Illustration: Shoshana Gordon/Axios
At 9:30am on January 24, the world saw, briefly, just how fragile the stock market is. When it’s left to its own devices — which is, essentially, exactly what happened — prices in more than 25o stocks oscillated wildly, causing unacceptable and chaotic trades, many of which had to be torn up after the fact.
Why it matters: Stock auctions, like the ones held at 9:30am and 4:00pm every day, are a transparent and reliable form of price transparency. The continuous trading that happens between those hours, by contrast, is rife with illiquidity, flash crashes, and market manipulation.
- Without an opening auction to anchor prices, the market proves utterly rudderless.
The big picture: As Walter Mattli explains in his excellent book, “Darkness by Design,” the stock market has, since roughly 2005, become dominated by ruthless and highly profitable financial intermediaries — banks and high-frequency traders — who trade against large investors.
How it works: During the trading day, the stock market operates on a “continuous” basis, with the time between trades measured in microseconds. In such a system, it’s generally impossible to instantaneously match a natural buyer or seller with someone wanting to do the opposite trade. Instead, middlemen intermediate almost all of the trading.
- The exceptions to the rule are the opening and closing auctions, when trading can be done in size, and the high-frequency traders don’t have an edge.
Between the lines: There is no particularly good reason why stock markets need to trade continuously. Until March 2020, for instance, stocks listed on the Taiwan Stock Exchange traded in mini-auctions every five seconds.
- When Taiwan switched to continuous trading, the move increased both trading costs and adverse selection, according to a paper studying the changeover. It was unambiguously bad for investors.
- The exchange itself, however, saw higher volume, higher fees, and higher profits — which explains why it switched.
Reality check: It’s hard to see the U.S. moving to a system of “frequent batch auctions,” or discontinuous trading — no matter how much better that would be for investors — because such a move would be bad, financially, for the exchanges themselves.
- The events of last month, however, underscore that auctions are much more robust than continuous trading, and are much more efficient for the large investors — pension funds, insurers, and the like — who invest on behalf of everyday Americans.
The bottom line: America has too many stock exchanges — well over a dozen — and, as Mattli compellingly demonstrates, a set of toothless regulators who seem incapable of enforcing rules about what happens on them. (It’s been almost a decade since the most recent SEC action against the NYSE, and that was a hand-slap.)
- In an ideal world, there would be no continuous trading. A series of auctions would be much more effective at providing investors with the liquidity they need, without any bid-offer spread at all. They don’t even need to happen every five seconds; a handful of auctions per day would probably suffice.
Go deeper: My review-essay of Mattli’s book appeared in Foreign Affairs in 2019.