Tagged: Arbitrage

Half the Market

I’ve seen at least four Wall Street Journal stories in May alone about a quiescent VIX.

The CBOE’s volatility index derived from options pricing on the S&P 500 hit a low Monday last seen in Dec 1993, the WSJ said (subscription required). It moved lower still yesterday, 9.58 intraday.

Implicit in the storyline is a bull market, since one roared from 1993 to the bursting of the dot-com bubble. But the conclusion violates the Law of Small Numbers, the human propensity to assign undue value to insignificant data sets.  As proof, the VIX was a hair’s breadth from record low in Jan 2007.

Remember that? Lehman, little did we know, was failing. The financial crisis thereafter manifested in markets like a Hollywood blockbuster action movie where the hero outruns the explosion as the structure dissolves in showering computer-generated fantasia.

Since we can make equal bull or bear cases with the same data, it supports neither.

Aside: The investor-relations profession has a notorious proclivity toward the Law of Small Numbers. Stock’s down 3%, so we call somebody to learn why. You’re chasing the exception. Track instead the central tendency in the whole data set so you can see what changed before the stock fell 3%.

And assigning rational motivation to the VIX defies the data.  Less than 20% of daily market volume comes from rational thought. The rest is tracking the mean, arbitraging spreads back to the mean, or hedging departures from the mean.

Where everything is average, volatility vanishes. Thus a dead VIX fits. It offers little predictive value (save higher volatility always follows very low) and simply points to low spreads.

The reason is market structure. Passive investment tracks benchmarks and so seeks the mean – average price. Arbitragers look for departures from the mean to trade for profit. The market is riven with arbitrage so few mean-divergences survive to the close. But boy is there opportunity. You’ll see soon.

Meanwhile, those managing risk offload exposure to someone else, which produces equal and offsetting trading – which reinforces the mean.

And here’s a shocker. We track daily share-borrowing – shorting – as a percentage of total trading volume. Short shares are 48.1% of volume, which means long trades are 51.9%. In other words, nearly half the market is short.

Locked markets, or trades where the bid to buy equals the asking price to sell, are prohibited, so there will always be a spread, a dab of volatility. Arbitragers are almost guaranteed gains by being long and short everywhere.

We also measure intraday volatility, the spread between average intraday high and low prices. It’s 2.5% – astonishing arbitrage fodder.

For perspective, the S&P 500 rose 0.5% the last ten sessions. That means stocks are 400% more volatile every day than the ten-day change in closing prices.

Arbitragers are making tremendous gains by consuming intraday volatility.

It may be that Exchange-Traded Fund (ETF) market-makers are responsible. It explains why ETF costs are so low: Arbitrage gains are additive.

And ETF sponsors can rent out liquidity, shares accounting for the 48% of trading that’s borrowed – boosting returns. There’s support in the data. We track passive-investment patterns and correlate them to short volume, and there’s agreement.

ETF market-makers have four arbitrage opportunities: a) ETF net asset value versus ETF price; b) ETF versus underlying index; c) ETF price versus prices of components of the index; d) ETF price versus options and futures on components and the index.

By the close, ETFs and indexes want to peg the measure so divergences converge at average.

It’s a circumstantial case. But evidence piles up that ETFs are consuming spreads while simultaneously driving stock-prices and deflating the VIX.

What’s the risk?  Mortgage-backed securities did the same thing to real estate.  There was a finite asset, homes. With cheap mortgages, lots of money wanted exposure. So home loans were securitized – replicated – to expand demand, delivering great returns to those selling them. It worked till home prices stopped rising. Then replicated value evaporated. Half the market.

There are less than 3,600 US public companies when ETFs, multiple share classes and closed-end funds are removed. Low rates have created high demand. To expand access, ETFs replicate exposure, and are booming. It works so long as stocks rise.

When that stops at some sure point, extrapolated value will be marked to zero. Half the market.  Won’t arbitragers save the day? Not if volatility jumps as average prices plunge.

Expectations vs Outcomes

“Earnings beat expectations but revenues missed.”

Variations on this theme pervade the business airwaves here during earnings, currently at fever pitch.  Stocks bounce around in response. Soaring heights, crushing depths, and instances where stocks moved opposite of what the company expected.


Well, everyone is doing it – betting on expectations versus outcomes.  The Federal Reserve Open Market Committee meeting wraps today and much musing and a lot of financial betting swirls around what Chair Yellen is expected to offer as outcome.

Then Friday the world stops at 8:30am ET, holding its breath to see if the expectation for April US jobs matches the outcome.

And by the way, I will join Rick Santelli in Chicago Thursday morning, in between, on Squawk on the Street to pontificate fleetingly and I hope meaningfully.

Obsession with expectations versus outcomes in equity markets and across the planar vastness of economic and monetary data blots out long-term vision and fixes attention on directional bets.

It’s not investment. And it’s no way to plan the future, this mass financial pirouette around a data point.  But it’s the market we’ve got. We must understand it, like it or not.

Back to your stock. The reason that after you beat and raise your stock falls is what occurred ahead of your call.

It may have nothing to do with how you performed versus consensus. For proof, droves from the sellside are looking for IR jobs because trillions of dollars migrating from active portfolios into indexes and ETFs aren’t using sellside research. Or listening to calls.

It reminds me of the Roadrunner cartoons, Wile E. Coyote running off the cliff. Remember? Parts of Wile E. drop in order, the last thing remaining, his blinking eyes.

That’s to me like results versus consensus.  The eyes of Wile E. Coyote, last vestige of something fallen off the cliff of colossal change to investment and trading behavior. The sellside still has everybody thinking outcomes versus expectations matter to investors.

No, they matter to the hordes with directional bets – over 40% of the market.

They bet long or short, or on the spread between high and low prices. They may have fixed for floating swaps that pay if you beat, leading counterparties to sell your shares – and the bettors are short your stock too, so they make a fee on the bet and more covering as your stock falls.

And the CEO says to you, “What the heck?”

If your stock is 50% short (we measure it) and slamming the ceiling of Sentiment due to a marketwide derivatives surge after expirations – which happened Apr 24-25 – it doesn’t matter if you crush consensus. Structure trumps Story. Price will fall because bets have already paid thanks to the broad market.

The market makes sense when you understand what sets price.

Active investment leads less than 20% of the time. The juggernaut of indexes and ETFs rumbles through at about 34%, and it’s now distorting share-borrowing and Risk Management. The latter is 13-16% of your market cap – hopes for the future that can sour or surge on any little data point.

Let’s bring it back to the Fed and jobs and the economy. I said your stock will move based on what happened beforehand.  That can be a day or two, or a week or two.

The economy is massive. It will move on what happened beforehand too but the arc is years. No matter what may be occurring now, which in turn will manifest in the future.

The threat to the US economy and stocks is a lack of appreciation that tomorrow is a consequence of yesterday, not of tomorrow.  For the better part of a decade, furious fiscal and monetary effort promoted borrowing and spending so people would consume more.

But the consequence of borrowing and spending is debt and a lack of money. Which causes the economy to contract in the future. Stocks are pumped on past steroids. If the economy beats and raises, everything can still fall because of what happened yesterday.

We must first navigate consequences of yesterday before reaching the fruits from today.

Same for you. The stock market is awash in bets on divergences, even more when financial results mean opportunity blooms. Your active money clangs around in there, often as confused as you.

Your challenge and opportunity, IR professionals? Helping management develop an expectation of market form that matches the outcome of its function now.

ETFs and Arbitrage

The biggest risk to an arbitrager is a runaway market.

Let me frame that statement with backstory. I consider it our mission to help you understand market behavior. The biggest currently is arbitrage – taking advantage of price-differences. Insert that phrase wherever you see the word.  We mean that much of the money behind volume is doing that.  Yesterday eleven of the 25 most active stocks were Exchange-Traded Funds (ETFs). Four were American Depositary Receipts (ADRs).

Both these and high-frequency trading turn on taking advantage of price-differences. Both offer the capacity to capitalize on changing prices – ADRs relative to ordinary-share conversions, and ETFs relative to the net asset value of the ETF and the prices of components. In a sense both are stock-backed securities built on conversions.

For high-speed traders, arbitrage lies in the act of setting prices at different markets. Rules require trades to match between the best bid to buy and offer to sell (called the NBBO). Generally exchanges pay traders to sell and charge them to buy.

In fact, the SEC suspended an NYSE rule because it may permit traders to take advantage of price-differences (something we’ve long contended). We’ll come to that at the end.

Next, ETFs are constructed on arbitrage – price-differences. Say Blackrock sponsors an ETF to track a technology index. Blackrock sells a bunch of ETF shares to a broker like Morgan Stanley, which provides Blackrock with either commensurate stocks comprising the tech index or a substitute, principally cash, and sells ETF shares to the public.

If there’s demand, Morgan Stanley creates more ETF shares in exchange for components or cash, and then sells them. Conversely, if people are selling the ETF, Morgan Stanley buys the ETF shares and sells them back to Blackrock, which pays with stocks or cash.

The trick is keeping assets and stock-prices of components aligned. ETFs post asset positions daily. Divergences create both risk and opportunity for the sponsor and the broker alike. Blackrock cites its derivatives-hedging strategies as a standard risk associated with ETF investing. I’m convinced that a key reason why ETFs have low management fees is that the components can be lent, shorted, or leveraged with derivatives so as to contribute to returns for both the sponsor and the broker.

On the flip side, if markets are volatile as they have been post-Brexit and really since latter 2014, either party could lose money on unexpected moves. So both hedge.

For arbitragers, a perfect market is one with little direction and lots of volatility. Despite this week’s move to new market highs, there remains statistically little real market movement in the past two years. If a market is up or down 2% daily, does it over time gain, lose or stay the same?

Run it in Excel. You’ll see that a market declines over time. Thus arbitragers short securities using rapid tactics to minimize time-decay. If you want a distraction, Google “ETF arbitrage shorting” and read how traders short leveraged ETFs to make money without respect to the market at large.

In fact, this is the root problem: Taking advantage of price-differences is by nature a short-term strategy. Sixteen of the most actively traded 25 stocks yesterday (64% of the total!) were priced heavily by arbitrage, some by high-speed traders and some by investors and the market-makers for ETFs.

Offering further support for arbitrage ubiquity, the market is routinely 45-50% short on a given day. Short volume this week dipped below 45% for the first time since December, perhaps signaling an arbitrage squeeze and certainly offering evidence that arbitragers hate a runaway market.

If the market rises on arbitrage, it means parties SUPPLYING hedges are losing money. Those are big banks and hedge funds and insurance companies. Who’d take the market on a run to undermine arbitrage that’s eating away at balance sheets (big banks and hedge funds have suffered)?  Counterparties.

In our behavioral data Active investment is down and counterparties have been weak too, likely cutting back on participation. That comports with fund data showing net outflows of $70-$80 billion from US equities this year even as the market reverts to highs. The only two behaviors up the past 50 trading days are Fast Trading (arbitrage) and Asset Allocation (market-makers and brokers for ETFs and other quantitative vehicles). Yet more evidence. And both are principally quantitative.

Assemble these statistics and you see why the market seems oblivious to everything from US racial unrest, to a bankrupt Puerto Rico, to foundering global growth and teetering banks.  The market is running on arbitrage.

What’s the good news, you ask?  The SEC is aware of rising risk. It suspended an NYSE rule-filing on fees at the exchange’s Amex Options market after concluding the structure may incentivize arbitrage.  The SEC is scrutinizing leveraged ETFs and could end them.

But most important is the timeless self-regulation of knowledge. If we’re all aware of what’s driving the market then maybe the arbitragers will be their own undoing without taking the rest of us with them.

Making Water

If someone says he’s going to make water, it means one thing.  If he says he’s providing liquidity, it means another.  We should clear (and perhaps clean) that up.

In the stock market, some firms call themselves “liquidity providers.” The term suggests they’re creating something somebody else needs (here we depart sharply from making water). Liquidity by definition is the availability of assets to a market. Providing assets is important, helpful and benign, it would seem.

Hudson River Trading, one of the biggest liquidity providers (the terms high-frequency trader and liquidity-provider can be interchangeable), said in its last 13f it had 64 positions, the largest at $32 million in the exchange-traded S&P 500 fund SPY, leading a baker’s dozen ETFs topping its holdings. The biggest stock position was XOM at $1.5 million or 19,000 shares. A retail investor could own as much. Hudson River trades thousands of securities and millions of shares daily. If one could see its short positions, I bet the two would about cancel out. Effectively, zero assets.

If liquidity is availability of assets, how do you deliver assets when you don’t own any?

The NYSE enlists the help of a group it calls Supplemental Liquidity Providers (scroll to see them). SLPs, the exchange says, “trade only for their proprietary accounts, not for public customers or on an agency basis.” In its fee schedule the NYSE says it pays SLPs $0.06-$0.30 per hundred shares.

Did you catch that? The NYSE pays firms to supply liquidity but only proprietary trades – their own orders – qualify. The traders it’s paying are just like Hudson River. If the NYSE isn’t paying them to bring assets, the only other thing they can offer of value to the exchange is prices.  And setting prices is really arbitrage.

The Nasdaq does the same thing.  It pays traders around $0.31 per hundred shares to “add liquidity.” We’ve written for years about the system of incentives in the stock market. It’s called the “maker-taker model” because buying and selling are treated differently, not as the same activity.  Search our blog for “maker taker” for more and read this one.

Are there auto parts liquidity providers?  Grocery liquidity providers? There are automobile distributors, yes, who buy inventory wholesale from manufacturers. But they sell to the public and fold service, financing and support into the customer experience.

Broker-dealers like Citigroup or Raymond James that sell shares to investors write research, commit capital, provide trading services and account management, underwrite offerings, syndicate financings.  You won’t know the names of many equity liquidity providers. Most offer no services and have no customers.

What’s the value?  Little for you, issuers and investors. They are price-setters for exchanges, which in turn are data-sellers. Best prices are valuable data. The REST of the market participants with customers (humans and software systems alike register as brokers) must by law buy data about the best prices to make sure customers get them.

It’s perverse. Exchanges pay traders with no purpose save arbitrage – which call themselves liquidity providers – to set prices for anyone who actually IS a real buyer or seller. Sound to you like making water into the wind? Yup. But to quote humorist Dave Barry, we’re not making any of this up.

Chasing Gaps

Have you ever set an important goal?

Whatever your objective, you must plan how to arrive at your final destination as though it were a journey and you were constructing a map or set of directions. And then you persevere, letting nothing deter your purpose.

We don’t all achieve our goals and any extended effort carries risk. You can fail. Your directions could be wrong. You may have underestimated the obstacles between aspiration and destination.  Or you stop caring. Right?

What if success instead constituted correctly tabulating the difference between planned and actual progress? Boy that would be a lot less stressful. And you would have an arbitrage formula!

Every week governments the world round disgorge data on employment, the real estate market, manufacturing, exports, imports, budgets, capital spending, commodities, corporate profits, relative values of currencies, economic growth and more.

Yesterday, markets in the US considered the balance of international trade, The Institute for Supply Management’s non-manufacturing index (fairly strong) and the Purchasing Managers Index of services (modest but new orders were abysmal). Today’s data smorgasbord features mortgage applications, oil inventories and the Federal Reserve’s Open Market Committee ledger called the FOMC Minutes about what central bankers said at the March meeting.

Economists and investors troll the data for indications of future economic growth or contraction. They’re looking for progress toward purpose. Arbitragers react to it differently, trading the spread between expectations and outcomes.

Fundamental investment dominates? If only. We measure market behaviors. Active investment is barely more than a third of the daily volume of arbitrage.

We could define arbitrage as the difference between planned and actual progress – how something is faring relative to goal, or expectation.  In practical terms, arbitrage funds seek spreads between the current price of stocks and their forward value reflected in a futures contract.  If a stock is considered undervalued now but likely to rise later (call that a goal), a trader will buy the stock and sell a futures contract for commensurate shares.

The less predictable the future is, the shorter the arbitrage timeframe. Weekly options and futures tied to equities, exchange-traded funds and indexes used to be a rounding error. Today they’re 35% of the options market. Trading in options has a notional value five times that of stock-market dollar-volume daily. Nearly 50% of options trace to one security: SPY, the giant S&P 500 ETF.

If the S&P 500 is the goal, the path, the standard, then options reflect the difference between the goal and the expectations, the progress. You see?

Alas, a marketplace with relentless data minutia and nearly infinite ways to bet money on the difference between goal and progress shifts the purpose of the market from goal-achievement to chasing gaps. Why focus on the long term with its pervasive risk and uncertainty when it’s cheaper and less risky to speculate on whether the PMI Services number will be up or down and how new short-term expectations will affect markets?

Now add this in:  Yesterday the Bank of Japan talked the yen down by suggesting it might take interest rates further negative. The Reserve Bank of Australia warned about currency strength, tantamount, too, to talking money down. The Reserve Bank of India cut rates to a five-year low. Money denominates stocks, bonds, derivatives, commodities. Moving money-values constantly shifts focus from the future to a pairs-trade.

Markets are packed with speculators because we’re obsessed with information that deviates the purpose of capital markets from goals to whether something has departed from a benchmark. It institutionalizes averages and promotes arbitrage – chasing gaps.

We could change it by stilling the tides of data and currencies. Prospects for that goal? Currently a number approaching zero. I believe I’ll take out a short futures position.


Outcomes are culminations, not events.

Denver bid farewell this week to retiring Broncos quarterback Peyton Manning who for eighteen years accumulated the byproducts of focus, discipline and work, twice culminating in Super Bowl victories.

The idea that outcomes are culminations translates to the stock market. What happens today in your stock-trading is a product of things preceding today’s culmination just as our lives are accumulations of decisions and consequences.

Rewind to Feb 11, 2016. The S&P 500 hit a 52-week low of 1829. Recession fears were rippling globally. European banks were imploding, with some pundits predicting another 2008 crisis. China was lowering growth views and weakening its currency to pad the landing (word since is some 5-6 million workers will be laid off through 2017).

In apparent response, the US stock market soared, recovering to November levels. If the market is a proxy for the economy, it’s a heckler hurling eggs. Wiping away yolk, pundits said markets expecting monetary tightening from the Federal Reserve saw stasis instead. Recession fears were overblown and an overly reactive market rebounded.

But headlines don’t buy or sell stocks, people and machines do.  Markets move on money. This is what we’ve learned from more than a decade of market lab work, repeating behavioral measurements with software, servers, algorithms and models.

Follow the money.  The most widely traded equity in the world, SPY, is a derivative. It’s an Exchange-Traded Fund (ETF) tracking the S&P 500.  Nearly 50% of all options volume ties to it.  In 2016 so far almost every trading day at least 12 of the 25 most actively traded stocks were ETFs.

Why do we say ETFs are derivatives? Because derivatives extend access to assets, exactly the thing ETFs do. They’re securities trading on underlying stocks without owning them. The sponsor owns assets, yes. But ETF investors hold only a proxy.

ETFs depend on arbitrage. Rules the SEC approved for ETFs effectively sanction use of information the rest of the market doesn’t know about demand by the big brokers who produce ETF shares for trading.  These brokers are continually shorting index components and derivatives or ETF shares to close the gaps that form between the value of the ETF and what it represents (stocks, sectors, commodities, bonds, indices).

In the stock market, the price-setters are primarily short-term traders (high-frequency firms) arbitraging small price-divergences in many things simultaneously. ETFs are stocks that provide exposure to other stocks, sectors, commodities, bonds and indices. For arbitragers, they’re a massive additional layer of arbitrage permutations:  How might this financial ETF vary with that energy futures contract, and this basket of energy stocks?

What develops in this market is a disregard for fundamental factors. Prices are mathematical facts. Spreads drive directional-change. The market’s purpose devolves from economics to how to price a stock, sector, commodity, bond, futures contract, option or index relative to things associated with it or its value at a point ranging from fractions of seconds to next month before a derivatives contract expires.

It’s not investment but arbitrage of such scale and size that few recognize it. Yesterday, the most actively traded stock was the VelocityShares 3x Long Crude ETN linked to the S&P GSCI Crude Oil Index Excess Return (UWTI).  Yes, that its name! It’s an exchange-traded product backed by Goldman Sachs, and it dropped 13.3%. Offsetting, the eighth most active stock was DUST, the Direxion Daily Gold Miners Index Bear 3x Shares, which rose 13.7%.

Neither DUST nor UWTI owns tangible assets. Their returns depend on derivative contracts held by banks or other counterparties. Now step back. Look at stocks. They are moving the same way but over longer periods. Market moves are a culmination of whichever directional trade is winning at the moment, plus all the tiny little arbitrage trades over ETFs, stocks, commodities, bonds and indices, tallied up.

There are two links back to fundamentals. First, banks back this market. Some of them are losing badly and this is what European bank trouble last month signaled. And this IS a consequence of Fed policy.  By artificially manipulating the cost of capital, the Fed shifted money from scrutinizing economics to chasing arbitrage opportunities.

When arbitrage has exhausted returns, the market will change direction again. It’s coming soon.  The bad news is the market has not yet considered economic threats and is ill-equipped to do so.

The Vacuum

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how it’s really priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

Defend Yourselves

You need to defend yourselves as public companies.

This clarion lesson comes from last week’s trading halt at the NYSE though we think the exchange handled the outage correctly. Humans want pictures of perfection like Saturday’s Balloon Rodeo in Steamboat Springs. But don’t expect serendipity in securities markets. Your equity is the backbone of your balance sheet, basis for incentives, currency for investments. Know how it trades.

The root of the NYSE’s July 8 200-minute trading penalty box is the Flash Crash, a May 6, 2010 plunge and recovery in equities that spanned about a thousand Dow Jones Industrials points in twenty minutes.  During that maelstrom, trades executed at stale prices because timestamps on orders didn’t keep pace with market activity.

Now five years later, the exchanges are aiming for a July 27 deadline on two updates to timestamps mandated by Finra and the SEC. The new timestamps will calibrate to 100 microseconds are less, with one coming from orders occurring at exchanges, and the other timestamp for ones flowing through broker-operated dark pools relying on proprietary data feeds.  The thinking here is better timestamping will improve market-function and offer better future forensics. For instance, was there separation between exchange and dark-pool prices as occurred in the Flash Crash?

You don’t have to know this in the IR chair. But what if the CEO or CFO asks? It’s the market for your shares. There’s a great deal more to it than your story, a point made stark in a moment.

The NYSE claimed it had been testing timestamps and made a mistake in a deployment. Why test new code when the Chinese market is imploding, Greece is teetering on the Eurobrink and volatility is exploding in US equities – all of it interconnected through indicative value-disseminations for global indexes and ETFs that depend on timestamps?

Be that as it may, the NYSE handled the problem appropriately by stopping trading, cancelling orders and focusing on getting operations fixed in time for the closing auction. That in itself points to the larger lesson, which we’ll articulate in a moment. We heard lots of talking heads say “our fragmented market is a plus in crises because people could continue trading.”

The outage in fact demonstrated the opposite. We measured in NYSE data that day an 18% reduction in Fast Trading generally for NYSE issues, and commensurately higher investment behavior. In other words, with trading halted for half the day, speculators were less able to interfere with real investors’ moves.

By extension, we can infer with data support that much of what occurs intraday is effort by arbitragers to spread prices among securities that must track benchmarks – market indexes – by the time trading concludes.

Guess who supports that effort? The exchanges.  I’m not castigating here. But if you’re depending on information from an exchange (or its partner) to understand your trading, you had better darned well know how the exchange operates.  When the Nasdaq charges traders to buy shares at its primary market and pays them to sell at the BSX platform, it’s helping traders multiply prices and spreads. Do you see? Paying traders to engage in opposite actions incentivizes arbitrage. All exchanges pay traders for activity that’s got nothing to do with investment.

I’ll rephrase:  The exchanges fragment markets purposely in order to sell data and create transactional opportunities. It would be akin to your real estate agent encouraging others to bid against you as you’re trying to buy a house.

The NYSE’s trading halt proved that a fragmented market harms investors and helps arbitragers, because when it was closed for three hours there was less fragmentation and more investment – but lower volume. Volume often confuses busy with productive.

Don’t track volume without also metering what sets your price! Yet that’s not the Big Lesson for public companies.  No, it’s that the single most important pricing event of the day is the closing auction. And the audience depending most on it is the one tracking benchmarks (not taking risks like active stock-pickers).  Blackrock and Vanguard – the Asset Allocators collectively and by extension.

The number one force in your market is tracking broad measures, not weighing your earnings. This money is perpetually owning and yet constantly trading to match index-movement. You must quantify the price-setting actions of this colossal demographic group. If you don’t, the intelligence you’re offering management about what’s driving your price is almost certain to be incorrect.

Defend yourselves with an objective view.  It’s part of the job. Counting on exchanges is yesterday’s way.

Flash Boys

I don’t skateboard. But the title of Michael Lewis’s new book on high-speed trading, Flash Boys, made me think Lewis could’ve called it DC-town & Flash Boys.

Legendary skateboarder Stacy Peralta directed the 2001 documentary Dogtown & Z-boys chronicling the meteoric rise of a craze involving slapping wheels on little boards and engaging in aerobatic feats using public infrastructure such as steps and handrails. From Dogtown, slang for south Santa Monica near Venice Beach, Peralta’s Sean-Penn-narrated film tracked the groundbreaking (and wrist-breaking) 1978 exploits of the Zephyr skateboarding team, thus the “Z-boys.”

Skateboarding has got nothing to do with trading, save that both are frantic activities with dubious social benefit. We’ve been declaiming on these pages for more than a half-decade how fast intermediaries are stock-market cholesterol. So, more attention is great if the examiner’s light shines in the right place.

If you missed it, literary gadfly Lewis, whose works as the Oscar Wilde of nonfictional exposé include Moneyball (loved the movie), Blindside, Liar’s Poker and the Big Short, last week told 60 Minutes the US stock market is rigged.

The high-frequency trading crowd was caught flat-footed. But yesterday Brad Katsuyama from IEX, a dark pool for long investors that rose out of RBC, dusted it up on CNBC with Bill O’Brien from BATS/Direct Edge, an exchange catering to fast orders.

Which brings us to why Lewis might’ve called his book DC-town & Flash Boys. The exploitation of speedy small orders goes back to 1988. In the wake of the 1987 crash, volumes dropped because people feared markets. The NASD (FINRA today) created the Small Order Execution System (SOES – pronounced “soze”) both to give small investors a chance to trade 100 shares electronically, and to stimulate volume. Banditry blossomed. Professionals with computers began trading in wee increments. Volume returned. The little guy? Hm.

Regulators have always wanted to give the little guy opportunity to execute orders like the big guys. It’s admirable. It’s also impossible. Purchasing power is king. Attempt to make $1 and $1,000 equal in how trades execute, and what will happen is the big guys will shift to doing things $1 at a time. The little guy will still lose out but now your market is mayhem confusing busy with productive.

These benighted gaffes seem eerily to originate in Washington DC. Michael Lewis says big banks, high-speed traders and exchanges have rigged markets. We agree these three set prices for everybody. But they’re following the rules. (more…)


The humans are the minority.

A three-month study of internet traffic by web-security firm Incapsula found that 61.5% of page views were generated by machines. Humans managed only 38.5% of web traffic.

It seems absurd but our own experience bears it out. We receive hundreds of comments on the blog version of these overwrought homilies but the machines are more opinionated than the humans. In recent months, automated “bots” have attempted to post over 1,500 comments. We’ve approved just the handful from actual humans.

Most of you readers with comments use a dark pool. By which I mean you reply to the email version when you opine on our assertions. In this fashion, you avoid displaying your comments where others can game them. Keep those nondisplayed orders coming!

The machines are good. You could at times almost buy that a person penned the prose. Speaking of skilled machines, Virtu Financial Inc., a dominant high-speed market-maker, intends to go public. Virtu filed confidentially, meaning it posted its regulatory filing quietly in December using a provision of the 2012 JOBS Act to omit the meat investors use to weigh business merits and prospects. (more…)