High Frequency Trading: Should it remain legal in our financial markets?

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Introduction

The evolution of markets has brought a significant set of investors and traders along with it; new technologies allow agents to harness an advantage over each other in order to make more profits. One increasingly controversial methodology is the use of algorithms and its extensive application in high frequency trading. Simply put, high frequency trading (HFT) is the process of transmitting trading orders in large quantities at rapid speeds (Smith, 2015). Essentially, the use of these algorithms strips the human intervention on orders in the markets and allows trades to be placed at speeds unmatched by investors acting manually. ’ recent book : A Wall Street Revolt has brought HFT into widespread public knowledge (Hull, 2014), and thus stirred controversies and has given rise to opposition from non-HFT investors, and regulators

(Securities Exchange Commission, Ontario Securities Commission, etc.). HFT firms and advocates are now on the defensive, and their arguments for benefits of HFT have been tested and evaluated numerous times through research and studies. After the Flash

Crash of May 2010, regulators have come under scrutiny for their failures to properly assert HFT regulations, on whom the SEC officially placed the blame on through a published report in June 2010. The report also highlighted the need for regulators to extend their regulatory duties to this mysterious and unregulated segment of the market

(Serritella, 2010).

HFT firms claim they provide benefits to the market, but opposition argues that their disadvantages (some allegedly illegal) far outweigh these benefits and therefore

HFT should be banned from the financial markets. The benefits they claim to provide are; liquidity in the financial markets, lower bid-ask spreads for certain securities, and lower

Nigam,3 price volatility in the overall financial market (High Frequency Trading: Emergence and

Evolution of High Frequency Trading, 2012). Through the use of topics in law and economics, such as; the principal-agency problem, externalities, normative Hobbes theorem, moral hazard, and others, we will go through some arguments against HFTs. I also present some arguments which defend HFTs to conclude whether or not it should be legal in our financial markets, and what the future might hold for this trading methodology and its interaction with the market.

Arguments against HFT

The most common stance against HFT by non-HFT investors has been, and still is the use of front running (Mckenna, Marketwatch, 2015). Front running is the act of using non-public material information to execute a trade in a professional account before a client’s account, and is deemed illegal in the financial markets. I believe this statement, or rather the term, is wrongfully prescribed to HFT as they have no clients and act solely as agents of their own assets. What actually happens is that HFT access price affecting information much faster than other players in the market and the execution of a trade based on this information is not front running, it is called flash trading, a major difference

(because unlike front running, flash trading is predatory but legal) (Bogoslaw, 2009). HFT traders acquire information with the use of extremely fast networks that are connected to an exchange’s data centre (for example; NYSE, or the CME). The cost to build a fast network with the use of the latest technology is not a small cost by any means, and can cost hundreds of millions of dollars (depending on the distance between the firm’s data centre and the ) (Philips, Bloomberg Technology, 2012). For non-HFT investors, it would be in their best interests to file a class action lawsuit against an HFT

Nigam,4 firm, this would make it relatively cheaper for the individual investors to file a claim (using economies of scale). A strong basis of the lawsuit would be the violation of the SEC rules and contract that HFTs have presumably agreed to follow when they establish themselves and participate in the financial market(s). However, previous attempts of class action lawsuits have been dismissed by federal courts because of lack of evidence provided by the investors that they were being defrauded on trades by HFTs, this case was based on

Michael Lewis’ book (Rohan & Conner, 2016).

Despite the difference between front running and flash trading, retail investors are still up in arms with regulatory authorities which allow HFT firms participate in the financial markets, in fact, Italy is the only country in the world where HFT firms are taxed, in an effort to reduce this practice (Stafford, 2013). Non-HFT investors allude to the fact that

HFT firms are in a way, trading predatorily in the markets, by snatching up orders before the bulk of the investors get there first. The speed advantage that HFTs have allows them to bid up prices of securities in different equity exchanges by miniscule amounts. This process of buying and selling in the exchange leads to a strategy used by HFTs known as latency arbitrage. Latency arbitrage is when a firm uses the time discrepancies between market orders on different exchanges to buy stock at a lower cost and then sell them for slightly more (sometimes by just a cent) to institutional firms that have placed

“buy” orders in the market before the HFT, and process the opposite for a “sell” order.

The HFT firms anticipate these orders by what is known as pinging, which basically allows the HFT firms to decipher what institutional traders are buying or selling in large orders and at what price (Scopino, 2015). Pinging is the process of sending multiple lots of orders

(100 shares) at different prices into an exchange only to cancel it once they are notified if

Nigam,5 one price they placed the order at has interested the opposite party of the transaction, the remaining lots of orders with different prices are cancelled fairly quickly. A large order is dispersed to be filled at different exchanges, and the difference in time that it takes for an order to reach each exchange is all the time that is needed for HFT to use latency arbitrage to profit. For example, let’s say that an institutional investor places an order to buy 100000 of XYZ stock to exchange 1 (ex. NYSE). But at exchange 1 there were only

45000 shares that could be bought at the price the investor ordered them at. The remainder of the order goes to different exchanges to continue the purchase of 55000

XYZ stocks that are needed to complete the investors order. Through the use of pinging,

HFT see that 45000 stocks of XYZ were bought at $X at exchange 1 and quickly race to other exchanges to buy more of stock $XYZ at price $X. When the slower technology- equipped order from the institutional investor arrives at the other exchange(s), the HFT firms sell the XYZ stock at $X plus additional cents on the dollar. This time discrepancy allows for a risk free trade for the HFT firms. The process of pinging has been studied and is considered a manipulative practise (Scopino, 2015). The intention of sending in an order of a security just to cancel the order can affect prices of the security while signalling false information to other investors in the market. HFTs can alter the prices through this practise in their favour and thus profit with virtually no risk. As for latency arbitrage, this practise is not considered illegal in the financial markets but is controversial. It allocates the distribution of wealth by extracting income from the non-HFT investors and transferring it to HFT firms. In this scenario, the non-HFT firms are directly financially injured by the practises of HFT firms, and they do not gain anything from it.

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Apart from competing against non HFT firms, HFT firms also compete grudgingly against each other. The race to harness information from the exchange nanoseconds earlier is done through what is known as colocation. Colocation is a method used by HFT firms to situate their trading servers as close as possible to the exchange on which they wish to trade from. This is because the closer they are to the trading data centre, the faster their speed advantage will be over other investors, leading to better margins for latency arbitrage. Frequently, HFT firms are able to colocate their equipment inside the actual exchange, for large fees to the exchange. Most investors are excluded from this transaction because of the very high cost of colocation. For this reason, investors complain that HFT firms are essentially buying their rights to arbitrage, an economic phenomenon with compensation that should be awarded to the most skilled players, and the method of fee-for-service colocation seems like a shortcut to the regular arbitration methods. The act of colocation does bring up some moral hazard on part of the exchange.

For one, the intricate “black boxes” that are colocated inside the exchange act as the data centres for the HFT firms, but they cannot be fully monitored by the exchange because of their complex structure. Essentially, the exchange cannot always know how these black boxes operate and whether they perform the actions they claim to perform (CBS, 2010).

If any monitoring method does exist, it comes at a cost to the exchange, which would be passed onto the HFTs collocating and thus would trickle down to non-HFT players, yet again. This private agreement between the exchange and the HFTs can also be dangerous if the agreement to cooperate fails. The normative Hobbes theorem states that the law should be designed to minimize the harm caused by failed private agreements.

Since even regulators do not know the full capabilities of HFT computers, it is hard to

Nigam,7 design law to adhere to the normative Hobbes theorem, let alone minimize the harm caused by a failed agreement. Just as the unpredictable Flash Crash of 2010, we cannot comprehend the damages caused by a possible failed agreement between an HFT and a financial exchange.

The opposition also argues that the securities exchange (ex. NYSE, TSX) is not performing its fiduciary duty to all market players by allowing HFT firms to operate on their exchanges. The basis of the argument is evident in one of the stipulations in the contract of a listing agreement for the NYSE which states that a “fair marketplace for all players” is what is to be expected of the exchange (NYSE IPO Guide, 2013). If the plaintiff is able to prescribe an appropriate definition to “fair marketplace” and prove that the presence of

HFT firms make it unfair, they have reasonable grounds for claiming negligence and or breach of duty by the financial exchanges. Although if breach of duty were the grounds for legal action, a standard care of precaution by the exchange would then have to be established as well. These processes and transaction costs (price of discovery, exchange of information between lawyers) are apparent reasons that non-HFT firms and players hesitate pursing legal action against HFT firms individually. Rather these investors may find it beneficial to point out enough evidence for regulatory authorities to take further action (as SEC has done after the release of Flash Boys, 2014) as it would be part of the authority’s obligatory duty to investigate. Eric Hunsader, CEO of Nanex LLC conducted his own research after the Flash Crash and found that the NYSE had violated SEC rules by sending out data to its proprietary feed and public feed at different times. His research led to an investigation by the SEC and resulted in a fine of $5 million to the NYSE

(Mckenna, Marketwatch, 2016).

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Even after all the studies that have been conducted on HFTs, they still present a realm of unknown attributes that has not been comprehended yet. Since the SEC had focused mostly on manual trading and some forms of computerized trading, it has lagged in terms of regulation of the far more advanced , especially HFT. In other words, they were not fully capable of regulating HFT firms until after the Flash Crash of May 2010 forced them to do so, and still lack considerably. This is also a problem, because without proper regulation, it is hard to determine the faults and cracks that were, and still may be present with HFT. Another reason to add regulation is to estimate expectation damages; what can go wrong with an HFT, and if it does, what will the damage be, how much will it cost, and who will bear the burden of these costs? The incomprehensible nature of HFT firms definitely invites much opposition, and from all fronts (market players, market regulators, etc.). During the Flash Crash of May 10, 2010; the DJIA, S&P, and other indexes crashed and fell several thousand basis points

(aggregate) when an order was placed by a mutual fund to sell off $4.1 billion of E-Mini

S&P contracts (Treanor, 2015). As mentioned, the official report of the Flash Crash, which was released in June 2010, placed the blame of this bizarre and unprecedented behavior in the hands of HFT. Additionally, the report stated that HFT firms then pulled their capital and their orders out from the market in order to prevent further losses (to themselves)

(Philips, Bloomberg, 2013), a time when liquidity must have been of high demand. Now, consider the fact that equity exchanges provide HFT firms with liquidity rebates

(PricewaterhouseCoopers, 2015), which is compensation for providing liquidity in the financial market(s). If a contract was in place at the time of the Flash Crash, the respective exchanges would be able to seek damages from HFTs, not only would the threat of legal

Nigam,9 action deter other HFTs from pursing the same strategy under a similar scenario, it would also help negate the economic effects these type of events would have on other investors.

We can use Gary Becker’s (Cooter & Ulen, 2011) model to gauge what the effects of these events might be. If a legal battle were to ensue, and HFT firms were found guilty, this would establish a sense of crime deterrence, and lead to the two effects stated above.

The regulatory authority would play the role of applying extra policing resources (through regulation, fines, etc.) in addition to the crime deterrence as well.

Aside from allowing latency arbitrage, alleged front running, and lightly regulated practise, the exchanges in fact earn revenue by allowing HFT firms to trade on their exchange. This is when colocation comes into the picture again. On the NYSE, the fee is said to be $30000 a month, and in exchange for this fee, the HFT firms gain the ability to access market information faster than others. The first and foremost idea that comes to mind is the conflict of interest in which the exchange has many clients but discriminates the speed of access to its’ information based on monetary exchanges. In essence, it could be said that the exchange has used discriminatory pricing in order to reap benefits from its users, and the fact that exchanges are for-profit organizations does not help this situation either in terms of the regular investor’s perception. Ideally, the exchange(s) will act as any profit maximizing firm as simple economic theory suggests and look for ways to increase profits, but this comes at the cost of their other consumers (non-HFT investors).

As mentioned before, HFT firms pay a high fee (not only to exchanges, but also to laborers) to construct their networks and connect to exchanges to shave milliseconds off of their trades. This race against time is a form of competition and innovation in the HFT

Nigam,10 industry, an industry that just has a far simpler and better way of making money than non-

HFT players. If the business model allows HFTs to remain profitable and encourage innovation in the markets, they should be able to use this model to generate profits. The number of middle class workers employed by large HFTs to construct their networks exceeds the thousands (over the past decades) and can be seen as a consumer surplus in the employment spectrum. There have been accusations of HFTs hurting others in the market by explicit price manipulations (unlike pinging where price manipulation was a by- product of the practices of HFTs) (Geiger & Mamudi , 2014), but studies have debunked this allegation. Other than that, HFTs are not really hurting any players in the market, rather they increase liquidity and efficiencies in the markets.

There are HFTs that have reported profits for consecutive months at a time, that is, making a net profit every day for a few months (CBS, 2010). This is (or has been) unheard of in the investment industry, and the implication is that HFT traders are not traders, but cheaters. To be “correct” about trades at such a high rate is unfathomable by traditional investors (buy and hold, short, etc.), and the fact that HFTs are able to accommodate these profits without fundamental research without consequences changes the perception for non-HFT players in the market to one that is in favor of HFT firms.

Apart from non-HFT institutional investors, there are other externalities that result from the presence of HFTs in the financial market. Retail and small (mom and pop) investors have come to a certain understanding of HFT firms from the acclaimed Michael

Lewis’ book. Lewis explains that HFT firms are a source of markets being rigged in favor of the bigger players, and that mom and pop investors are losing out to these bigger

Nigam,11 players (Lewis, 2014). This drawdown of investment from the markets hurts not only the mom and pop investors, but also all financial intermediaries that manage their money through the markets, as well as firms in need of capital. Mutual funds, pension funds, trust funds and others report that smaller investors do not trust the market as much as they did before because they feel that they are being cheated (Schack, 2013), and therefore instruct their money managers to invest in other assets. As for the firms, especially new firms considering IPOs, it is harder to gain the trust of investors on a wide scale

(institutional, retail, mom and pop) because of the changed perception of the financial markets. This hinders the possibility of an IPO being as successful as it could have been, or for a well-established firm; the probability of new shares being distributed at a fair price.

Essentially, the prices of securities would be discounted in general (for overvalued, and undervalued securities). This is undesirable for undervalued securities, because their prices will be discounted even further than the value that is already established in the financial markets.

A different perspective to look at the externalities of the actions of HFT is the relationship between the institutional investor and their client(s) that incur losses from latency arbitrage conducted by HFT. When clients invest their money with said investors, they are guaranteed fair market prices, and best execution of orders in their account(s).

However, because of latency arbitrage, the best execution price is not possible for securities which are exposed to HFT arbitrage. The client may have the substantial evidence to prove that the institutional investor is not fulfilling its fiduciary duty and performance according to contracts signed in the opening of an account with the incumbent’s firm. The principal-agency problem models this exact relationship, and the

Nigam,12 problem of moral hazard (through the investor not taking precaution on trading securities exposed to HFT) is evident and can be significant if a good portion of equities in a client’s portfolio are affected of latency arbitrage.

Defending HFT Trading

HFT firms gained traction in the markets at the beginning of the 21st century, and at first transacted 10% of the orders in the markets. Fast forward to today and that percentage has grown to about 65%, even though they encompass less than 20% of the investment firms in the market.

So why, or how can HFT traders be good for the market? Despite the “flaws” described previously, HFTs provide a variety of sources that are valuable to investors across all levels in the financial markets. The main advantage HFT provides is liquidity, using high volume and frequency to buy or sell securities that there is a demand for in the market. HFTs act as market makers and fill orders when they see an opportunity, but other investors have problems with how HFTs fulfill these orders (latency arbitrage). We can say the by-product of the HFTs actions are good and valuable to investors, but the main purpose of their business is frowned upon in the markets.

HFT firms also provide investors with price efficiencies, through the result of lowering bid-ask spreads on securities they trade in. Lower bid-ask spreads make it cheaper for investors to trade securities, but again the problem arises when we look at the method HFT firms use to do this. HFTs have been accused of shaving some cents off of these spreads and pocketing them. At the end, the non HFT investor would have been

Nigam,13 able to buy or sell the security for 2 cents cheaper, but the HFT pockets 1 cent so now it is only 1 cent cheaper, but cheaper nonetheless.

There are certain legal problems that arise when talking about HFT methodology.

The first obvious one is the problem of front running, or the alternative term flash trading.

As previously mentioned, HFT firms use pinging to decipher what price of a security would be efficient to buy or sell at. When they find out this price, the algorithms put in orders to buy all available stocks of this security, then send out an order to sell these securities at another exchange with a higher price. The small benefits add up and can accrue millions of dollars in profits per year, if not more. To use a good analogy, imagine that you are shopping and see an item you would like to purchase but wait for it to go on sale, but there are “scalpers” (HFT) that pay the store to find out what the sale price of this item will be. As soon as the item goes on sale, those scalpers buy the item for $X and sell it to you for $X plus an additional dollar amount (fractional). Even though you purchased the item, and may have got it on sale, you did not get the best price that it was offered for by the principal. Now imagine the same process happening simultaneously to thousands of people in thousands of locations. This example is a simplified resemblance of how HFTs, non-HFT, and financial exchanges interact in the market, and the profits (although miniscule per security/good) shave off valuable savings from other investors, which go directly into the pockets of the HFTs engaging in the said securities. This type of

“predatory trading” resembles the distribution of income being unfairly adjusted for the non-HFT investors.

Economic principles

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Given the currents state of the financial markets, I suggest that we are in a Pareto efficient market. Pareto efficiency states that the markets are allocative efficient if no player can improve their position in the market without worsening the position of another.

If we eliminate HFT players in the market, the bid-ask spreads would rise for many investors participating in markets in which there were HFTs. If HFT players persist, latency arbitrage still will exist but so will liquidity and lower bid/ask spreads. To go in any one of these directions, another player in the market will be made worse off, therefore economic theory suggests that we are in a Pareto optimal state in the markets. However, the possible introduction of regulations may change this status in the coming years.

Robert Cooter’s book states an important part of information economics; “An economic innovation provides a better way to make something or something better to make” (Cooter & Ulen, 2011, p. 113). A better way to make something lowers the cost of production and increases the supply of this good, and therefore decreases the price of this good in the market. HFT is that type of innovation, which has provided a better way of transacting orders in our financial markets, therefore cutting costs, increasing the supply of trades and lowering the price the consumer pays for the trades to be made. A simple diagram below shows us the additional consumer surplus in the market because of lower prices and higher quantities that are potential outcomes of a higher supply of

Nigam,15 trades:

S S’

Price of Trades +Consumer Surplus (Bid/ask)

D

Quantity of Trades

Using simple economic theory, it is easy to see why some non-HFT investors do not oppose HFT practises, it is because they gain consumer surplus (below the original price in blue dotted area) and access to lower spreads and the investors that do oppose

HFTs weigh their disadvantages more than their advantages. But as we saw earlier, there is a loss of consumer surplus through the practise of latency arbitrage. To determine the net gain or loss, we would have to figure out which effect is more significant and whether the existence of HFTs benefits the consumer overall.

Another simple economic theory we can use to dissect the long-term impact of

HFTs stems from competitive and absolute advantage. As of now, all HFT firms have absolute advantage against non-HFT firms. The excessive profit margin attracts new

Nigam,16 players into the HFT market, and doing so increases the supply of HFT firms. As the number of suppliers increases, the profit margins will decline. This has already been occurring over the past few years as evident by the lower profit margins of current HFT firms. This effect has the potential to make all HFT firms become marginally profitable in a few years, if not earlier. This undesired profit level will cause more innovation, one that will hopefully be less controversial in the financial market(s) and encompass more profits for the pioneers of said innovation. But as we progress now, the emergence of more HFTs will cause more upheaval in the financial markets until a strong approach is taken up by the regulators.

Based on the research that has already been done on HFT and their practises, I believe a reform in the financial markets is required. Although, I believe HFT firms will still persist at a steady rate, the widespread opposition cannot go unheard by the regulators.

Alternatives have already been introduced and initiated in hopes of limiting the effects of

HFT practises. Eric Budish, Peter Crampton, and John Shim suggested the use of frequent batch auctions (Budish, Crampton, & Shim, 2015), which changes the continuous time frame of trading to discrete intervals, thus reducing the latency that HFT firms gain from speed advantage and the amount of times they would be able to use this strategy. A whole new equity exchange has been introduced to limit the effects of HFT; it is the IEX (The Investors Exchange) platform, founded by the acclaimed protagonist of

Lewis’ Flash Boys; Brad Katsuyama (Schmidt & Michaels, 2016). IEX already accommodates 1.54% (IEX, 2016) of the market share of trades that are conducted in the market, proving that there are investors that value the service and mandate of limiting

HFT practises. The benefits provided by HFTs cannot go unnoticed either, for this reason

Nigam,17 it is highly possible that HFT remain legal, but only with the addition of regulations. As for the HFT firms, their industry is declining along with their profit margins, and with the possible introduction of market regulation and other ATS (alternative trading systems) like

IEX, these profit margins would decline even further and discourage others to launch more HFT firms. In a few years, it is possible that we may have a monopoly of HFT firms that accommodate trades in all of our markets with regulation enforced by authorities, but until then we have to accept being the turtles in the race.

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