Tagged: Flash Boys

Trivago and Traders

I was high-frequency traded by a travel site.

Had that happen? You web-search a place and pricing and there’s no availability for the date you want so you check elsewhere and suddenly there’s vacancy – but now it costs more so you better act fast!  It’s like the stock market’s recent performance.

It’s not the first time I’ve been played by algorithms but it happened trying to book rooms in Crested Butte this week as we toured my visiting mother around the continental divide. Having spoken with hotel staff and knowing there wasn’t peak demand, I waited. At the hotel we got the best bargain of all. If you want a good deal, cut out the middle man.

And when you’re shopping online for a hotel deal, realize it’s a cabal. Expedia owns hotwire, hotels.com, Orbitz, Travelocity, and trivago to name the biggest brands. Priceline owns booking.com and Kayak among others.

When you start searching for a travel deal, the machines know almost instantly. It’s an integrated network where much of the pricing and supply are controlled by a handful of players.  Start looking for rooms, and rates rise not due to supply outstripping demand but because middle men change the prices.

Let’s think about the stock market. Expedia and Priceline have an advantage through being many places simultaneously. They’re in effect trading all the stocks – all the places you go unless you cut them out and go straight to the hotel.

Who in the market trades everything?  No, not Goldman Sachs. None of the big brokers trade anywhere near all the securities in the market. That’s not the business they’re in.

But high-frequency traders do. All our clients down to the very smallest ones under $50m in market cap are traded daily by high-frequency firms.

High-speed firms trade thousands of securities everywhere simultaneously, generally exchange-traded products where setting the prices everyone sees is the aim: stocks, commodities, derivatives and currencies.

But these firms don’t want to own anything. Wrap your head around this idea, because it’s a lot like getting travel-deal HFT’d.  The travel sites keep changing prices in order to prompt a reaction.  You’ll get teased: “Four left at this price!”

It’s the same in the stock market.  High-speed traders with vastly powerful networked machines connected to all the trading venues know every time there are ripples of supply or demand in any security.  Instantly, the price for that stock changes. If you’ve read the book Flash Boys, you get what I’m saying.

But let’s go one step further.  In the last 17 weeks through July 29 this year, there was not a single one in which Active Investors – buy-and-hold stock pickers – led as price-setters (through both the Brexit Swoon and Brexit Bounce).  In nine of those weeks Fast Traders did.  That’s over half the time (otherwise it’s been Asset Allocation – indexes and ETFs – or Risk Management, counterparties to derivatives like options and futures).

This is why the market is defying fundamentals. It’s exactly how pricing and supply defied fundamentals when we were trying to book a hotel in Crested Butte. Elevation Hotel & Spa was not remotely out. But the fast-trading hotel algorithms sure wanted everyone to think so.

The same thing happens repeatedly through each trading day. Stocks soar, and then falter and fall…and someone tries to book some shares…and all of the sudden prices race back up and the Dow Jones rises 80 points.  Better act fast!  These prices won’t last!

The truth is that the equivalent of booking.com is making it impossible for anyone to know the real supply and demand of stocks.  Since investors can only guess the same as we do hunting for hotel deals, they scratch their heads and try to buy.

You might say, “But we get good hotel deals.” As in the stock market, electronic trading ended laziness at big brokers and exchanges. But now the middle men have taken over. They’re now worse than what we had before. They’re fostering dangerous illusions.

Illusions cause markets to become mispriced because it’s impossible to separate the middle men from the actual supply of product.  How to solve it? First, understand how much of your daily volume is being driven by middle men. Then you can begin to measure what’s real.

Ultimately, investors and public companies should confederate to create a market that bars high-speed traders. Until then don’t be fooled by either HFT or booking.com.

Reflection

Most of you are out this week, but you’ve got phones.

Unless you’re disconnected from them like we were (by choice) a couple weeks back in the Caribbean, you’ll see this post. Send it to your CEO and CFO.

Whatever the theme for the year – “it ended flat,” “The Fed led,” “August Correction,” “Flash Boys,” “The Year of the ETF” – we’ll wrap it by pointing you to our friends at Themis Trading for a final lesson on market structure.  Read “Yale Investment Chief: America’s Equity Markets are Broken,” (if you’re not reading the Themis blog you should be) and reflect:

-The $25 billion Yale endowment fund favors private investments where horizons are longer and less liquid. Think about how often you’ve heard you need “more liquidity.”

-“Market fragmentation allows high-frequency traders and exchanges to profit at the expense of long-term investors.”

-“Market depth is an illusion that fades in the face of real buying and selling.”

-“Exchanges advance the interests of traders by sponsoring esoteric order types, which for hard-to-understand reasons receive the approval of the SEC.”

-And if you’ve not yet done so, read Flash Boys

Then read this editorial in the New York Times.

On January 6, we’ll talk about 2016.  Happy New Year!

The Frontier

A war of words is unfolding in our profession.

In case you’ve not followed, it’s about the market for the product you manage as investor-relations officers. Many of you have read Flash Boys, Michael Lewis’s (The Big Short is soon coming to movie screens) engaging story of high-speed trading in equities. IEX, the upstart Lewis profiles, aims now to become a stock exchange, listing and trading your shares. Its application is up for public comment.

The dirt’s flying. IEX is accused by establishment exchanges of operating an unfair structure. The broker earned its stripes by offering investors a transparent alternative trading system characterized by the Magic Shoe Box – a fiber optic coil standardizing access to prices. You ought to read what’s been said and how IEX is responding.  We suspect its future fellows may regret having hurled recriminations. Seriously. See the comment letters from foes and friends (Southeastern Management’s supportive letter, signed by fellow investment managers in Declaration of Independence fashion, is a must-read. We’re finalizing ours now.).

Why care from the IR chair? Can your CFO explain to the Board how the company’s shares trade?  Public companies have left responsibility for the market to somebody else. The small city of Bell, CA followed this strategy and later found its managers were paying themselves a million dollars. Do you know what your exchange sells?

We’re picking no fights with the Big Two though you regular readers know we’re critical of their arbitrage incentives, how exchange revenue-drivers shift focus from investment to setting prices. When they match a baseline percentage of trades in your shares (and quote best prices often enough), then under the rules of the Consolidated Tape Association, exchanges receive the lion’s share of market-data revenues from the national system tracking prices and volumes. I think the establishment simply resists sharing with IEX a piece of this pie (how about growing the pie bigger?).

By setting prices continuously the exchanges create additional proprietary data that they sell back to traders and market centers. Why do they buy it?  Any participant serving customers must offer best prices and to ensure that they do, rules say they must buy all the data. Fee schedules for the exchanges show data-feeds can cost vast sums.

Yet in a perverse irony that cannot be blamed solely on the exchanges, traders with no customers often set most prices. These firms are the high-frequency traders about which Flash Boys unfolds its racy narrative.

IEX won’t be paying fast traders to set prices. It’s got a straightforward approach to matching customers. Read the comments on both sides and send a couple along to your executives. Ultimately the equity market exists for you, public companies, and your active investors, not so traders can arbitrage some split-second spread. We should then ask why legacy exchanges are paying for split-second prices.

We admire our friends at IEX and want them to succeed. Where companies once listed on many exchanges – Pacific, Boston, Philadelphia, Chicago, Cincinnati and other markets – the choices today are Either Or.  BATS has no current plans for listings beyond ETFs so it’s a duopoly. Our profession should welcome a fresh third option.

As the tryptophan turkey high tomorrow washes by and you give thanks (in the USA we worship turkey on the 4th Thursday of November, international readers), be glad about the ever-present opportunity for say on market structure, about which issuers are notoriously silent. Resolve to be louder.  Go forth boldly and lay claim to the frontier.

Crumbling Quotes

Terra firma. In Latin, “solid earth.”

Two thousand years ago people thought Latin would be the lasting language of commerce. History disproved that thesis, but the notion of a firm foundation remains. In stock-trading, however, the ground relentlessly crumbles as prices shift in illusion.

The significance of this condition goes beyond whether investors are getting fair prices. Iconoclastic IEX, the alternative trading system and prospective exchange introduced popularly in Michael Lewis’s book Flash Boys, has a solution. More on that in a moment.

Many don’t think there’s a problem. Costs are low, we’re told. Apparently stocks trade easily. But the success measures themselves are incorrect. Clear supply and demand, identifiable participants, differentiated price, service and products – these are hallmarks of free-market function. The buyers and sellers who benefit from low spreads are those whose minds are always changing.

The stock market today forces competitors to share products and to match each other’s prices. Most observable prices come from parties aiming to own nothing by day’s end. Quotes reflect seismographic instability. Nobody knows real supply or demand because 42% of traded shares are borrowed and by our measures 85% of market activity is routinely motivated by something besides rational thought. Half the volume flows through intermediaries who take great pains to remain anonymous. Imagine walking into a shopping mall full of storefronts without signs. You’d feel like you were frequenting something illegal, chthonian.

The eleven registered exchanges and 40 alternative systems comprising the National Market System are in competition with each other no differently than Nordstrom and Saks, but no law requires Nordstrom to point customers down the concourse because a marquee posting best prices says it must. In free markets, humans compete on merit. If you want a good deal cut out the middle man. (more…)

First Things First

If you’re in a tree sawing off a branch, note which side of it you’re standing on.

The guy studying the branch was Brad Katsuyama, CEO at dark pool IEX, which has designs on exchange-hood. He was speaking along with others before that folksy and fashionable Washington DC club, the Senate Permanent Subcommittee on Investigations (you get a titular sense our republic is engaged in perpetual sleuthing – and how do you conclude a hunt when its sponsor is permanent?).

Katsuyama, who called markets “rigged” in Michael Lewis’s Flash Boys, said yesterday, “IEX was created within the current regulatory framework.”

Translation: “We invested big bucks finding a solution that helps investors and complies with rules and we won’t cut off our noses to spite high-speed faces.”

Wait a minute. Doesn’t IEX hate the current framework? For those who’ve not read Flash Boys yet, I won’t spoil it. Ronan Ryan, who earns his own “problem” chapter, entertained a big NIRI National breakout session last week. Karen (beloved spouse and ModernIR COO) thought it was the best one ever at NIRI. Even with the f-bombs.

I’m not knocking IEX! Love ‘em. But a point has been missed. In order to facilitate what should naturally occur – buyers finding sellers – IEX had to perform unnatural acts. Let me rephrase. There are rules governing stock orders. To comply, IEX created the Magic Shoe Box, a 38-mile fiberoptic hampster wheel to neutralize fast-trading’s version of location, location, location.

Why is some crazy Rube Goldberg contraption necessary to structure a market so it appeals to real investors? Today’s equity market defies Occam’s Razor, which at risk of offending you experts on philosophy I’ll dumb down to “simplest is best.” For proof, the outfit heralded with restoring fairness must perform technological gymnastics to achieve it.

Having committed effort to solving a problem that only exists through synthetic warping-by-market-rule, IEX now is in a quandary. It can’t call for an end to something for which it just found a solution.

We here at ModernIR have long decried how arbitrage prices stocks. The role of the consolidated tape in prices, how data revenues are shared among market centers, and what makes data and circuits at exchanges valuable cements that reality. This foundation now underpins the US stock market with its ETFs, its 44% short volume daily, and its tens of trillions of dollars annually.

It may be an SOB. But to paraphrase political leaders of past generations describing distasteful foreign dictators who were allies: it’s our SOB.

The Senate hearing spotlighted “maker-taker,” about which we’ve written much and often. It describes incentives paid to traders to bring their orders to markets. The NYSE is on the record calling for its end.

We remain uncertain if the new owners of the NYSE understand how the market works. Remove incentives at the NYSE, and why would anyone do business there? It’s a marketplace lacking any native orders. It imports 100% of its goods, with rebates.

“Quast has gone round the bend,” you say. “He’s for HFT.”

Not at all! But first things first. Before we outlaw maker-taker (happy to explain what this means – just send me a note), we had better disconnect markets from each other, and remove the requirement that trades match between the best bid and offer. If we don’t, we will have a stunning disaster. Public companies should care about that.

And if the SEC is unprepared to loosen its grip so the market may function as a free one should, where buyers and sellers match at prices within the natural limits of supply and demand, then we best get used to the SOB we’ve got.

Either way, IROs, do you measure markets the way they work now? Monitor behavioral market-shares, short-volume and dynamic fair value. If you’re tracking ownership and moving averages, you’re missing most of what’s actually occurring.

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!

The Recovery

It’s all in the recovery.

That’s the philosophy put forth by a friend of mine for dealing with unpleasant facts.

I think the chief reason for the recent swoon in stocks was not anemia in the job market but a sort of investor outrage. You can’t troll a trading periodical or blog or forum without wading through rants on why Michael Lewis, author of the bombshell book Flash Boys on high-speed trading, is either guilty of torpid whimsy (a clever phrase I admit to swiping from a Wall Street Journal opinion by the Hudson Institute’s Christopher DeMuth) or the market’s messiah.

What happens next? Shares of online brokerages including TD Ameritrade, E*Trade and Schwab have suffered on apparent fear that the widespread practice at these firms of selling their orders to fast intermediaries may come under regulatory scrutiny.

What about Vanguard, Blackrock and other massive passive investors? Asset managers favor a structure built around high-speed intermediation because it transforms relentless ebbs and flows of money in retirement accounts from an investing liability to a liquidity asset. Asset management is about generating yield. Liquidity is fungible today, and it’s not just Schwab selling orders to UBS, Scottrade marketing flow to KCG and Citi or E*Trade routing 70% of its brokerage to Susquehanna.

It would require more than a literary suspension of disbelief to suppose that while retail brokers are trading orders for dollars, big asset managers are folding proverbial hands in ecclesiastical innocence. The 40% of equity volume today that’s short, or borrowed, owes much to the alacrity of Vanguard and Blackrock. The US equity market is as dependent on borrowing and intermediation as the global financial system is on the Fed’s $4 trillion balance sheet.

Hoary heads of market structure may recall that we wrote years ago about a firm that exploded onto our data radar in 2007 called “Octeg.” It was trading ten times more than the biggest banks. Tracing addresses in filings, we found Octeg based in the same office as the Global Electronic Trading Co., or GETCO. Octeg. Get it? (more…)

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…)