Yearly Archives: 2011

Why Vanguard Likes High Frequency Trading

Editorial Note: This Market Structure Map first ran June 29, 2010. It’s reprinting because Tim Quast is following the lead of congresspersons by taking a “fact-finding junket” aboard a sailing vessel off the coast of Belize. It’s in the public interest.

Oscar Wilde said that illusion is the first of all pleasures. Of course he also wrote that anyone who lives within his means suffers from a lack of imagination.

Buttressed on either side with those brackets about illusion and means, let’s look today at what’s afflicting our market and why some institutions like transient trading when others don’t.

Vanguard, an institutional investor focused on passively managed funds, supports high-frequency trading. George Sauter, CIO for the Vanguard Group, wrote in the firm’s comment letter to the SEC on market structure that high-frequency volumes reduce trading costs through competition and tighter spreads. He quantifies the benefit to investors at roughly 10% over a decade. A passive fund providing 9% returns per annum would deliver only 8% returns without HFT. (more…)

Arbitragers Love Monetary Intervention

Say you were playing poker.

I don’t mean gambling, but real cards. You’re engaged with some seriousness. You’re watching how you bet and when, reading the players ahead and after you.

Then The House starts doling out stacks of chips. Would you play more or less cautiously if you had free chips?

Apply this thinking to equity markets, IR folks. In trading data, we saw European money sweeping into US equities Nov 28. Why did markets trembling Nov 25 decide by the following Monday to up the ante in risk-taking? Primary dealers implementing policy for global central banks also drive most program-trading strategies.

Thus, European money surmised that central banks would intervene, and their behavior reflected it. The rest caught on, and markets soared Nov 30 on free chips from central banks. It was short-lived. By Dec 2, we saw institutions market-wide assaying portfolio risk and locking in higher derivatives insurance. The chips were gone.

Money sat back expectantly. On Dec 8, The House delivered chips as the European Central Bank lowered interest rates. That’s devaluing the euro. At first, cheapening the euro increases the value of the dollar – which lowers US stocks (a la Dec 8). But if you’d hedged with derivatives as most of the globe did, you bluffed The House. Plus, the Fed will likely have to follow Europe’s bet up with a see-and-raise to devalue the dollar back into line with the euro (expect it next week, but before options expirations).

In poker, having “the nuts” is holding the best cards, and knowing it. Central banks have given arbitragers the nuts. (more…)

A Rational View of Share Prices

Belated Happy Thanksgiving!

After breaking for a week as an act of giving thanks, we’re back. Karen and I joined 88,622 others in Aggieland at Kyle Field in College Station for the A&M football game last Thursday versus the Texas Longhorns. Disappointing outcome, great Thanksgiving.

There’s something special about Texas. People passing you on the street say hi and the kids say yes ma’am and yes sir. There’s a lot of what Kenny Chesney calls “the good stuff.” What may be the world’s greatest college bar, the Dixie Chicken, sits on the main College Station drag like an Old West saloon. Batwing doors, even.

Speaking of swinging doors, gyrations in markets make it awfully hard to use your stock price to measure investor sentiment (wasn’t that the idea behind exchanges?). In fact, there’s inherent contradiction between the way markets behave now and how the IR profession cultivates holders.

IR folks typically seek buy-and-hold money that does not trade. Yet executives frequently ask about the stock price. The news rushing at us round the clock tries to explain market behavior in rational terms. Yet stock prices are set by the latest fleeting bid or offer. Nine of ten times, those prices are not rational. (more…)

Public Companies, Pay Your Market-Makers

 Apparently, exchanges are not bastions of deep liquidity.

 In a bombshell dropped at a congressional hearing yesterday, top executives for the NYSE and the Nasdaq proposed – to borrow from humorist Dave Barry, we SWEAR we are not making this up – that you pay them fees, small-cap companies, which they will distribute to market-makers to incentivize trading in ETFs that trade your shares.

 Exchanges already incentivize most trades, but in the hundred most liquid names there’s great profit in the data off the consolidated tape. You small-caps offer no profit. So in addition to charging you listing fees, they now want to charge you market-making fees – but in the ETFs that hold your stocks.

 Congresspersons unfamiliar with how arbitrage works and how ETFs are principally one-day investment vehicles won’t see through this self-serving and patently ridiculous proposal. The SEC may also overlook the glaring contradiction to well-functioning capital markets and approve it. Public companies don’t read exchange proposals as they should and don’t comment on them.  No opposition? Approved.

 For more, we’ve asked permission to re-run a blog post today by Joe Saluzzi at Themis Trading: (more…)

ETFs and Divine Creation and Redemption

There’s a saying: It’s easier to keep the cat in the bag than to get it back in there once you’ve let it out. Nobody is likely to stuff the Exchange Traded Fund (ETF) cat back in the bag.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea. (more…)

Having never gone to a Neighborhood Pumpkin-Carving, we were wistful when squirrels promptly devoured the face off our finished product (marked “easiest” in the booklet of pumpkin-carving patterns we purchased). Ah well. What some consider a jack-o-lantern others see as a meal.

Speaking of scary, for those keeping record we note more currency-driven events to explain to your executives. First, the European Central Bank last week threw down the red carpet for Greek lenders, so the dollar dived and stocks soared on changes to perceived risk and anticipated further global currency-printing. On Halloween, Japan intervened to weaken the yen by buying other currencies, so the dollar strengthened (less supply, same demand) and markets plunged. On Nov 1, fear of setbacks on the Greece deal drove risk managers back to the dollar, pushing it up and stocks down more.

US markets should be proxies for fundamental value and forward multiples of collective corporate cash flows. Not meters for currency fluctuations. Happy Halloween.

Speaking of meters, there is Tom Peterffy, immigrant, billionaire, and architect of automated trading. Peterffy ranked 236th on Forbes’ list of the 400 richest in 2009, fruits of long labor revolutionizing how stocks trade. Peterffy, founder of Timber Hill and Interactive Brokers, pioneers in automated multi-asset-class electronic trading, believes automated trading goes too far. (more…)

Outrage in the Dark

Observe. Orient. Decide. Act. OODA.

This is how Pipeline Trading describes its predictive analytics for helping buyside customers identify large-block trading opportunities.

For those of you who missed the news that rocked The Street this week, Pipeline, a dark pool, was fined $1 million by the SEC for misleading clients about the nature of its liquidity.

Were you harmed? Check to see if your shares trade at Pipeli—

Oh. You can’t. It’s a dark pool. You don’t know if your shares trade there unless Pipeline’s orders route to your listing exchange.

Of Pipeline, SEC Enforcement Director Robert Khuzami said in a statement: “Investors are entitled to accurate information as to how their trades are executed.”

Pipeline offers a platform where institutional customers like mutual funds can find “natural liquidity,” or real orders from other buysiders. What’s more, Pipeline provides execution algorithms that mimic how high-frequency traders try to project price and volume in order to place profitable trades ahead of moves. If the buyside can beat HFT at its own game, then instead of being victimized, it can also generate alpha – market-beating returns on trades. (more…)

Did you see the Nicole Kidman film ten years ago called The Others?

A woman becomes convinced her house is haunted. In case you’ve not seen it, I’ll save the twist, but it’s the twist that matters. Things are not as they seem.

Crack WSJ markets writer Tom Lauricella asked in a page one article Oct 18 if markets are cracked. Traders he surveyed said building positions in stocks is getting harder. Liquidity is thin. Spreads are rising. Getting trades done – completing an order to buy or sell shares within projected price ranges – is challenging now in the most liquid names.

In the movie The Others, the problem is perspective. The answer to what’s going on depends on how you look at it. Since we’re limited by the camera and the perspective of the central characters, the reality of the problem doesn’t manifest itself till near the end.

In markets, it seems like liquidity is the problem. But what if it’s a matter of perspective? Classically, liquidity is capital. Today it’s somebody on the other side of the trade. Are they the same? No. What’s on the other side of most trades? A machine. Why is it there? Incentives. It’s not there because it’s committing capital. It’s there because it’s paid to be there. (more…)

I read this at an Occupy Wall Street site:

“Let me tell you a wonderful old joke from communist times. A guy was sent from East Germany to work in Siberia. He knew his mail would be read by censors. So he told his friends: Let’s establish a code. If the letter you get from me is written in blue ink, it is true what I said. If it is written in red ink, it is false. After a month his friends get a first letter. Everything is in blue. It says, this letter: everything is wonderful here. Stores are full of good food. Movie theaters show good films from the West. Apartments are large and luxurious. The only thing you cannot buy is red ink.”

Great joke. No doubt scrutinizing your trading data to make sense of it is like something written in red, the code for which is blue.

Speaking of which, chances are, your earnings date is approaching. Your intraday volatility (spreads between high and low prices) is perhaps 4%. Across our client base, it’s now over 4% on average. To help you make sense of your stock price, the exchanges and designated market makers and surveillance firms are giving you columns of data on trading by different brokers and sector or economic news. They tell you so-and-so upgraded the sector, causing a strong rally.

You’re not sure. In your gut you think the euro has got a lot to do with it. Maybe the dollar. It would be nice to know. And it would help if you could assess how money will react to the news you announce next week or the week after. (more…)

Influencing behaviors in your trading

In politics, Bill Clinton perfected the “trial balloon.” You float an idea of one shade because you’re planning on getting people to embrace an idea of another larger construct.

In fiction writing, authors will create portent by ending a chapter with something like: “She could never have imagined the consequences of her decision.” You can’t wait to turn the page to find out what she couldn’t imagine. The writer has subtly influenced your behavior.

The Fed is always trying to influence our behavior. Market performance October 4 (today) was mostly about Fed influence. Affirming commitment as lender of last resort – which sounds good but means “we will print endless piles of cash” – is the same as devaluing the dollar. So the dollar plunged in the last hour of trading, and stocks soared. (We all want stocks to rise but think about a teeter-totter. That’s stocks and dollars.)

In trading markets, exchanges continuously toy with behaviors by changing the spreads between fees for taking shares away and credits for bringing them to sell (this is the root cause of high-frequency trading). Exchanges are influencing behaviors.

Why does it matter? IR is about influencing behavior. In the past, we did it mostly with operating results, investment thesis and investor-targeting. Today, it must go further. Do you consider the impact of Fed policy and adapt your institutional outreach to match your investment thesis to impending changes in behavior? You should. If programs stall, don’t keep talking to growth money; shift to high-turn, deep-value money. (more…)