would remain on that book and they would go on to the next stock or security main on that book and they would go on to the next stock or security and then someone could approach the desk and put in a sell order that that could match up against that 86 bid and they might put, okay, that'll trade, and someone on the side would write and say, okay, and then, when they went through the whole list, they would go back and say, okay, we're alive on these stocks. If you want to interact with them, you have. You know, 10 minutes before we close the session, and then they were about to lunch and then they would call this afternoon session and they would just repeat the process.
Speaker 2:I can't see them having more than 50 stocks and bonds to trade. I just can't. I don't really know, and there is records. I sent you a document that the Constitution for 1817 came from. It's great, the sec historical society, and I believe that they're sitting on a lot of things that you could probably find. But it's very hard to search their database. I don't know why if they don't give like a hey, we have all this. You know well, maybe I just couldn't find it the right way, but there's a ton of documentation out there and I'm sure it's just scattered. The exchange probably has some, maybe the SEC has some and maybe some old guys from the New York Stock Exchange might still have.
Speaker 2:They used to have these sheets, the fixed commission sheets that they worked off of. They used to have these sheets, the fixed commission sheets that they worked off of. They used to have these cheat sheets too that told them how much they had to enter the market for when there was the absence of buyers and sellers. There was all sorts of things that, as I was growing up in the business, I became a member in 1992. And you know, and that, and, and you know, when you're green you just sort of step back and you try to let you know, maybe find a mentor or let somebody you know flow through and you figure it out. But within three years I doubled my business, I was doing better, I figured it out and then, you know, within five or six years I I was. You know, I was up there as far as executing, executing the orders on the exchange, and I made my first four as a member on the New York Stock Exchange.
Speaker 2:I started on September 10, 2001. And so the next day, as you know, it was September 11. American Stock Exchange building was damaged and they needed a place to go. So the New York Stock Exchange, because of electronics, had shrunk and they had this building next door that they rented and they had a blue room and an extended blue room and that room happened to be empty at the time because, like I said, they had shrunk because of computer systems. Because, like I said, they shrunk because of computer systems, the specialists were able to give, the specialist firms were able to give their specialists more stocks to trade because of the advent of the computer.
Speaker 2:Before this, just before this time, this is like in probably 1999. You got to remember, in 1999, they started talking about going to decimals. In 1999 they went to 16th and then, right after they go into 16th, they started immediately talking about going to decimals and then having the uh, having trades automatically trade in size to order match buck, where in the in the past the specialists would look at every order, see if he wanted to interact or see if someone crowd wanted to interact with it, and then they would announce the trade and then you would interact with it and then the specialist clerk would type back and send the reports back to the person who entered into the system. My clients most of the time found that using that system was not a good idea. Lines most of the time found that using that system was, you know, was not a good idea. So I ended up with the orders in my hand and I would stand in a crowd and execute the orders accordingly. You know.
Speaker 2:So at the time the new york stock exchange had extra space.
Speaker 2:The amex got damaged.
Speaker 2:They moved all the trading for the amex in stocks and etfs into the New York Stock Exchange and they moved the options down to the Philadelphia Option Exchange and so these guys were making some.
Speaker 2:In some cases they were making markets side by side, meaning like the American Stock Exchange option market maker was making a similar market to the Philadelphia. And in ETFs we were making markets in the extended blue room in Triple Q or Diamonds, which is the Dow, and QQQ is the NASDAQ, and then, of course, spy is the SPY, which is the S&P 500 ETF, and then, right across the threshold of the blue room, the New York Stock Exchange was making markets in the same thing. We did find that a lot of the New York Stock Exchange brokers did enter the exchange, the American Stock Exchange, to execute in that, because they had better markets, and they had better markets because they were at this much longer than the New York Stock Exchange specialists. When I would walk in there they would make me a million shares up no problem, or a million, and they never really had a problem.
Speaker 1:Well, you have said a bunch of things that I think need to be explained. Can we go back for a second to the beginning, because I have a question that's obvious to you, I think it's obvious to me, but it's not going to be obvious to be explained? Can we go back for a second to the beginning, because I have a question that's obvious to you, I think it's obvious to me, but it's not going to be obvious to most people. So what it sounds like is a bunch of people said we can make more money if we declare an exclusive right to exchange these things and we're going to say we're not going to deal with anyone outside. That just sounds like a straightforward monopoly.
Speaker 2:Now, in fact I used to call it a cartel.
Speaker 1:Well, it is, except that you want to have an orderly market, and losing your seat on this exchange is a big punishment, and so it's actually a mechanism of ensuring that you obey certain rules, that you don't countenance, you don't foment fraud, you don't deal in ways that violate the rules and norms of the exchange. It's actually a way of improving the quality of the transactions. Now, of course, they made a fortune by doing that also, but having an exchange and having people whose job it was to make and I want you to say what this means to make markets, to ensure that these markets are orderly and there's some way of being able to exchange these assets, that's a tremendous public service, and I don't think most people recognize that.
Speaker 2:Yeah, so you said a lot there. So let's start with the monopoly part. I would call it a natural monopoly, and the idea is that the market should be centralized, because fraction markets are not as robust as a centralized marketplace. So the robustness is liquidity, and so I've seen fraction markets, fraction markets will work in an SPY, qqq, egif a very, very liquid security. You can trade anywhere in the street and get a good market.
Speaker 2:But if you're trading a smaller cap stock that needs to be babysat, we'll say, or just needs to have a mentor or a big brother watching out for it, the special system was better than any other system for that.
Speaker 2:And so there's a pricing mechanism on the floor that is based around the specialist, and so the exchange itself demanded that the specialist enter the market in the absence of any public orders. And so if I walked in as a seller of a small cap stock, that the specialist enter the market in the absence of any public orders. And so if I walked in as a seller of a small cap stock and the specialist had nothing, he'd say I'll buy 100 shares, which is the minimum increment, and maybe that was the minimum increment that the exchange demanded that he buy from you to get started and we'll go from there. So now I know I had, say, 28,000 shares of a small-cap stock that I knew was going to significantly move the market. In the same sense, the specialist had to show the exchange that he entered the market properly, and I would then sort of work in conjunction with the specialist, not to be collusive with him, but the idea was for me to find a real buyer and a price.
Speaker 1:Yeah, a price, there's a price. You post a price. There's a market in this asset and there wouldn't be a price.
Speaker 2:I wouldn't post my, I would not post my total volume, but I would ask him. He'd ask what's the market now? And I'd tell him I'll offer 5,000 shares. Please show 100 shares, or please show 500 shares out loud so that someone would look and say, oh, there's a sell there. And it was quite often.
Speaker 2:Many times my style of executing was not a way that a lot of brokers would do it, and I think I had a little bit more success for other people in these small cap stocks because I came from the American Stock Exchange. That is a lot of small cap and then I would see that this order was going to sit around for a long time unless I moved the market. So what I would tell the specialist is where's the next bit? I don't have one. Ok, well, let me execute 100 shares where you need to enter the market for fair and orderly trading they call it continuity and let me put it down and then offer it down. Or is there an order on your book that I could reach for to send a message to the marketplace? Hey, look what's going on here. This thing is down a dollar now and we're looking for somebody. And I would do that. Sometimes the stock would be trading in a tight range for a month. And now I'm walking in, but it only trades 4,000 shares a day and now I want to move eight times that. So what I'll do is I'll go in and I'll push the stock down to a price that I get. No, if I have no interest, I don't have no interest.
Speaker 2:But most of the time no one would pay attention until you put a piece of stock on the tape and sometimes the specialists go look, I'll buy 5,000 shares from you at this price down $1.25, just to see what we get. And sure enough, I'd say, okay, let's do the 5,000. You know I won't stick it in your face and let's see what we get from that. And sure enough, you put the 5,000 shares on the tape in a small cap stock and somebody would walk in. What's going on? And I'm like I'm a seller, okay. And I'm like I'm a seller, okay, and I come back, I'm a buyer, what can we do? And then that's where the new price was, because the supply, you know, was outstripping the demands and to get to it, to find them, I had to move the stock. So I had to reprice the stock from where it normally trades to where we could find buyers. And the opposite would happen if I was a buyer in the absence of sellers and a specialist would work like this to nurture the stock.
Speaker 2:And that's what we would call continuity and fair and orderly trading. And there's other times where the stocks maybe have news on it and it was crazy wild crowds. The stocks maybe have news on it and it was crazy wild crowds. But even the crazy the crowd, they were still trading in a fair and orderly way, even though the public won't notice that. You know, there was rules around the trading. There was floor managers that would make sure that everybody did the thing the right way. There was floor officials that made sure you didn't break the rules and up and that nobody was going to soil the good reputation of the New York Stock Exchange and eventually the American Stock Exchange. When they came indoors, and even before they came indoors, they created what we called the SRO, the Self-Regulatory Organization.
Speaker 2:So that was the basis of the ethics on Wall Street for quite a while. You know, yes, the security laws of 1935, you know established the SEC and that's when the government started to put the heavier hands on what we were doing. So obviously up until 1935 is a lot of time, you know, over 100 years, where you know the members themselves, police themselves, made sure that their reputation and their ethics were beyond reproach, and that is part of the institution as well. And that also made people trust what was going on there. So people were not afraid to put their money to work in a place that they felt was safe. You know, and you know you alluded to, you know the, the, the, the elites, you know saying we're not going to trade with anyone else, and that was part of it. You know they didn't, they wanted to make sure that, you know, nobody was going to damage the reputation and that also spurred more and more business, because the trust factor goes a long way.
Speaker 1:It's essential. Actually, the market would just dry up otherwise. And so having the threat losing your seat on the exchange if you have this position losing your seat on the exchange you'd have to do something pretty bad. But the threat of it maybe people wanted to behave honorably anyway because they recognize the value of having a place that people can trust. But even if I'm tempted, the threat of losing my seat on the exchange, that's pretty draconian.
Speaker 2:The industry adopted the saying your word is your bonds. And they did that because when you go out to a trading crowd, you're affecting a contract and that contract is a verbal contract. And when I trade with someone, if I'm a seller, I take out a sell ticket. I write the sell. I sell 5,000 shares of XYZ. Handwriting.
Speaker 2:You are handwriting that we're handwriting it yeah, at the time we were handwriting it and sometimes if I had 50,000, I put 5,000. So I didn't want anyone to look at my pad and say, oh, this guy's got 50,000. So I put 5,000. I just put five on and no one would know what it was. So people couldn't jump my order or you know. And sometimes you know, even though you trusted people, you still gotta still have to worry. There's I was just saying there's, there's, there's a certain code amongst the pirates to make sure the ship doesn't well, and stealing signs in baseball.
Speaker 1:it's not really legal, but if you steal a sign in baseball, that's it's sort of within the bigger rules. That's not really a violation If you're stupid enough to write the actual number and they see it on your pad, okay.
Speaker 2:Well, yeah, in a sense I had to go up in front of the exchange at one point because somebody interacted with my order when I just barely announced it. But he saw what my order was, so he screamed in my face soul, before I could even verbalize it. But there were two other members that wanted to interact with my order as well. So I looked him in the eye and go, really, I said, really, it was okay, let them do their 10 to 10,000, 10,000. And this gentleman, he executed the rest of it. You know he, he actually worked for a large firm, although if I named the other, that was Gene Streep.
Speaker 1:That's a different thing. Rather than saying I think the price is going to move because I saw this number, this is he's actually executing part of what the trade was going to be. That's terrible.
Speaker 2:Well, it was in triple Q and he and when I made a bid in triple Q there was a, there was a, a layoff market based on the basket of the stocks. That was probably what he said sold you know. You know that basket was probably offered as a basket underneath my price. So he was just trying to lock in. You know, maybe a 16th or even four or five penny, who knows. But he was happy to trade at that price to lock in, and everyone had a different formula and different ways of doing it. So there was only three members who there was 20 members in that trading crowd, but only three wanted to interact with that.
Speaker 2:But what they did exchange compliance person said okay, you violated our rules, saying that you changed the principle of the ticket, and I said no, I didn't, I go.
Speaker 2:What you don't understand is the fair and orderly part of it, and what was not fair about that is he saw my trade ticket and the other two guys didn't have that ability. And so when I looked him in the eye and said, really Okay, and I know you saw that he understood that I had caught him and he understood that the fair part was to let other two guys onto my trade ticket, which had happened, and, to tell the truth, the guy I traded with was about to leave the American Stock Exchange and go to the New York Stock Exchange as a specialist for the New York Stock Exchange as competition in ETF market making, and so I think that the exchange was particularly after that guy, and they really weren't after me, they were after him, and so they were trying to make a big deal about it and I refused and they tried to get me to agree to facts that weren't factual and they said well, you're not going to get in trouble, you just have to sign this and say this is what happened. I go.
Speaker 2:I'm not signing it because that's not what happened, and they would say, well then we're not going to close this investigation and it shall remain open, I go, go ahead, I go, I don't care, I'm not saying yes, I'm not going to sign my name to something that's not factual, it's not what I believe happens and I'm not doing it and that's part of the ethics, you know. I could have just said, oh yeah, fine, I'll sign it. And this guy, you know, goes off and they try to fine him or ban him and take away his seat. So, you know, nobody's beyond reproach, you know, and that's part of the problem. But for the most part, you know, your word is your bond and the people that I dealt with on a daily basis, they stuck to their trades, they didn't try to break trades or say I don't remember, you said it.
Speaker 1:It's on a daily basis. It's not worth it If I do that one day and I try to deal with you tomorrow and the day after that you look, I don't trust you.
Speaker 2:It happened, it happened more than once. There was a floor trader who wanted to trade stocks and not options or etfs, and come and stand in in in trading crowds, and that's when they were trying to scalp for eighths, basically because the minimum increment trade was an eighth, which was $0.12. And if you had a $2 or $3 stock, it's still trading in eighths. And so if you could bid three and an eighth and offer a three and a quarter and just keep matching back and forth say you were maybe a short seller at a quarter and a long buyer at an eighth, and you stand there all day long and collect an eighth 25,000 times, but it's just standing there. The problem occurred like for me is I walked in as a buyer and lifted the quarter, and when you entered a trading crowd you would ask. You could do it two ways. You could ask for a market, which meant that the market that was posted was no longer valid, and they would tell you okay, it's an eighth of quarter, $5,000 up. But on the screen, if I looked up, I said an eighth of quarter, $25,000 up. So if I was going to, if I wanted to get a minimum of $25,000 in. I would walk in and say a quarter bid for $50,000 and see what I got, and knowing that there's $25,000 offered out loud, I would get my $25,000. If the specialist had to make up $5,000 or $10,000 of it, so be it, because he posted $25,000.
Speaker 2:In this particular case, $100,000 or plus, because everybody's trying to scalp these tickets, these small-cap stocks. And when I lifted it, this guy just backed out of the back of the crowd and I stood there, listened to him. When I asked him for a market, he said $10,000. He offered $10,000 shares at. And when I lifted it, all of a sudden he tried to back away and disappear. Just walk away. I go, where are you going? You owe me 10,000 shares, he goes oh, no, I canceled. I go yeah, okay, you canceled. Then another time he was on the offer and I lifted it and maybe he was long and he wanted to sell it. I go no, no, no, you canceled. Yeah, or you're a fan? Yeah, so I wouldn't trade with him. Yeah, yes. So then what happened? Was that guy only lasted for another month or two? Yeah, because everybody saw what he was doing.
Speaker 1:It doesn't take long they ignored him.
Speaker 2:Yeah, they ignored him and he was done.
Speaker 1:They ignored him and he was gone. It was just that. That's the argument for those. The small exchanges like that, the everybody knows everybody, you just can't get away with that oh yeah, I know I knew who I could trust and who I couldn't trust.
Speaker 2:I knew I knew if someone walked in the crowd that it was. It was, um, it was going to be a big order, because certain guys would never walk into a crowd unless they had a big order, you know. So there was like it was like to be a big order, because certain guys would never walk into a crowd unless they had a big order, you know. So it was like Clint Eastwood walking into like a quiet western town. So when you saw one of the Clint Eastwoods walking in, you know, okay, here we go, this is going to get good. And you would know, okay, you know, let's get the orders, you know, and start making, making it, making the stock move a little bit.
Speaker 2:You know, sometimes you stand in the crowd, you know, all morning long and nothing happened, and one guy walks in and you're like okay, and then you say hey, there's a buyer and like, okay, what does that mean? It means you should give me what you have left on the desk. He goes well, I got, I'll take 250, 000, got more. But the guy only started me with $25,000. And then I would go to work. I was like, hey, let's see what we can do here. I'll offer you $250,000 at this price and he might bid me down. And then we meet in the middle. He might say I'll offer you $250,000 at three dates and he'd say, no, I'm sticking to an eighth. I'll say $250 at a quarter fill or kill.
Speaker 1:You know, those are pretty small margins, but that's how a price comes together.
Speaker 2:That's right, it's a negotiation. So we made a negotiation. People would ask why do you guys trade in eighths and quarters instead of pennies? And I said, well, that it lends itself to negotiation was a whole. Uh, you know, if, if, if you are one bid and I'm at two, if we meet in the middle, that's one and a half, and then if the market's made one to one and a half to meet in the middle as one and a quarter, yeah, and then so on and so forth, they stopped at one and an eighth because historically, people would cut the dollar, which was a silver coin, and they would cut it into eighths.
Speaker 2:You couldn't cut it, they used shears. So if you went back in time, even in the Middle Ages, they would cut coins into eighths and they called them bits or pieces of eight and you couldn't cut it anymore because it was too small to cut. You know, that was it. That's why we, we, we use that, that, that monetary, uh increment, and it also meant itself to negotiation, and so that's what we used, you know, in um, in our trading. Now, when we did go to decimals, we went to nickels first and that was a little hairy because it was sort of hard to understand, you know. You know 05, you know you'd have to say 05 instead of 5 because it could be $5 at a nickel. You know, so you'd say 05.
Speaker 1:I never thought of that. The eights works really well verbally. So the one, two, three, five, eights. It's clear, and you can hear me say that, so there's no ambiguity. 05, 07, that's hard.
Speaker 2:We had traded in teenies before 1999. Anyway, on the American Stock Exchange we traded in 250, 256 in the ETFs because they were that liquid and so those things started trading in 1998. So we did trade in these weird. I think it was sort of ridiculous to go down to $2.56.
Speaker 1:Yeah.
Speaker 2:But they did, you know, and then talk about a sub penny. They trade in sub pennies. Now the HFT trades inside the quote, so they could show that they made price improvement because of best X rules. So this, you know, that's moving into the next level here, which is a screen-based market. You know, into the next level here, which is a screen-based market. So in 1999, they had already predetermined that we were going to go to pennies and we were going to go to a screen-based market and we were not going to have the choice of remaining an auction market. And so that has some ramifications to it, meaning that the big cap stocks were fine, they traded terrific, but the small cap stocks started to suffer and at the time we had something called the Wilshire 5000 Index, which is made out of 5,000 stocks. Well, the Wilshire 5000 no longer has 5,000 stocks. Well, the Wilshire 5,000 no longer has 5,000 stocks. We don't even have 4,000.
Speaker 2:I think there's about 2,500 or maybe 2,300 stocks that are standalone stocks that aren't an ETF or esoteric product that is viable, and all those other stocks that used to be public are now in the private equity hands, or they just don't come to market until they become more mature and they just wait it out until they see a good opportunity to go public. So you got to understand. The exchange is not the institution that takes a stock public. The dealer does, the banker does, the banker does. The banker promises a certain fee and the exchange is a secondary market in trading shares. So when I decide to make a joint stock company and list my share and put my shares out there, the banker sells the shares out to people and then they rely on having the stock exchange listed for a secondary market.
Speaker 2:So if you look at the electric security laws of 1935, there's different rules for IPO and there's different rules for secondary trading and the IPO is really for the bankers, and some bankers have to worry about those rules and do those things correctly. And there's different things. I think it used to be that there had to be 435 individual owners before you were qualified to list on New York Stock Exchange. So they wanted a broader-based market. They didn't want a narrow ownership, they wanted enough people involved in the stock, and so that investment banker now had to go out and find at least 435 individual people or institutions to buy that stock, and so the idea was let's spread it out and to talk about the exchange being capitalism.
Speaker 1:Yeah, this is how it works.
Speaker 2:You went out into the public and gave the opportunity to participate in the American economy In some cases the Canadian or the English through what we had called ADRs American Depository Receipts. So the US market just came out on top, for whatever reason. London was was never made it to this to the same strength that we did, um, the japanese. For a little while there they looked like they were gonna, they were gonna do all right, they, they, they. They crashed and burned after 1989 and you know, we just I think that there was a lot of innovation in the U? S markets and I think there's a lot of you know reasons for that that are institutionalized. I know you restarted this conversation based on the fact that you believe that institutions are what made capitalism capitalism, and I agree with you.
Speaker 1:And I agree with you because it was just evident to me, you know, from, from being I believe it, you knew it, you actually had evidence and that was why I was interested in talking was that you actually had the experience. I had this intuition that it was likely true, but you had seen it.
Speaker 2:Yeah, well, I told you the story of that when I would host students and my big joke riddle would be hey guys, which stock do you think is the best? Or which invention do you think is the best for you? What do you think is the greatest invention or stock that's out there? And they would think about it. And someone said, well, I like my iPhone. I think it's the iPhone. And someone would think about it. And someone said, well, I like my iPhone, I think it's the iPhone.
Speaker 2:And someone would say, how about the wheel? I go, well, the wheel's not represented there. I go, what other inventions do you think of? And they would say, oh, I like this or I like that. Some little kids would say your toys are us, or things like that. I was like you know what? What you don't understand is that the best invention here is the exchange itself. And we stand in the overlook and I wave my hand over it. The exchange itself is the greatest invention, because without that invention, these other inventions don't get to succeed. They don't get to move quickly through the market and through the economy.
Speaker 2:The beautiful part about the US capital market is that they give you enough money for you to move quickly through your growth. If you're growing, they'll give you the money and they want you to match that. There's been plenty of small companies that die because they couldn't keep up with their own demands. So they created a great product and the man was so great that they couldn't keep up with it. And people would realize, hey, these guys are selling these things, these widgets, like hotcakes. We have to jump in that market too. And so they would get a competitor who was ready to go to five or ten thousand units every two weeks. They could scale up. Yeah, they couldn't scale, and so they would go, and so someone else would steal their position as first mover.
Speaker 1:Yeah.
Speaker 2:And so what the exchanges did is give you the money and give you a way to be able to scale your product to meet the demand for it. If there was, scale your product to meet the demand for it. If there was, and if there was a demand, you might be a small cap stock and you might have some, some stock on the shelf. Let's say you're like a shelf offering, meaning that hey, uh, right now we only need this much money that we're going to put to work and if we could get bigger, we're going to have some stock on the shelf. We'll announce that we're taking it off the shelf and sell it into, either on a secondary, which is you hire a banker and he'll say we're going to sell $100 million worth of stock, and they would do that or you could sell periodically into the open market.
Speaker 2:You would have to announce prospective stock. You would have to announce certain things and let people know what was going on. Prospective stock. You would have to announce certain things and let people know what was going on. Most people would know, like professionals would know, if they entered a stock that had a shelf offering that was now live, that they were probably going to be buying some prospective stock that would be delivered with prospectus. Say, hey, you bought a stock You'd have to announce that it was prospective stock and and then they would, uh, and then the pns department would you know you would walk the ticket and the pns department knew that that stock had to be delivered with a prospectus. And you know, and that was one way of doing it for small cap stocks, um, you know what?
Speaker 1:what you have said is, I think, easy to miss because you make it sound so obvious. If I want to raise money and I try to organize an IPO that's an initial public offering I make a deal with a banker. We agree on maybe a price that we're going to offer it at, and there's some people out in the world they don't know much about this company and they're considering buying it. There's two considerations. One is is this product going to take off? The other is if I need that money, am I going to be able to obtain it? Which means, is that asset going to be liquid?
Speaker 1:The presence or absence of a secondary market is a key consideration. So if there is some kind of thick secondary market where I can sell it this afternoon, if I need to, I'm going to pay more for the IPO, and so the reason that I love your story about the most important thing is the exchange itself. The exchange itself is not managing the IPO. What they're doing is providing a guaranteed secondary market, and that means that IPOs are far more successful in the United States than they're going to be in other countries that don't have these rich, thick secondary markets that the financial industry is saying we will provide this for you. That's a genius move and no one understands that. No one understands that. Yeah absolutely.
Speaker 2:One of the things I mentioned in an email to you was that, because the specialists also traded in these very large cap stocks and made a lot of money, they didn't have any problem in making a thicker market in the smaller cap stocks that needed them Because, first of all, it was mandated by the exchange that they entered the marketplace. Second, there was fierce competition among specialists to get those listings because they never knew which one was going to end up being a big cap stock eventually.
Speaker 2:Yeah, a lot of volume. Yeah, they would bend over the volume and the ability to trade them, and so what they would do is they would compete and say I'm going to spend this much money on your stock on a daily basis to make sure we make a good market, and then the specialist would basically bargain with the companies give me your listing and I will do these things for you. And if you got the stock, then you know you, you did it because they expect you to do it, and so and these are smaller cap stocks that they don't even try to come to the market anymore because this doesn't exist anymore. This is not a specialist is. What we have is hft now, and they do not risk capital. They just don. They'll tell you they do. You should never risk any capital, and I'll get to that shortly. So the specialist basically created a subsidy for the small cap stocks through which the bigger caps gave money for. So the specialist subsidized trading in small caps because they made a fortune in the big caps, and so that subsidy helped grow the market and make it liquid. And I think that's what separated us from some of these other countries' stock markets is that even in the smaller cap stocks, you found liquidity that was not normally there because of the competition amongst specialists, of the competition monk specialist, the ability for the specialist to add capital to that stock because he made it in other places.
Speaker 2:They also would charge commissions on orders that were left on their book. They charged more commission than I ever would. They had ways to make up if they took a loss. They had ways to make up for the loss and that was the key. They always figured if I lose here, I'll make it back there, and so I'm going to do my job. My job is to provide a liquid, thick, liquid market continuity. So continuity was what they said. So I'm not going to just let the stock go from.
Speaker 2:You know, go trade down two dollars on 300 shares. You know it just doesn't happen. I mean, I could do that occasionally. I would do that. It was called the block trade and occasionally I would put together in a small cap stock. I would put together a pre. I want to say it was predetermined, but it was. It was already negotiated, maybe on a desk somewhere. And hey, chris, I need you to put on 350,000 shares of a stock that I might trade 350 shares a day. And I'd walk out and I'd say to, to the price that we put the block trade on, would all go on at the price of the block trade. So you would get lucky if you did this, and quite often the specialists would participate too on the block. And what they would do now that you say, okay, there's this big seller that just got pulled out of the market and it went down two bucks, then there would be bids that would show up and push it right back up. So, didn't care, because they wanted the liquidity, the buyer was happy because they got stock at a discount as far as they were concerned, and then they would have backup bids and, um, I did business for some institutions that were well, one of them, one of the guys that did business through my customers, was Dimensional, which was founded by.
Speaker 2:I believe his first name was Charles Booth of the Booth School in the University of Chicago, and he was him and some of those Chicago boys were instrumental in portfolio theory. You know, basically, diversify, risk, and so they always like find me a seller, I want a discount bid, I'm going to give you a discount bid, you know, and they always were asking me to find the trades, to trade like that and I'm sure they still do to this day. If I have the word out to their, to their brokers on the street, I'm ready to make discount bids in any of these small cap stocks. And if you look at their universe, they have a universe. Every stock that's, that's that's been traded. You know and and and and you know some people don't even know they exist, but they're there. They're there If you look them up as holders of. If you look up any small cap stock, you're going to see Dimensional as probably in the top five holder of that stock.
Speaker 1:Well, I'm looking at the time and I know this is a busy day for you. Can we talk a little bit about HFTs and then we should wrap up?
Speaker 2:Yeah. So in 2006, they changed the rules. They called it Reg, nms, national Market System, and what they wanted is the exchange to move into what they were going to call a fast marketplace, meaning that if an order came over an electronic system, it would aggress the market without human interference, regress the market without human interference. So if we weren't going to interfere which was like no way I'm a seller, better than that offer I want to sell no, you couldn't. That stock was going to trade on what was the published screen market offer. And so what they did is they forced the law brokers and specialists basically out of business, you know.
Speaker 2:So the idea now was that you had to go to a screen base and at the time I had already had a handheld that we were already demoing, and so what I would do is I put my interest in the system and so I would be represented on the electronic screen as well. But if, if someone walked in and said I'm a buyer and I said, well, I'm a seller, I would maybe remove my offer from the screen-based system and I'd still trade in what they call the hybrid market. And so we would trade hybrid and then, especially, go back to old tools and print the stock and we would go across the tape, and that was away from the electronic market, but it still had to be within the confines of the quote on the bid or the offer in the middle. If not, I had to arrest the market one way or another to clear the bid that was there, and then the specialists would print it and we would have a valid trade.
Speaker 2:We moved from that hybrid now to total screen-based trading. There's no more interacting inside of those you know say basically, you put your interest in, I put my interest in, and we trade through the system. Sometimes you wouldn't realize it, but a guy might have an offer in the system that we couldn't see, that maybe showed 100 shares at a price, and so when I aggressed the market, I traded with that guy, and maybe I didn't get to the guy that I just said hey, I want to buy your stock. Okay, I'm in the system.
Speaker 1:So that guy would be like hey, what about me?
Speaker 2:I go. I don't know what happened, I go.
Speaker 2:I feel better, and so because we didn't know, and so that's part of what was going on and what what happened, um, away from the natural buyers and sellers, is that the specialists sold their specialist units to firms called high frequency traders, and and this system was, was, uh, was put into place as an alternative, as a free market alternative, to the specialist heavy hands. You know meaning like hey, this is a cartel and we need to remove a cartel and have competing market makers. So there's Jane Street and there's Citadel and there's Susquehanna. There's a handful of market makers out there that theoretically compete with one another in all these stocks. The problem lies is that the person who bought the specialist book on the New York Stock Exchange is in control of the order book, and so they see all the orders that are flowing into that stock, and some of those orders are like they enter the market 100 shares at a time and immediately cancel, and they do that so fast just to see. They're basically pinging the marketplace to see if there's any interest at that price, and the person who's in charge of that book the HFT that's in charge of that book they can see those cancels coming through. There's a market maker that's not the principal market maker can't see those.
Speaker 2:And so in 1999, the SEC demanded that the brokers chase after something called best execution, and then it was a way that they felt that captured order flow was being um was being charged too much commission, meaning like, if I went and I sold the stock down 30 cents and then it went right back up, the sec would say, well, not only did you charge a 16 to execute that order, you also charge 30 cents on top of that because you put the stock down $0.30 and it went right back up and so that's excessive commissions and you did not work for your customer, and so we don't like that. You're going to have to change the way you do business and you're going to follow best X rules. Follow best X rules. So these are the best X rules out there that demanded that they trade with a TWAP or a VWAP, which is time-weighted average price and volume-weighted average price, and so, basically, every order that gets entered into the New York Stock Exchange system, or even NASDAQ or any of them, have this, have these monikers, you know.
Speaker 2:So, some guys, what some guys will do is they'll break the order up so that the so that the high frequency traders can't recognize their pattern. So there's a pattern of flow that the, that the books recognize like buy 100 shares at this price. But so sometimes you know if they you know if they're trying to work for best X, if the stock's trading above best X, above the VWAP or the TWAP, they will try to trade less until the TWAP or the VWAP catches up. But the HFT knows they're there, so they're also getting on the bid and they know how these orders are going to come into the marketplace. So they're always one step ahead of the algo that the member brokers use to execute on the electronic system.
Speaker 2:And if people see this, they're going to say oh, you're wrong, you're 100% wrong. And I'm going to say I'm not, I've been there long enough to know and to see. And they're going to say we don't have access to that, we don't see that, we don't do this, except that when I would have an offer and I wanted to hit a bid and the bid was shown out loud for, say, 500,000 shares and I had 650,000 shares that I would try to sell all at once and offer I might only get 400,000 done, even when there's 1,000 showing, and what happened is they were faster because of co-location in the order book room, which is Malwa, and also they were speedier to other remote markets. So some people used microwaves to generate, yeah, but by speedier.
Speaker 1:You're talking about milliseconds. This is not an hour Millisecond. Yeah, no, yeah, yeah, milliseconds. So it's an arms race.
Speaker 2:They paid. So I mean, there's a 60-minute story on the RBC trader who realized what was going on, what he did to time his orders hitting every marketplace at the same exact time. So they couldn't do that. He created spools of wire same exact time. So they couldn't do that. He created spools of wire. So if he was located in New York, he would create a spool of wire that would be at the length of going from, say, the New York Stock Exchange's data room or order trade book up in Mylar, new Jersey, out to Chicago. And so what he would do is he would send it all at once and the orders would theoretically arrive at each exchange or each order, but all at the same time. So that was his way and it was kind of just an ingenious way of doing it.
Speaker 1:I never heard of it. That's fantastic.
Speaker 2:Oh yeah, it was like he understood I was arguing against. People didn't like my mouth because I would say what are we doing here? We're creating an inferior marketplace because of this. There's no human interaction. So who am I going to argue with the machine? Yeah, and if you have some coder that's coding an algo, like I call it a parasitic algo at the HFT, it's not broker-to-broker anymore. Your world is your bond. It's gone. There's no face-to-face, no trust. There's someone that's it's being banged into a code in a computer and that person doesn't even understand, doesn't see, anybody, doesn't interact.
Speaker 1:But that's because nobody understood that function. Yeah, nobody understood that function, and so, yes, the ethical check is now gone and it was informal. It's hard to understand those informal rules. Well, I'm afraid that's a good place to stop. I hope we can talk again sometime, because we've barely scratched the surface.
Speaker 2:But I know you have other things to do.
Speaker 1:Well, you should write about this and I would look forward to reading it.
Speaker 2:I sent you an email. It wasn't an email.
Speaker 1:It was a small book.
Speaker 2:And I was really off the top of my head. There's some stuff that I would like you know some of the time. You know to just get a date. I would jam it in there to get their exact date of some of the stuff. But a lot of the stuff was just off the top of my head and it's complicated and it's difficult to explain. It takes a lot of explanation. To me it's second nature.
Speaker 1:Yes, but that's what's good is. Your intuition about this is so far ahead of the other people that I've talked to, so I really appreciate you being on today, and I hope we can talk again in a few months because I would like to follow up on some of these things.
Speaker 2:So thanks, so much I appreciate it. I would like to follow up on some of these things.
Speaker 1:So thanks so much, Richard I appreciate it.
Speaker 2:I love your podcast theme because nobody pays attention to that and, honestly, you know, I told you that Coase was my favorite economist and basically it's really because of that dinner that he had, where all those guys tried to attack him and then he fought them off. Yes, I kind of feel like that was me in more than one occasion.
Speaker 1:I was going to say I think it's because it's not just that you admire that, you identify with that.
Speaker 2:Yeah, exactly so it's like hello. You know this is, this is what's going on. And even though they say, no, this is not what's going on, I'm saying that's what's going on and you know. So I identify with them and, of course, my job was to collect commissions and you know that's about the transaction, it's all about the transaction.
Speaker 1:Yep and so, yes, it was a cost of transactions, but it also was providing a service that I think most people don't understand. So, chris Cornetti, thank you so much for having been part of. The Answer is Transaction Cost. Whoa, that sound means it's time for the twedge. I have two twedges this episode. One a list of dad jokes and the other a one-liner about options.
Speaker 1:First, today's stock market report. Helium was up, feathers were down, paper was stationary. Fluorescent tubes dimmed in light trading. Knives up sharply. Cows steered into a bull market. Pencils lost a point. Hiking equipment was trailing. Elevators rose. Escalators continued their slow, steady decline. Barbells were up in heavy trading. Light switches were off. Diapers those remained unchanged. The market for raisins dried up, but soft drinks fizzled. Caterpillar stock inched up. Sun peaked at midday. Balloon prices were inflated. Scott tissue touched a new bottom. Batteries drained early but then caught fire, putting a charge into markets. Well, the second is just an observation on options trading. Inexperienced options traders sleep like babies. They wake up every hour screaming, and then they soil their pants. Options trading is pretty tough.
Speaker 1:The letter for this month is from Casey. Casey writes Hi, mike, thank for the mental model of capitalism you shared on EconTalk. I loved the clarity. I was shocked to find I had spent my life as a small businessman without understanding that core idea. I think I was stuck at the outer peripher, spent my life as a small businessman without understanding that core idea. I think I was stuck at the outer periphery of the small inner circle because I didn't realize the transformative power of capitalism beyond just a loan. Now I'm wondering if there should be another, smaller inner circle. It would indicate a difference between traditional stock market capital and Silicon Valley capital. That feels so different to me. Then I heard a statement on Diamond's podcast Moonshots. It was to the effect that Elon Musk is in the unique position of having unlimited capital because of his repeated success. Every idea of his is oversubscribed with capital. Everyone will bet on it. Another circle, or will he remain a point and eventually merge into the circle when he proves human? Signed KC, end of letter.
Speaker 1:Well, kc, I think you're right and it hadn't struck me. It's quite possible that instead of just having an inner circle could make that continuous. And so do it with the darkness of the color. I think I had made the innermost circle red. It could be pink in the outside and then get redder and redder as you get closer to the center. I like the idea of it being more red, because that's a thumb in the eye of Karl Marx, of course. But there are gradations and nearer and nearer the center of the circle, then, yes, right or wrong, there are some people that can raise money just by saying I'd like to try to do this, and people can move in and out of that gradation. So I think that's a terrific idea. I'm going to use that. So thanks, casey.
Speaker 1:The Book of the Month is by Musa Al-Gharbi. So thanks, casey. The book of the month is by Musa Algarbi. Book is We've Never Been Woke, 2024, princeton University Press. Algarbi's analysis focuses on symbolic capital and the importance of those who try to use such capital to make themselves powerful. It's quite close to Hayek's notion of second-hand dealers in ideas. Algarbi's book is a great read. Not sure it's entirely correct, but it's certainly not entirely wrong. Well, the next episode will be an introduction to book two of Adam Smith's Wealth of Nations. Talk to you next time on Tidy C.