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13 February 2012

U.S. Equities: State of the Industry 2012

An excerpt from Sussman's deep dive into the current state of the U.S. equity market. Includes some thoughts on the future of the business.

(The following is excerpted from the report US Equities State of the Industry 2012. For more information on the report, click here.)

The state of our industry is improving. The U.S. equity market is being viewed more as a savior and less as an albatross. Stock prices are stabilizing. Volatility is subsiding. Correlations are unwinding. But there are even more challenges ahead as we face the full impact of years of market evolution in a low volume environment.

One of those challenges is the constant barrage of finger-pointing as to what is causing equity markets to muddle through a weak economic recovery.

Let's just take ETFs for an example. I hear all sorts of perfectly reasonable people buy into the idea that ETFs are causing this tremendous increase in correlations over the last few years. But there is little real evidence to suggest that.

While I don't have a counter-evidence, this is clearly an example of where the one who lays the charges ought to carry the burden of proof. In terms of volumes, the ratio of U.S. single stock volume to ETFs with those positions has fallen since 2008, during which correlations have risen (see Exhibit 1). 

While there is much more work to be done, the U.S. equity capital market is still the most efficient and robust in the world today. Yes, there are economies that are growing faster. Yes, other markets are quickly catching up in terms of reducing the overall cost of trading. Yes, U.S. regulations are not currently optimized to support initial public offerings. But once you start digging into the details of how other markets operate, it becomes clear that the U.S. is still the standard. 

One of the more controversial and nuanced details of U.S. equity market structure is the recent market-wide adoption of single-stock circuit breakers. Swept into regulation on the back of the flash crash, single-stock circuit breakers have been accused of being a lazier substitution of limit up/limit down rules (not even allowing mispriced orders into the market).

But the fact that single-stock circuit breakers occur on a regular basis is often pointed to as evidence of flaws in market structure. Still, one could argue, based on data supplied by Credit Suisse, that since so many circuit breaker triggers are caused by news, these stocks would have suffered tremendous drops anyway and that, in fact, market structure is a tertiary factor (see Exhibit 2).

The combination of cheap beta, high correlations and market regulation that make it difficult to support less liquid stocks has left us with an overabundance of brokerage services.

We believe that in the next two years, the industry will look much different than it does now. The most vulnerable part of the market is the execution-only agency business model. As volumes have dropped, the execution-only component has been hit the hardest. But we believe 2012 will be the trough and the full report contains estimates for the entire U.S. equity commission business as well as the execution-only component (see Exhibit 3).

(Editor's note: To view a video with Adam discussing his report and some of the data, please click here.)

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