Tagged: Exchanges

High Speed Risk

Is the era of high-frequency trading over? 

While you ponder whether “High Speed Risk” might be a good name for your garage rock band, let’s reflect on stocks. We said last week: “Our Sentiment is negative for the first time since the election. It’s a weather forecast.  No need for panic, only preparation.”

We measure the short-term movement of money with a 10-point scale. It was about 5.0 or higher from the election until Mar 9, 80 trading days. Last week it dipped below 4.5.

And weather arrived yesterday before today’s VIX expirations. It’s not news about the Trump administration.  It’s the end of a long, leveraged run. Monthly options and futures expired Friday the 17th.  New options traded Monday, Mar 20.

Yesterday was what we call Counterparty Tuesday. If counterparties have estimated demand Monday for new options incorrectly, they true up on Tuesday. Since markets fell, counterparties overshot demand.  

Derivatives have featured prominently in gains since the election. Investors have been buying both stocks and rights to more of them in the future. That additional implied future demand breeds higher current stock prices.

For the first time since the election, investors didn’t buy more future rights.  Does this mark an end to that pattern?  Certainly for the moment.  And it dovetails with the state of high-frequency trading.

For you new readers, let’s canvass high-frequency trading.  In 2007 after Regulation National Market System, a firm calling itself Octeg splashed through the data. In Intel alone, Octeg was driving 35% of monthly volume, crushing Goldman Sachs.

Who is Octeg, we wondered? The firm defied what we knew about brokers, which always wanted to hang a sign out, advertise that they had products for sale. We couldn’t find even a phone number for Octeg.  It was like stumbling on an unmarked warehouse in the suburbs packed to the ceiling with all the stuff you tried to buy at the mall.

While rooting through regulatory filings we found an address in Chicago and then another firm in the same suite called Global Electronic Trading Co (GETCO). 

And then we got it.  Octeg was GETCO spelled backward. The two were the same firm.

Getco dominated trading through the financial crisis, profiting on two ideas. First, exchanges began paying traders to sell shares on their markets. Think of it like a store coupon: Do business with us and we’ll give you a discount. Getco cashed coupons. In gargantuan manner. Exchanges paid them in coupons for relentless volume.

Second, Getco realized that it could be first to set price. So why not set as many prices as possible, forcing big institutions to chop their trades into smaller pieces?

Volume exploded. 

But it wasn’t investment.  Getco had no customers. It was using computers and mathematical calculations to continuously set prices in the stock market, getting paid to buy and sell stocks while simultaneously changing the price ever faster to force big investors into chopping up stock orders into smaller pieces so Getco and its burgeoning ilk could sit in the middle buying low and selling high in fractions of seconds.

At the pinnacle in 2009, we pegged this behavior, high frequency trading, at 70% of volume. Now high-frequency trading by our measures is less than 40% of volume.

The entire market the past decade is built on it. On the floor of the NYSE, four big high-speed firms price all NYSE stocks at the open. At the Nasdaq, a larger number does the same, trading prices for coupons.

The problem is high-frequency traders don’t have customers. They aren’t “working orders” for investors. They are buying low and selling high in fleeting fashion, for profit. Mistake these prices for ones from investors, and you mentally misprice stocks.   

You read that high-frequency traders are “market makers.” They’re “furnishing liquidity.” Traders with no customers can’t make markets. They can only exploit what others in the market don’t know. In 2007, it was easy. Now it’s not.

That’s because big stock brokers are doing the same thing with Exchange Traded Funds, rapidly repricing them, and index funds, and the stocks comprising them, and the options and futures derived from them. The big brokers are better at it than high-frequency traders because they have customers and can make longer directional plays by reading what customers are doing.

In a market without high-frequency trading, all stocks would trade like Berkshire Hathaway Class A shares.  About 400 shares daily.  It would be better for investors. But all the exchanges would go broke. Ironic, isn’t it?

High-frequency trading isn’t done. But with the market we’ve got, the harder it is for high-speed machines to price stocks, the greater the risk of big moves.

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?

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.

Compensation Model

What do you get paid to do?

That’s the question the SEC may soon pose to high-frequency traders, according to a story from Bloomberg yesterday.

“The maker-taker compensation model is very much in the core of what our market structure review folks are looking at,” said SEC Chair Mary Jo White.

If you’re the CFO or investor-relations officer for a public company, you should want an answer too. Because there’s belief silence from public companies about market structure indicates agreement.

Suppose I said, “In one minute, describe your business, its key drivers and how you differentiate yourself for investors.”  I bet most of you could.

What if I asked, “How do your shares trade and where, who trades them, and how are they priced?”

“I don’t even know what ‘maker-taker’ means,” you might mumble.

It’s convention in IR to ignore the stock but that ethos has led a generation of investor-relations professionals to think they don’t need to know how the stock market functions.

“I don’t want my executives watching the stock,” you say.  “If we run a good business, the rest will take care of itself.”

The largest institutional investors in the US equity market, Blackrock and Vanguard, are asset allocators. They’re not Benjamin Graham, the intelligent investor. They track benchmarks because that’s what they’re paid to do.

Active investors are paid to find good businesses, deals, and yet nearly 90% don’t outperform indexes. Stock-pickers are not less intelligent than mathematical models. But they seek outliers in a market that rewards conformity.

Follow me, here. The biggest investors use models, sending trades through the biggest brokers, which are required to meet “best-execution standards,” a wonky way to say “give investors good results,” which is determined by performance-averages across the market – which are being driven by the biggest investors and their brokers.

Thus Blackrock and Vanguard and their brokers perpetuate standards of conformity created by regulators.  Company story becomes secondary to indexes and Exchange-Traded Funds,  investment vehicles dependent on conformity. (more…)

Sizing Ticks

Ticks are blood-sucking insects, about how regulators have viewed spreads between stock prices.

Country singer Brad Paisley sings that he’d like to walk you through a field of wildflowers and check you for ticks. As a kid in tick country on Oregon’s Snake River breaks, I pulled plasma-bloated fatsos off my skin and watched my grandmother touch match-reddened tweezers to protuberant tick buttocks on my grandfather’s scalp.

Now the Securities and Exchange Commission is studying ticks. It’s in regulatory parlance SEC Release No. 73511, File No. 4-657.  You can comment by email at rule-comments@sec.gov, or on the website, here (include “File No. 4-657” in any case).

Fittingly, we’re in New York this week where ticks began, a timely escape from the season’s first deep freeze in Denver.  Your stock trades in penny increments, or ticks, thanks to rules created by the SEC in the 20th century.

The belief then was that brokers were charging too much with wide spreads in securities that jobbed small investors. Shrink ticks to desiccated carcasses and mom and pop would win went the reasoning. Fifteen years after slimming ticks, the SEC has ordered a study on widening them. The SEC didn’t say it made a mistake last century. It just told exchanges, “See if there’s a better way.”

I’ve read File No. 4-657 from introduction to footnotes and definitions.  We’ve summarized before but hitting highlights, the exchanges have proposed three clusters and a control group comprising effectively all the 1,750-ish small-caps in the market. Stocks will quote in five-cent spreads but trade anywhere between, or trade in five-cent spreads, or trade at five-cent spreads with a “trade-at” rule, this latter blasted by brokers because it prohibits undercutting prices at exchanges. (more…)

Without Your Knowledge

Facebook collaborated with two respected universities to study your emotional responses when shown different kinds of news. Without your knowledge.

We learned in June, you might recall, that Cornell, the University of California at San Francisco and Facebook delved into the doings and feelings of 700,000 of us folks without so much as a by-your-leave. The aim was unalloyed, as aims often begin when people sit in rooms with statistics and contemplate how to study them.  Do users post negative prose if they’re exposed to adverse news?

It seems innocuous, sure. I’m not knocking the social network and that’s not the point of today’s piece. If you’re sharing your innermost feelings with a community of one billion, your expectation for inclusion on the distribution list for the memo about a psychological study should be a number approaching zero.

Speaking of memos you didn’t get, we wrote two weeks ago that the SEC had in June ordered the stock exchanges and Finra, regulator for brokers, to craft a program for larger tick-sizes in small-caps. The plan is out. Without input from public companies. But you can yet weigh in. We’ll come to it.

There are four groups, not three as we’d initially thought. The three test groups will contain about 400 entities each with prices over $2, volume under a million shares, and market-cap of $5 billion or less, and will study trading in five-cent increments.

Lest you suppose this is the backwater of the market, there are only 754 large-cap companies in the Wilshire 5000.  Not enough to constitute two test groups. Most of the stocks trading publicly fit criteria for this proposed program.

That makes this plan more than a test. It’s a functional repudiation of Regulation National Market System. But instead of admitting its errors, the SEC simply ordered the exchanges to propose an alternative, thus permitting regulators to sidestep responsibility for screwing up 80% of the marketplace. (more…)

Setting Prices

Do you remember that movie, The Island?  The people who every day hope they’re selected to go to a tropical paradise are unwitting machinery for others.

I won’t give it away in case you’ve not seen Scarlett Johansson and Ewan McGregor tearing through the sky on some futuristic motorcycle. Things are not what they at first seem. That’s the point.

Which leads us to Nasdaq OMX PSX.  On August 1, the PSX becomes what it calls “a Price Setter Pro Rata algorithm for all symbols, pending SEC approval.” The PSX once was the Pacific Stock Exchange. Now it’s one of the Nasdaq’s three stock markets.

If it’s an exchange, why do they call it an algorithm? Because it’s less a marketplace than a mathematical calculation designed to do something: Set prices. It guarantees traders 40% of an order so long as size meets requisites.

In its marketing materials, the Nasdaq says the PSX is “a Reg NMS protected quote and runs on proven INET technology.” A quote? A price. Under Reg NMS, protected quotes must be automated and cannot be ignored by the market. So the PSX is a price.

INET was a trading system created by the dark-pool Instinet that merged in 2002 with Island, another electronic communications network, or “ECN.” ECNs slaughtered exchanges in the 90s, taking perhaps 65% of all trading at the peak before exchanges bought them and in effect became ECNs. Nasdaq acquired INET in 2005.

Now stay with me here. This story relates directly to you, in the IR chair. There’s a trading firm called Chimera Securities. We see it in about 75% of our Nasdaq client base. It’s a proprietary trader – no customer accounts. It trades equities and options. It provides a platform for hundreds of professional day-traders to execute diverse speculative tactics, and it runs automated strategies to utilize liquidity its traders hold. It’s a member of the Nasdaq OMX PSX, and the Nasdaq OMX PHLX, the latter the Nasdaq’s options platform. Chimera belongs only to these two markets. (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…)

We’re late this week due to celebrations around the anniversary of the rebellion from the Crown. We played croquet, appropriately and cheekily British we thought (no offense to our good friends and former overlords across the pond). Croquet has actual rules we learned.

Sunday, Karen and I loaded the bikes and set out with good friend Jeffrey to conquer the passage between two of Colorado’s tall “fourteeners” named Princeton and Harvard. We rode from the Arkansas Valley floor at 8,000 feet up Cottonwood Pass (which sounds like “cotton whupass”) from Buena Vista to the summit at 12,126 feet and a stunning view of the fruited plain.

Choosing a route from point A to point B had me thinking about stock trades (you do this long enough, that’ll happen to you too). Stock trades must have routes. Sometimes it happens automatically. Whether orders for shares in your stock meet their matches internally at Barclays or by dint of timing, routing, pricing and chance at Susquehanna’s dark pool, RiverCross, often is a matter of routing. Even online brokers afford ways to route trades now. (more…)

Mad Scramble to Skirt the NBBO

NBBO would be a good name for a rock band. But it stands for “National Best Bid or Offer.” It also appears to be some kind of joke, because everyone tries to avoid it.

The NBBO stems from legislation passed in 1975 by Congress to create a national market system. If you’re already snoozing, you’ll miss the good stuff. You cannot make up stories like this.

Back in the 1900s, several cases involving the NYSE and other exchanges and their proprietary data reached the Supreme Court. In each, the Court held that exchanges possessed an undeniable right to their proprietary quotations.

In other words, where we take for granted now that quotes for stocks are as basic a right as breathing, it used to be that keeping those quotes secret was as basic a right as breathing. (Since our markets flourished then and gasp now, we’d be idiots not to wonder which approach was correct.) (more…)