By Phil Mackintosh, Senior Economist, Nasdaq
As summer starts, we thought it was a perfect time to update our “Intern’s Guide to the Market Structure Galaxy.” This short introduction has plenty of links for interns looking to take a deeper dive into the topics mentioned.
Today we focus on market participants, IPOs, the rise of retail and automation. We also explain some of the core concepts about how markets work. Stay tuned for an “intern’s guide to trading” in the coming weeks.
Again, for those who have worked in the market for years, sit back, relax and enjoy the refresher—you never know when an intern might ask a question about the basics.
The markets are an ecosystem
All markets have a pretty simple underlying purpose: to bring together buyers and sellers.
Stock markets are a little different though, as they also provide issuers with efficient capital and investors with liquidity and income.
Modern markets have evolved into an ecosystem of specialized participants, each playing a different but important role in primary (IPO) and secondary (trading) markets.
Chart 1: The stock market ecosystem
Getting to the heart of the issuer
Issuers are critical to public markets. Without issuers joining public markets, there would be fewer companies to invest in, fewer dividends for investors and fewer securities to hedge and trade.
Public markets provide more listing standards, and SEC rules require corporate accountability via quarterly accounting statements and other disclosures. That tends to make public markets more transparent and relatively safer for investors. Because of that, most mutual funds are limited to investing in so-called “listed” stocks.
Last year turned out to be a multi-decade record for IPOs, with over 470 new listings raising $155 billion.
Chart 2: The stock market participants and market shares
The day of an initial public offering (IPO) is important for a company and investors. Typically bringing a company public adds to liquidity, which can boost valuations (without daily trading, investors require an illiquidity premium). However, there is also significant uncertainty – about investor interest and growth expectations that affect actual valuations. Although the average company is waiting longer to come to market, many are still unprofitable, creating more risks around their growth prospects.
Despite that, and the volatility created by Covid-19 news, last year’s batch of IPOs performed well on their first day of trading, with over two-thirds gaining on their first day of trading, for an average return of around 38%.
Chart 3: First day returns for IPOs were also near a record in 2020
But Covid still had an impact, making it harder to do “roadshows,” where management visit potential investors before they place stock with them. As a result, we saw an increase in SPACs and other more direct exchange listings being adopted by companies.
In addition, U.S. equity markets aren’t alone. Our public markets have to compete with private markets, OTC markets (formerly including pink-sheet and bulletin board stocks) and international stock markets for listings.
That said, the U.S. stock market is the largest source of equity capital in the world, with $58 trillion of market cap and trading of around $450 billion each day.
Listing exchanges and other markets
Exchanges play a central role in stock markets, literally. They are (by law) open to everyone. Creating a “single market” for issuers, investors and liquidity providers allows companies, investors and traders to all interact at the same prices despite their different time horizons and trading signals. Exchanges, by making prices public, also create competition to be the best buyer or seller. That creates tighter spreads that not only reduce transaction costs but also form prices that everyone can use for portfolio valuation and to find new assets to buy or sell.
Only a few exchanges actually engage in IPOs and list stocks. Thanks to pro-competition rules, there are around a dozen exchanges that are just markets for trading.
All those exchanges also compete with dark pools (also called “ATS’s) and other broker execution facilities, all of which fill trades “off-exchange” and print trades to the tape via the Trade Reporting Facility (TRF).
Chart 4: The stock market participants and market shares
Source: Nasdaq Economic Research
In contrast, bond markets don’t have exchanges. In those markets, banks provide different quotes to different customers and traded prices and volumes are often never disclosed. That makes it harder for any participant to know if their bond trade was at a good price (or not).
Issuers need investors
In order to raise capital, issuers need to attract investors. Long-term investors come in two main flavors:
- mutual funds and pension funds (also called “institutional investors”) and
- retail investors (or “households” in Chart 5).
Data suggests they both have around the same amount of capital to invest (approximately $15 trillion each).
Chart 5: Who owns shares (based on year-end 2019 data)
During Covid, retail investors started to trade even more than usual, thanks to the introduction of commission-free trading and increased saving caused by stimulus checks and the inability to spend on services (like vacations and restaurant meals) while social distancing rules were in place. The increased retail activity in 2020 culminated in the hyperactive trading of “meme” stocks in 2021. That trading has set much of the incoming SEC’s agenda, with a renewed focus on lots of complex market structure topics to fix, like:
- Payment for Order Flow (PFOF)
- The NBBO, off-exchange trading, tick sizes, round lot sizes and how to measure best execution
- Gamification on trading apps
- The impact of social media, market manipulation and investor protection
- Short selling and short sell disclosures
- T+1 settlement
It’s important to remember though that meme stock trading is not being done by all retail investors. Data shows retail investors mostly trade infrequently and for very small values.
Chart 6: Retail trade sizes appear to be mostly very small
Shorter-term holders keep markets efficient
Other smaller owners of stocks include hedge funds, banks, market makers, arbitrageurs and foreign investors who hold U.S. stocks for investment, risk management or trading purposes. Although each of these participants has different objectives, they all play a critical role in keeping markets efficient and liquidity cheap. In aggregate, they also make up the majority of trading (Chart 7).
Banks have many direct relationships with issuers and mutual funds. They research and often lend to companies. They also execute trades for mutual funds. Many also sell structured products that then need to be hedged in the market too. So, they contribute to both capital formation and liquidity. Many banks also run their own ATS’s (Alternative Trading Systems, such as dark pools).
Market makers don’t hold stocks for long as their specialty is being both a buyer and seller at the same time. Creating a “two-sided market” in each stock ensures investors can trade regardless of whether they are looking to buy or sell.
Hedge funds and arbitrageurs, in contrast, tend to hold long and short positions at the same time. Their strategies often also keep stock pairs or ETFs and futures efficiently priced. That helps reduce costs when investors try to buy a single ticker, helping make relative valuations more efficient.
Chart 7: Investors have the majority of assets; intermediaries do the majority of trading
Although intermediaries don’t usually hold their positions for very long, their strategies help keep markets efficient. Research shows that futures and options track their underlying asset prices very well, and prices adjust within milliseconds.
Other research shows that ETFs trade in line with their portfolios’ net asset values even if the ETF doesn’t trade. In addition, many ETFs are actually cheaper to trade than their underlying stocks.
Research even shows that short sellers help keep markets efficient by adding sellers to overbought stocks that (typically) underperform the market.
Trading at the speed of light
Speaking of how fast markets correct for price inaccuracies, it hasn’t always been that way.
Over the years past 50 years, trading has gone from human speed to computer speed to the speed of light. Nasdaq, with its “automated quote” (the “AQ” in Nasdaq), led the way in bringing transparency and automation to all investors. It’s an interesting history.
Computerized trading has led to fewer manual errors, faster processing and cheaper trading.
It has also made trading faster. A lot faster. Consider that a human blink takes around a quarter of a second (that’s 250 milliseconds). Light travels around 100-times faster between all the stock trading venues, which are actually data centers located in New Jersey. Compiling a consolidated quote takes even less time (currently around 0.02 milliseconds, or 20 microseconds).
All of which is to say, arbitrage happens very quickly, and markets are very efficient.
Chart 8: Distances between trading centers at the speed of light
What’s next?
Arbitrage happens so quickly that the SEC has been spending a lot of the last few years trying to work out how to update regulations to fit the new, faster speeds.
But that’s a topic for later.
