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Kenny Polcari Discusses How Major Events Can Affect Capital Markets

by | Aug 29, 2016 | PKF Texas - The Entrepreneur's Playbook®

https://vimeo.com/180182527

Russ: This is the PKF Texas Entrepreneur’s Playbook. I am Russ Capper, this week’s guest host, and I’m here with Kenny Polcari, Managing Director of Equities at O’Neil Securities and a Market Analyst at CNBC. Kenny, welcome to the Playbook.

Kenny: Thank you for having me.

Russ: You bet. So you probably feel like you’ve hit the big time now, you’re on the Entrepreneur’s Playbook.

Kenny: It’s been great.

Russ: So you’ve been trading equities for quite some time?

Kenny: 35 years but we don’t have to tell anybody.

Russ: Ok, we won’t, but it’s changed a little bit over that period of time.

Kenny: You think? It’s changed just a bit. I mean listen, I came to this industry in 1980 as a 19 year old kid in college. I started on the floor of the New York Stock Exchange where it was dynamic, it was energetic, there were 5500 type A personalities in the room; it’s what really gave the market its personality. I had no idea what the New York Stock Exchange was, I was a kid from Boston and I had this opportunity when I was in college to go there and spend the summer as an intern and so I did. I was there for a couple of weeks and it just bit me on the backside and I couldn’t stand it anymore so I spent that summer and I went back every summer until I graduated.

And then upon graduation I moved to New York in the summer of 1983 for what I really thought was going to be kind of a 2 or 3 year stint then I’d pack up, move back to Boston and get a job around home. I’m the middle of 5 kids from a Boston Italian family, Italian mothers are this right, and 35 years later my life just happened. And I’m still in New York; I’m still on the New York Stock Exchange although the change over the 35 years has been tremendous in fact.

Russ: Well you still seem to be very passionate about it.

Kenny: Because I love the business; I just so love the business, it’s just different and I’ve learned to adapt and change certainly over that time but more so over the last decade – that last 10 or 12 years – where there’s been phenomenal change almost daily. From the 80s and 90s it was a slow change, right? Certainly you didn’t have the automation, you didn’t have the technology; you didn’t have the change in rule set and so therefore we’d trade it in fraction of a dollar, it was open outcry, as so therefore the change happened slowly.

After the turn of the century and decimalization and sub-decimalization then the change started to happen faster. And then the events of 9/11 completely changed the narrative in the industry and a lot of people really don’t understand.

Russ: What was it about 9/11?

Kenny: It’s really tremendous, when you thing about what happened that day the Trade Centers were just 3 blocks away from the exchange and when that happened the exchange had become so automated and there was so much technology running the exchange that the cable wires and the fiber optic cables and the computer lines – not only for the exchange but for really lower Manhattan – all ran through the belly of the Trade Centers. And so on that day when the Trade Centers collapsed all the lines got cut and so therefore the southern tip of Manhattan was really plunged into darkness – darkness in terms of automations and connectivity to the world, not the lights necessarily.

And so the exchange was plunged into darkness and so if you remember the exchange had not opened for 6 days because they couldn’t – not because the building was damaged but because the infrastructure was damaged and so the country came to a standstill. The country came to a screeching halt, global finance came to a screeching halt and even though markets traded in Asia and Europe the U.S. is the biggest cog in that wheel and money moves around the world. It starts in Asia, goes to Europe, comes to New York, goes back to Asia and so it’s constantly moving, and for those 6 days that the money couldn’t come here people couldn’t – companies couldn’t transact, people couldn’t transact; money didn’t move around, it created a sense of fear in the marketplace.

And so what it did was it really changed the narrative because nobody in their right mind could have imagined that kind of event. There was no backup plan for that event. And so that event then caused the industry – really the country – to think about ok, the world is a different place now and so what do we do? How do we use technology to create security and stability versus just creating efficiency, which is where technology was going?

Russ: That’s right.

Kenny: And so as a result of that event the ripples effects continue to be felt even 15 years later in terms of the role that technology plays, how it plays it, the market structure we have – it’s very fragmented today and fractured. The New York Stock Exchange is no longer the central marketplace clearly because had they flown a plane into that building on that day… Listen, those 5500 people went to that building that day every single day and made the very core of capitalism work.

Russ: Right.

Kenny: And so if they had flown a plane into that building and knocked that building out and knocked all those people out this country would have been brought to her knees for a whole lot longer than the 6 days that we were out. And so therefore that realization has now caused a massive mind shift, not only in the U.S. capital markets but really global capital markets because other nations looked as saw what happened and realized what are we going to do? How do we protect our capital markets? And so the role that technology plays today is so much different then I think even originally envisioned, but I’ve managed to change with it and stay on with it. But today from the 5500 people there’s less than 300 people that work actually on the floor of the New York Stock Exchange.

Russ: But the biggest thing has been sort of the decentralization, right?

Kenny: The massive decentralization and so I would call it – it’s been a fragmentation or a fracturing of the marketplace because there are now 10 exchanges, the New York Stock Exchange being the original and physical exchange, the other 9 are virtual; they trade in the Cloud. You can’t visit them, you can’t see them; they don’t exist anywhere. The servers that run those exchanges are located all over the country in the event that they start to blow up Manhattan. Once again it’s a tragedy, I get it, but they won’t bring the country to her knees anymore because these other servers are located all over the country. Now, if they start blowing up the whole country that’s a different issue but then you’re not really worried about what GE and Johnson & Johnson is doing.

Russ: That’s true. So when you talk about technology being so involved and intertwined I think of all this high frequency trading that takes place. I mean that’s still relatively new and different.

Kenny: Well it was an industry that was born out of the technology. It was certainly an industry that was born out of – it was going to happen pre 9/11 as we went through the turn of century and went from fractions to decimalizations, which was the first major shift in the U.S. market structure – you could see the role that technology was going to play and the way that brokers now interacted in the marketplace; we now have – someone went and handed me a tablet – the open outcry was going to die, now I have to do everything on a tablet.

And then we went from decimalization to sub-decimalization and so now there used to be 7 price points, then there were 100 price points, now there’s 1,000 price points between every full figure because it goes out to .0001 all the way up to .9999 and so that gave birth to an industry run by super computers known as high frequency trading where these super computers now scan the 10 exchanges plus the 50 or 60 different dark pools that exist looking for minute prices differences and they arbitrage those price differences. And you think it doesn’t mean anything, thousandths of a penny, but if you do it all day long it’s a $9 billion industry, it’s not going anywhere.

Russ: Tell us what a dark pool is.

Kenny: A dark pool is a venue, it is not an exchange and I think that is very important for people to understand. It’s not regulated like an exchange; it is a venue where you can trade stocks. They were also born out of the events of 9/11 – they may have been coming anyway but the events of 9/11 once again lit the fire under the backside and gave birth and rise to those venues. Now those venues are mostly owned by the big brokerage houses and they are venues; they are internalization engines.

So Goldman might have a buyer of Coke and a seller of Coke and so now what they can do is they can internalize those order flows and not expose it to the world and try to trade it just amongst themselves. I think it fractures the system, I think it actually weakens the system, but yet I also understand after the events of 9/11 why they came to be. But I think those events are well passed us now and so the industry really needs to take a look at them. But what they are, the dark pools are exactly that; they are venues where big banks internalize the order flow and don’t expose it to the world which I think weakens the system.

Russ: Also though when I think of the technology and high frequency trading I also think of this new exchange – I saw it on 60 Minutes I believe – IEX; tell us about that.

Kenny: So IEX is now an exchange, it was not an exchange when it first came to be. It was another venue – an alternative trading venue – that was born out of the need to try to level the playing field in terms of market structure and speed and the role that High Frequency Trading was taking, the role that computerization was taking in terms of the speed at which people could get to venues and they run ahead by millions of a second and get there faster and ahead of natural order flow and get in the way of it.

And so IEX, which was started by a young man named Brad Katsuyama, who was at the time at RBC – RBC really funded this idea – he decided that he was going to create this venue that forced everybody that came into it to hit a speed bump and so that everybody when you came in couldn’t be faster than the guy next to you; you hit the speed bump and then everybody proceeded at the same speed so therefore no one had the advantage. And so it got a lot of press, Michael Lewis wrote that book Flash Boys; the book itself is entertaining. I think the first part of the book talks about kind of why it was born and the technology that was happening in the world as a result of 9/11, all that is very good. The second half of the book I think gets a little – they stretch a little bit; might be entertaining but it’s not completely true.

So they started this venue, it got a lot of exposure as a result of that; a lot of institutions bought into it. Certainly the High Frequency traders weren’t buying into it because they were being halted. And so they weren’t big buyers of it but yet the institutions, the big asset managers, the big mutual funds, pension plans – they liked the idea because it did level the playing field. And so it did get a lot of support but it’s a process to become an exchange in this country and so it started as a venue. He started as a venue and they sold it and they sold it and they sold it and they lobbied down at the SEC to become an exchange so now they operate like an exchange, but yet they still have that speed bump which is their bug selling point. That’s what they say separates them from the crowd, that they try to make it a level playing field. The other exchanges as of yet have not adopted that mentality. Whether that happens now we’ll see.

Russ: Okay, but that’s his goal right?

Kenny: Well that is his goal. I mean his goal is to be one of the major exchanges in the country. Now you have to understand something, you go to their office at – I think they’re at 4 World Trade Center or 7 World trade Center – but you go up to their office on the 7th floor and it’s just one room with a bunch of computers in there and guys sitting around in jeans and Polo shirts just looking at their computers like this; there’s no noise, there’s no excitement. Quite honestly it’s very boring but yet it is the face of what the future looks like.

Russ: Okay, but the High Frequency traders don’t want to use that; don’t want it to happen at all.

Kenny: No, so the High Frequency traders don’t typically go there. So they’ll go to the other venues because don’t forget there are 10 other exchanges and there are 60 other venues that they can trade at. And so they don’t need to go to IEX and so therefore most of them don’t.

Russ: When you described the office of IEX and guys sitting around in jeans and stuff it reminds me of my little glimpse of High Frequency traders is that they don’t really hire traders, economists; they hire math people.

Kenny: They’re called Quants for Quantitative Analysts or they’re Physicists and Engineers. They are – I like to call them computer nerds because they are. They write code because trading today is not about supply and demand; it’s not so much about the fundamentals it’s about the speed at which you can get to that venue, it’s about the algorithm that you use, how aggressive, how passive or aggressive you want to be. Whether you want to buy or sell something over a period of the whole day – 6 hours – over a period of 2 hours; depending on the multiple strategies that you can execute and order, they’re all written in computer code. And so all the people today coming into this industry are mostly quant guys; they’re not economists or finance guys.

Russ: Real interesting, does that sort of disappoint you that it’s gone in that direction?

Kenny: Well of course it disappoints me because I’m a finance guy and I graduated college 33 years ago when it really meant something to be kind of a finance guy, be in the trading floor, and it was all about your ability not only to communicate but understand economic principle, supply and demand; how you represented your order, how aggressive and how aggressive your customer wanted to be, what was happening in the market – what was causing the markets to move. Today it’s very different because what’s causing the markets to move in the short term is the noise; it could be news on Twitter, it could be news on Facebook.

It could be a rumor that’s floating around and because a rumor floats around so quickly that these smart algorithms – again, they’re algorithms that are written, they’re called smart algorithms – and what they do is they scan these headlines all day long in all these multiple venues looking for words; positive words, negative words. So if the headline is positive they initiate automatic buy orders, if the headline is perceived as negative they initiate sell orders and so this is why you see the volatility in the market intraday like that, because it’s all the noise.

Russ: So does that make you feel like you’re in one of these spaces that’s being disrupted?

Kenny: It’s not being, it is disrupted, right? It has been disrupted and so yes, I am in the thick of it, but I’ve managed to follow the disruption; to kind of change my business model. It doesn’t mean I’m necessarily thrilled about it because I think what happens now in the U.S. capital markets I think a lot of people on the outside view it more as a casino because it feels like that. And the last thing that the U.S. capital market should be is viewed as a casino because they’re a place where companies come to list their stock, to raise money, to create jobs. Investors can go and generate wealth for a lifetime. It shouldn’t be viewed – you want to go to a casino go to Vegas – and so it shouldn’t be viewed that way and my sense is that we, the industry, we’ve allowed it to get to that point by allowing the technology. But they say that technology is progress and they let that genie out of the bottle, you’re not going to put it back in.

Russ: So before I let you go, just an individual investor that’s trying to be in there for the long run like we’ve always done in the past, do you just go to eTrade or Schwab or something?

Kenny: Well it depends on who you are. It depends on the kind of assets you have; it depends on how much in terms of assets you have. You may be someone with a lot of assets that feels very comfortable and you understand the markets that you want to do it yourself you certainly stay at a place like eTrade or Fidelity and do it yourself. You may be somebody else that doesn’t necessarily understand it and wants the guidance of a broker and so you may go then – that’s a kind of personal preference in terms of how you do it. But I think as a long term investor what you need to eliminate and focus – you need to eliminate the daily noise and you need to focus on the long play. You can’t listen to the stock market goes up 50 points and down 50 point every day because you’ll drive yourself crazy. You can’t keep looking at your statement every night going oh my God, I made $1,000.00, I lost $1,000.00; you’ll make yourself nuts.

You have to focus on the long term and what the plan is and as long as the plan is good and solid that’s what the individual investor should focus on.

Russ: Kenny, I really appreciate you bringing us up to date on this.

Kenny: Well you’re very welcome, it was my pleasure.

Russ: You bet, you bet.

Kenny: I should come back and do this again.

Russ: You should for sure. All right, that wraps up my discussion with Kenny Polcari, Managing Director of Equities at O’Neil Securities. And that wraps up this episode of PKF Texas Entrepreneur’s Playbook.

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