January 14, 2015

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.

Participants did not choose this stock market. Spreading governmental paternalism deemed investors unable to figure out for themselves if they were getting good deals, so we have an equity market built around competition to set price, with exchanges and brokers paying intermediaries to be first, the exact opposite of merit-based deals and a market that forms critical mass for its consumers.

Which brings us to “crumbling quotes,” how our friends at IEX describe transient manifestations of apparent best bids and offers that deceive investors, Virgilian Sirens calling Odysseus to the shoals. IEX first created its patent-pending network architecture called in Flash Boys the Magic Shoe Box to add 350 microseconds to orders on its platform so ones arriving elsewhere wouldn’t race ahead on advance order-information. In effect, IEX added fractional terra firma to put everyone on the same footing.

Now, IEX has gone further. In an interview, CEO Brad Katsuyama and IEX’s math genius Dan Aisen (one of Forbes’ Finance 30 Under 30) said IEX’s Discretionary Peg Order (D-Peg) moves beyond the 350-microsecond beach head by generating its own calculation of fair prices milliseconds ahead so customers don’t inadvertently trade on IEX at prices that in an instant will no longer be the best. IEX is sleuthing out deception on behalf of its clients, old-fashioned service in a high-tech package.

D-Peg is gaining traction and so is IEX. The latest FINRA rankings of dark pools and other alternative trading systems put IEX fourth out of 40 measured platforms behind UBS, Credit Suisse and Deutsche Bank, and with significantly better shares-per-trade.

It’s fascinating to me that IEX works so hard to keep its customers from getting jobbed. My wife Karen and I know an attorney in government whose workdays are spent pursuing faintly deceptive private-company practices. Yet right here in front of us, perhaps the world’s best known market is built on a government-mandated model that routinely conjures deceptive prices.

The damage is more than missing out on a fractionally better price. Public companies assume share-prices they see are correct, yet no exchange bases order types on the consolidated tape that companies and retail investors depend on, because it’s out of step – a crumbled version of reality.

Stock charts usually show open, high, low and closing prices for shares, and yet the vast majority of trades occur at benchmarks between the best displayed prices. Listing exchanges tell public companies wondering why shares are up or down that they “broke through moving averages.” Yet all the registered exchanges offer proprietary data feeds that permit some to know about price-changes before the rest, who get stale data, day-old bread offered as oven-fresh.  Isn’t that deceptive?

The hallmark of enduring endeavor is truthfulness, reliability.  But in the stock market, Quae sunt quod non videntur – in Latin, “things are not as they seem.”  We’re glad to see IEX battling the establishment, and we hope they become an exchange that offers everybody including public companies truth in advertising.

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