The Private Equity for Families Blog

The Illusion of Liquidity

The public market meltdown that started last Friday and continued into Monday morning was met with expected bullish and bearish commentary. What was new for me was the New York Stock Exchange announcing that it would impose “time outs” if the meltdown exceeded certain benchmarks. Those “circuit breaker” benchmarks were revised in May 2012 by lowering the panic thresholds and switching the measuring index from DJIA to S&P 500. The Bloomberg news announcement follows:

If losses in the U.S. stock market worsen, keep in mind there might be a 15-minute break.

The New York Stock Exchange said it will halt trading for 15 minutes if the Standard & Poor’s 500 Index drops 7 percent.

The stock exchange will pause trading if the benchmark for U.S. equities slumps to 1,832.92 before 3:25 p.m. New York time, Sara Rich, a NYSE spokeswoman said in an e-mail.

The S&P 500 slid 3.9 percent to 1,894.93 at 9:42 a.m. in New York as markets were convulsed by a surge in selling.

Trading will stop for a second time if the gauge extends its losses to 13 percent before 3:25 p.m. If the plunge reaches 20 percent at any point during today’s session, NYSE will shut the market for the rest of the day.

Even though I have a vague recollection of circuit breakers imposed after the 1987 ‘Black Monday” crash, I cannot recall the New York Stock Exchange ever preconditioning trading hours for steep losses in the S&P 500? In fact, there have been two such interventions-one in 2008 and one in 2010. There have also been times when trading in a stock or exchange is suspended because of a technical glitch or illegal manipulation, but I have never seen a preannounced set of recesses and then a shut down if losses exceed 20%. Here is a summary of the rule now in effect:

In conjunction with all U.S. equity exchanges, the NASDAQ Stock Markets filed a rule change with the Securities and Exchange Commission (SEC) to modify the existing Market-Wide Circuit Breakers (MWCB) in order to address extraordinary market volatility. When triggered, these circuit breakers halt trading in all exchange listed securities throughout the U.S. markets. The rule was approved on May 31, 2012. This revised rule made a reduction in the market declines percentages threshold necessary to trigger a circuit from 10, 20 and 30 percent to 7, 13 and 20 percent from the previous day’s close. It shortened the duration of the halts from 30, 60 or 120 minutes to 15 minutes. Finally, the revision changed the pricing reference to measure the market decline from the DJIA to the S&P 500 Index.

In my opinion, these circuit breakers defeat the whole concept of a market and access to liquidity. Are we entering a new phase of public markets where the bidders can only sell off the market until certain benchmarks are met? The unintended consequences are what scare me? Will this guide short sellers to cover early because a “time out” might rob them of the opportunity to let their profits run? What does a 15 minute delay do for unfilled orders? What does the prospect of a shutdown do for potential sellers who might fear no liquidity when they need the cash today?

The reason I like the Private Equity asset class at moments like this is valuation stability. My private investment in a motor business, automotive supplier, aerospace equipment business or precision machining shop is worth the same today as it will be tomorrow. What someone will pay for it in a full sale process may change (and I may hold rather than sell low) but its fundamental worth as a store of value does not change. It seems like the stock market is now beginning to offer a different value proposition: My stock is worth only what I can trade it for when the market is operating.  Since it only represents an infinitesimal minority ownership and a digital entry on the books of the Depositary Trust Company, its worth relies entirely on participants’ confidence in the marketplace where it trades. If you start conditioning liquidity and people understand what it means, I wonder whether that marketplace will continue to attract the same group of participants?

The one way nature of these time-outs bothers me too. I did not observe NYSE preannouncing trading suspensions or shut downs when Quantitative Easing was in full bloom and Central Bank “money printing” was finding its way into the S&P 500. The credibility of a market that has unlimited liquidity  going up but regulated liquidity when the markets are going down is not a real market and certainly not the public equity market I have watched for most of my life. I simply cannot understand how the mutual fund industry can deal with this regulated approach unless it responds by imposing “gates” like those being implemented for certain “non-governmental” money market funds? All I know is that the rules are increasingly complex and rigged in favor of those sophisticated participants on the inside.

It is also no coincidence that after the NYSE announcement, the markets rebounded. Were the shorts covering because they feared suspension or shut down? All I know is that the market is being conditioned under the guise of “safety and soundness”. The more fundamental question is whose safety and soundness is the NYSE really looking after?

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Rob McCreary

Rob McCreary has more than 40 years of transactional experience as an attorney, investment banker and private equity fund manager, and has spent his career in building entrepreneurial organizations with successful track records Founder and chairman of CapitalWorks, he is responsible for developing and maintaining senior relationships with investors and portfolio governance.

This blog represents the views of Rob McCreary and do not reflect those of CapitalWorks or its employees. This blog is not intended as investment advice. Any discussion of a specific security is for illustrative purposes only and should not be relied upon as indicative of such security’s current or future value. Readers should consult with their own financial advisors before making an investment decision.

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