Tagged: Dark Pools

Total Confusion

The Nasdaq will now run Goldman’s dark pool.

Walk up to any random stranger and blurt that phrase and see what happens. Nasdaq?  Goldman? Dark Pool? You’re crazy?

Bloomberg reported on Halloween that banker Goldman Sachs would turn over management of its so-called dark pool Sigma X to exchange operator Nasdaq. If you work in the equity capital markets (like the investor-relations profession) you need to understand what’s going on.

It requires a history lesson. In 1792, brokers meeting under a downtown New York buttonwood tree to do business realized that sharing customers would mean more buyers and sellers – a market.  They created the New York Stock Exchange, a “farmers market” for stocks, where interested consumers could peruse the “booths” for products they liked.

Fast forward to 1971. A national association of securities dealers created a quotation system for stocks that became the Nasdaq.

Enter Congress.

Four years after eliminating intrinsic value from money by disconnecting it from assets such as gold, the USA was in “Stagflation” (inflation without growth, something that again seems to be gaining purchase in the data) and people were borrowing shares like crazy and using derivatives in totally new ways.

Worried its new paper money lacking substance was going to derail the stock market, Congress in 1975 passed the Section 11 amendments to the Exchange Act to form a National Market System that could be better “managed.”

Before Congress intervened, stocks were traded at the markets where those shares were listed, and markets were owned by brokers.  After Congress took over, markets were gradually separated from the brokers who created them and stocks could trade anywhere (suppose regulators forced Whole Foods to carry Safeway’s private-label products).

Government moves at glacial speed but leaves the same plowed troughs as do vast wedges of frozen water.  It’s only looking behind that you see the scored landscape. Brokers wanted to match buyers and sellers, so they created exchanges. Regulators linked all those exchanges together, undermining competition while claiming to enhance it. Then regulators separated the markets created by brokers from the brokers.

That’s like a Farmers Market that bars farmers. How does the produce get there?

So faced, brokers created new private markets that were dubbed rather unceremoniously “dark pools” because they’re private members-only affairs.  Here’s the bizarre part. Goldman Sachs operates Sigma X because its customers – investors and traders – wanted to get away from the stock market!

Think about that.  In 1792, brokers pooled stock-buying to create a market. Today, customers of brokers want to avoid the stock-buying pools brokers first created, now called exchanges but which today are for-profit businesses selling data and technology and bearing little resemblance to the early stock bazaars.

Why would buyers and sellers choose a stock Speakeasy over a stock shopping mall?  Because mall shoppers can’t tell if they’re getting a deal or screwed.

But now there is so much pressure on brokers to do this or that to comply with rules that they’re afraid to operate markets. Every time they move, a regulator fines them.

In some ways, we’ve come full circle.  Brokers created exchanges.  Stocks traded on exchanges.  Regulators decided brokers were hurting customers and so separated exchanges from the brokers who created them. Now an exchange is taking over the market a broker created as a substitute for the exchange brokers originally created.

Confused? You should be! This is crazy stuff.  There are too many rules, too little transparency, free interaction.  For investor-relations professionals it means more work for your investors trying to buy shares. Markets should make it easier, not harder.  Isn’t that the point?

For forty years, public companies have been spending money and time targeting investors while ignoring the market where those investors buy shares. Effort targeting investors is for naught if they can’t buy or sell stocks efficiently. Have we got it backward?

Dark Costs

Credit Suisse. Deutsche Bank. ITG. Pipeline. Barclays. UBS. BNP Paribas. Citadel. Goldman Sachs. Liquidnet. Bank of America Merrill Lynch. Citigroup.

What commonality unites these firms? All have been fined for violating rules on so-called dark pools, private stock-trading venues.  At least three are now defunct, Pipeline shutting in 2012, Citi halting its Lavaflow unit last December after paying $5 million to regulators for compromising customer data, and Citadel saying in March this year it would mothball its Apogee platform.

Morgan Stanley and JP Morgan have been investigated but as yet have had no knees capped in the twilight. This is no collection of backwater outfits but a brokerage Who’s Who. These firms are running your buybacks and underwriting your offerings, the pillars upholding equity market-making and liquidity for shareholders.

Ask any Vice President of Marketing at a public company how the firm’s products and services are sold and you’ll get an unhesitant response. But your CFO likely doesn’t know what a dark pool is or why the big brokers running them are continually afoul of rules. You’re the product manager of the equity market if you’re occupying the IR chair. You’ve got a golden opportunity (and in a sense a duty) to be the expert.

Word is ITG, a publicly traded firm itself and among the largest independent operators of markets serving as alternatives to the big exchanges, will pay more than $20 million to settle allegations of trading against customer orders in 2010. It’ll be a test for the company to survive a wallop of this proportion.

Citadel, the hedge fund founded by mogul Ken Griffin, has been fined more than 20 times for breaching various rules. A bad actor?  Visit the Finra newsroom (formerly the National Association of Securities Dealers, Finra is the watchdog for stock brokers) and you’ll see a continuous litany. In the past month alone Goldman Sachs, Raymond James, Wells Fargo, LPL Financial and Aegis Capital were fined tens of millions collectively for demeaning market rules. In May and June, Morgan Stanley paid $3 million.

If everybody is paying regulators, could it be market rules are like the tax code – so byzantine that everybody is routinely in violation? We could countenance a concatenation of penalties for fringe firms jobbing the innocent. But fines are the central tendency. It feels like Las Vegas when Bugsy Siegel ran it.  You’re gonna pay the vig. (We think regulators want to end dark pools. Since they created the rules – Regulation ATS and the Order Handling Rules – that birthed dark pools, they don’t want to reverse themselves. So they may instead penalize alternative venues out of existence.)

Why would public companies accept a market so complicated that Goldman Sachs can’t comply? It gets once more to the IR job today.  At minimum we should understand and measure its performance as we would any other market to ensure that our best interests and those of customers and shareholders are being served. If you want to sell in China, the market is big but what determines whether you can or not is structure.

“Dark pools” is an inaccurate term but if you’re an investor-relations officer you should understand them.  Exchanges like the NYSE cannot give preference and must post prices. They’re public markets.

Dark pools are not public. You need permission from the market’s operator to use one, and most don’t list prices for shares because the reason they exist is to escape a bizarre feature of the stock market: List a price and somebody will attempt to be above or below it in order to keep your price from being matched. Prices are today like the way a friend of ours in California describes using turn signals when driving: A sign of weakness.

So dark pools decide who gets to enter, and the products in dark pools like your shares are listed by amounts, not price. If a pool has 10,000 shares of XYZ, the price will be halfway between the best bid to buy them and offer to sell them in the public market. Ostensibly nobody knows I’m after at least 5,000 shares so I get more at a decent price.

See?  Now think about that. A mall brings people wanting to consume things together with retailers selling them.  In the stock market, complex rules make it challenging to find anyone selling what you want to buy, and the moment you lift a finger, the price changes (this is why your investors increasingly use ETFs and other derivatives – it’s too complicated to get big amounts of the underlying asset).

You say, “I’m a road warrior, a vagabond of highways and jetways, a troubadour of the corporate story. I don’t have time for this stuff!”

Have we got it backwards? Shouldn’t we first understand – and have a say in – the market for our shares before we market our wares?  (I fashioned that rhyme myself.)  Structure counts. Caveat emptor.  Latin but timeless.

Lava Cools

Euclid could have been a hedge-fund manager.

The Greek mathematician and father of differential geometry defined our understanding of three-dimensional shapes in roughly 280 BC. Thanks to Euclid we know what a cube is, and that right angles are all equal.

In 1982, mathematician James Simon started a money-management firm that would seek superior returns not by studying business strategies and financial statements but instead through adhering to mathematical and statistical methods, especially differential geometry. Today secretive Renaissance Technologies, called RenTech by most, manages $37 billion, mainly for its principals. Jim Simons retired in 2009 with an estimated personal fortune of $12.5 billion. Math works.

In 1999, two years after the SEC passed rules on handling trades and set regulations for alternative trading systems that today we call “dark pools,” Richard Korhammer and his engineering colleagues started a direct-access platform they named Lava Trading, a subtle nod to differential geometry and the construction of surfaces. Everything, including equity markets has a surface, and in stocks it’s the top of the book. But below it, in what’s not displayed, is where the action lies.

In 2003, Lava filed a patent on its technique for aggregating market data and placing some trades while hiding others – the top of the book versus the rest of the orders. Differential geometry. The firm became the market-share leader in direct access, a way to describe how investors could skip the stock exchanges to trade with each other.

In 2004, Citigroup spearheaded a dark-pool invasion by big brokers, buying Lava Trading for some $500 million and making it an independent unit. LavaFlow Inc. became known for its market-participant ID (MPID), a four-letter identifier traders use to see who’s driving orders.  Goldman Sachs’s primary MPID is GSCO.  Morgan Stanley’s, MSCO.

Lava’s was FLOW, and FLOW was everywhere. It’s still big. For the week ended Nov 10, FINRA ranked LavaFlow sixth among dark pools behind Credit Suisse, UBS, Deutsche Bank, and the star of Michael Lewis’s hit market-structure tell-all, Flash Boys, IEX.  Combine FLOW with Citi’s two other dark pools and Citi ranked third.

But Citi is chilling LavaFlow, hardening the surface, shutting it down.  In July this year, the SEC fined LavaFlow a record $5 million for permitting a smart order router, computer code that makes buy/sell decisions with high-speed data, to use confidential customer information in trading decisions.

The SEC said these orders totaled 400 million shares over three years. Citi dark pools match that much every two weeks so the allegations concerned roughly 1% of it, a rounding error.

Pulling out of a market where you’re ranked 3rd of 36 seems extreme. But it reflects facts that you must know in the IR chair. First, the stock market isn’t a “market” anymore, and brokers know it. A market by definition is aggregated buy/sell interest, and the stock market today is the opposite of that.

Number two, rather than admit the rules they made in 1997 birthed dark pools and shattered the stock market, regulators are going to regulate dark pools out of existence, and Citi sees it coming. If you think that’s good, remember how we got here to begin.

Third and perhaps most important, Citi ranks second in another market: Derivatives. Bloomberg reported in September this year that Citi has grown its derivatives business nearly 70% since the nadir of the financial crisis and now serves open derivatives contracts worth $62 trillion, second behind market-leader JP Morgan ($68 trillion). It’s the largest counterparty for interest-rate swaps, the biggest derivatives segment.  In derivatives, Citi IS the aggregator.

It fits what we see in equities. When energy stocks took a breathtaking hit the past few trading days following OPEC’s decision to maintain production levels, the behavioral shift was in hedging. The magnitude of movement in prices says it wasn’t driven by real ownership but notional value.

Notional value can reflect tremendous demand or its utter absence in the space of heartbeats because it’s not actual ownership.  We saw stocks drop 30% or more in two days without any meaningful movement in investment behavior.

This is what institutions are doing. It reflects the uncertainty of everything, everywhere. A great deal more money than most realize is putting and taking interest in stocks through derivatives like swaps. That fact is increasingly setting your share-price.  For Citi, the money is in this aggregation, not in equity fragmentation.

The Big News

With crowning dreams of California Chrome and the unfortunately tinny conclusion to the equine trifecta dominating news, you might have missed what counted last week.

There was Liquidnet, operator of a members-only trading market for the buyside (a “dark pool”), paying $2m to settle SEC charges it shared confidential client information through its Infrared ID program at the NYSE and a couple other applications.

There was Wedbush, clearing firm for high-frequency traders, facing SEC charges that it inadequately policed how clients used its brokerage desk to directly and anonymously trade stocks (called sponsored access or direct market access for you word collectors).

Big news, both. But not The Big One.

No, I learned the big news first from Karen (our chief operating officer and my beloved spouse), who emailed a link saying, “Read this.” Not much later, Joe Saluzzi (NIRI National was fortunate to have Joe as my fireside-chat guest yesterday afternoon on whether markets are both broken and rigged) emailed snippets and said , “From Chair White speech…”

He meant Mary Jo White, SEC chair. She’d addressed the Sandler O’Neil Global Exchange and Brokerage conference June 5. And she said, drum-roll please:

“The secondary markets exist for investors and public companies, and their interests must be paramount.” (more…)

Crossfinding

We marked May’s end aboard a boat on the trade winds from Norman to Anegada in the archipelago of the British Virgin Islands. It’s an indisputable jewel of that empire upon which the sun once never set.

Now, back to reality!

“Arnuk and Saluzzi, the principals of Themis Trading, have done more than anyone to explain and publicize the predation in the new stock market.”

So writes Michael Lewis in his No. 1 New York Times bestseller Flash Boys, which rocked the US stock-market community. If you’re coming to NIRI National next week in Las Vegas, put this on your calendar:

I’m moderating a fireside chat with Joe Saluzzi (regular CNBC and Bloomberg TV guest, two 60 Minutes appearances about high-frequency trading) on Tuesday June 10 at 4:10p in Bellagio 2. Click here for details. Expect insight and entertainment – and bring hard questions!

Speaking of markets, did you see that Credit Suisse and Goldman Sachs released details about their dark pools? These are members-only trading venues regulated as broker-dealer Alternative Trading Systems under what’s called Reg ATS.

Credit Suisse’s Crossfinder is reputedly the world’s largest such market, which is in part due to the volume of orders that other brokers are routing to Credit Suisse. We monitor routing practices. It’s apparent to us that Credit Suisse leads in routing market-share.

Now, why do they lead? And why should you care, there in the IR chair? Because how the market for your shares functions is in the IR wheelhouse. Right? You know how your company sells products and services. How about the way your shares are bought and sold?

After all, the goal of IR boiled down to quintessence is to foster fair value in your shares and a well-informed marketplace. How do you know when that’s true?

One might say “when my shares reflect a certain multiple of the discounted present value of future cash flows.” But that measure is only true for investors measuring cash-flows. Eighty-five percent of your volume comes from forces motivated by something else.

You can’t control these but you can influence them, and measure them, and differentiate between when your active investors are setting price, and when something else is. To the degree that the prices of one are similar to the other, your market is fairly valued. It’s that simple, but you have to establish a way to measure it (we have).

Which leads back to Credit Suisse Crossfinder. In its Form ATS, the broker says it segments participants in its market into four groups.

Son of a gun. We segment the entire market into four groups, both in individual shares, and broadly, so we can see variances in these groups comparatively and by duration.

Credit Suisse calls the four groups Natural, Plus, Max and Opportunistic. The broker creates what it calls an “objective formula” predicated on a “variety of metrics” to “capture the trading behavior” of these clients.

Well. That’s exactly what we do. We think Credit Suisse is successful because it observes its clients’ behaviors and clusters similarities to improve outcomes for them. Logical stuff. I’m sure they know which behavior is dominating at any given time.

So do we, in the way we measure four behaviors ranging from natural to opportunistic. Now, why does this matter to IROs? For the same reasons. To improve behavioral outcomes. And because it’s how the market works. It’s how institutions are behaving.

I’ll probably fall short of instilling profundity, but this is on a magnitude of realizing that the earth you thought was flat is in fact round. It changes everything.

The holy grail of market intelligence isn’t knowing if Fidelity bought. It’s understanding whether the behavior of your dollar-flow is natural or opportunistic. That, my friends, is where the meaning lies.

Well, The Meaning may also be just off the coast of Virgin Gorda. Meanwhile, see you next week (booth 615) in Las Vegas!

Why Auctions Work

Did you know that auctioneers make bad grocery-store clerks?

So argues a GEICO TV commercial – unwittingly teaching a last lesson on high-frequency trading. I’m sure you’re ready to move on!

Ever see the movie The Red Violin? It traces a storied musical instrument through hundreds of years of handling by varied humans in different cultural steppes while interspersing scenes from the hushed confines of a high-end auction room a la Sotheby’s. There, the approved bidders are assembled hoping desperately to own it. We cut away, vignettes building to a climactic conclusion in the auction room. The bidding begins.

In auctions if you bid, you only buy if you’re the last bidder. In the stock market you get to buy when you’re the first.

In the GEICO ad, one customer outbids the other for groceries and nods with satisfaction. In the Red Violin, emotions embedded in ancestry and history push bids for the instrument ever higher. But only one party walks away with the case. It’s not a recent movie but if you’ve not seen it I won’t spoil the ending.

From movies and stocks we sweep west, panning across the high desert along the Oregon-Idaho border where the Snake River bottomlands are fertile ground for fruit orchards and sugar beets and potatoes grown by Ore-Ida for McDonald’s restaurants around the world. (more…)

The Dark Exchange

I’m reminded of a joke (groans).

A man is sent to prison. As he settles into his captive routine he’s struck by a midafternoon affair among his jailed fellows. One would shout out, “Number 4!” The others would laugh.

His cellmate, seeing the newbie’s consternation, explained: “We’ve been here so long we’ve numbered the jokes instead of saying the whole thing. Here, you try. Number 7 is a really funny one.”

“What, just shout it?”

“Yeah, exactly.”

“Number 7!”

Silence.

The cellmate shook his head. He said, “Some people just can’t tell a joke.”

Speaking of numbered jokes, the NYSE filed with regulators to offer new order types – regulated ways to trade stocks – designed to attract large institutional orders now flowing to “dark pools,” or marketplaces operated by brokers where prices aren’t displayed. The exchange has long battled rules in markets that promote trading in dark pools, arguing that these shadowy elements of the national market system inhibit price-discovery.

Let’s translate to English. The NYSE is a big stock supermarket with aisles carrying the products your equity shopper needs, where prices and amounts for sale are clearly displayed. Across the parking lot there’s an unmarked warehouse, pitch black inside, with doors at both ends.

You can duck into the supermarket and check prices and supplies for particular products, and then hurry over to the warehouse and run through it holding out your hands. You might emerge with the products you wanted at prices matching those in the supermarket. (more…)

Data Darkness

There’s apparently a reality TV show called “Dating in the Dark.”

It must lack the cachet of Survivor or The Bachelor because you don’t hear much about it. The gist is that a number of people of opposite sexes wander around in utter blackness falling in love. You wonder how that’s superior to the displayed market – so to speak.

But in the equity market, dating in the dark is a big deal. I’m talking about how stock orders find each other. Take Coca-Cola (KO), which reported yesterday. From July 8-12, according to Fidessa’s Fragulator, 25.6% of trades occurred on KO’s listing exchange, the NYSE. But 29.4% were on the FINRA NYSE tape, a reporting facility for trades between brokers rather than on exchanges.

The remaining 44% of KO’s trading mostly met in displayed markets at the Nasdaq, BATS and Direct Edge, and the NYSE’s derivatives-centric platform called NYSE Arca, formerly the ECN Archipelago.

Why does this matter to you, IR professionals? It’s important to understand what’s happening. This is the market you manage – the equity market for your shares.

So, FINRA – the Financial Industry Regulatory Authority – is trying to address concerns that a large amount of stock-dating in the dark is bad for markets. That volume of KO’s on the FINRA NYSE tape? It’s “dark pool” trading, where buyers and sellers meet secretly and anonymously through brokers acting like millionaire matchmakers.

Last week FINRA sent a proposal to its members that would create new reporting rules for dark pools. If adopted, alternative trading systems, or facilities where the principal function is matching trades but the regulatory structure is one for broker-dealers rather than the regime exchanges operate under, would report their trades to FINRA on a delayed basis using a unique market-participant identifier. That way, FINRA would know what trades and volume occurred in each facility to better identify market-manipulation. (more…)

Follow the Money

If you appeal a parking ticket to the Parking Department, what’s your expectation of objectivity? The Parking Department collects revenues.

Which brings us to word circulating last week from CEO Duncan Niederauer that NYSE Euronext and other exchanges are confronting the growing problem of off-exchange trading. “It impacts the quality and integrity of the U.S. capital market – and ultimately the ability of markets to enable companies like yours to raise capital efficiently,” Niederaur wrote in a letter to issuers (which a variety of alert readers passed along to me).

Shouldn’t we first ask why money has fled displayed markets? Private equity is working great. It’s a non-displayed market. Pensions and endowments have nearly twice as much money in private equity than public equity today. Investors aren’t forced to transact off the exchanges. They choose to.

Now exchanges want regulators to herd them back to displayed markets…for your good? Or for theirs? There’s a biblical proverb that says, “The first to present his case seems right, until another comes forward to question him.”

I think fragmented markets are a problem. But the reason the NYSE and other exchanges want trading between brokers to move back to exchanges isn’t for capital-formation purposes. It’s because the NYSE and other exchanges are data and technology vendors. NYSE Technologies last year generated $473 million of revenue supplying data, circuits and technologies to those trading your shares. (more…)

The IR Jetsons

What surprised me most was how twice as many people knew “high-frequency trading” compared to “dark pools.”

The Nasdaq’s Mike Sokoll, Liquidnet’s Nicole Olson and I kicked off a session on how equity markets work at NIRI’s conference on IR fundamentals in Santa Monica yesterday. As we were unfolding the map of market behavior, we polled the audience:

How many of you have heard of “high-frequency trading?”

It appeared to me that two-thirds of the hands in the room went up, and there were between 80-100 investor-relations and treasury professionals in the ballroom at the Loews Beach Hotel.

And yes. It was lovely there, above Muscle Beach (I walked from the sandy side of the hotel to the front for a cab back to the airport, five minutes in the lovely January sea air in suit and tie).

When we asked how many had heard of dark pools, only a third said so. That may change soon. One big reason more people know about high-frequency trading is that the media have given it ink. Yesterday, FINRA announced plans to scrutinize dark pools over whether gaming occurs, where traders may post orders on stock exchanges that create arbitrage opportunity in members-only markets where no price information is offered (dark pools).

Which leads us to IR 101 in 2013. I was trading notes recently with a friend and fellow IR veteran about the Nasdaq buying Thomson Financial and The ICE buying the NYSE, and we got to talking about what’s changed and what hasn’t in our profession.

Fifteen years ago it was 1998. eBay went public Sept 24 and closed up 163% at $47.38 (raising $63 million on 3.5 million shares offered). IR pros were doing the Big Four (positioning their companies in the capital markets, shaping internal and external financial communications, building capital-markets relationships, monitoring how equity is traded). (more…)