February 8, 2011

Pay Attention to Your Trading

We’re leaving most of this week’s email to our friend Joe Saluzzi at Themis Trading. Joe is a groundbreaking and thoughtful critic of contemporary trading, and among the smartest people we know. Last October, Steve Kroft interviewed Joe on 60 Minutes about our machine-driven markets.

Read what Joe says below about the recent Nasdaq website security issue. Even if you trade elsewhere. You all trade everywhere today. Do you know how much of your volume trades on your listing exchange?

How about your volume at other venues? The brokers executing these trades? The smallest investor trading just 100 shares can know whether a trade is executed on an agency or principal basis. But public companies don’t even know the brokers behind the majority of trades.

How about your daily short volume? Exchanges are currently implementing circuit breakers on short trades as required under SEC amendments to Reg SHO. But public companies don’t even know what part of their daily volume is short.

With those seeds planted, Joe’s comments:

This weekend we learned that the Nasdaq Stock Market had its computer network breached. The WSJ broke the story saying Nasdaq’s “computer network had been broken into, specifically a service that lets leaders of companies, including board members, securely share confidential documents.”

It appears from press reports that the trading system wasn’t compromised and that the hackers were more interested in just getting inside information from corporate board members from a product called Director’s Desk. One customer that Nasdaq had for Directors Desk was none other than that Ponzi-sniffing organization known as FINRA. Well, as the Church Lady said on SNL this weekend, “Isn’t that special.”

We know there are numerous computer attacks on corporations every year and that this is probably similar to those types of attacks. But what really concerns us is that the stock exchange business has changed dramatically over the past two decades. No longer is there a central auction place where capital can be provided by dealers. No longer do listing fees make up the bulk of an exchange’s revenue. Now, exchanges compete in an extremely low margin, highly competitive business where they all court the biggest high-frequency traders.

We wonder if their goals of fairness and investor protection have been sacrificed at the altar of the almighty return to the shareholder. We wonder if the exchanges are spending enough money to protect the information that investors hand over to them daily or if corners are being cut to make sure profits stay healthy? We wonder if our regulators, who also seem to be budget constrained, are paying close attention to these security issues?

Publicly traded corporations who list on these exchanges should be concerned about this breach of security. They should also be concerned how their stocks are traded. Do they even know what goes on in their stock on a daily basis? Do they realize that up to 70% of the volume in their stock is machine based and probably doesn’t even know what their company does? Have they seen the almost daily “mini-flash crashes” or the constant predatory behavior that exists in most small caps?

Corporate IR executives need to know more and should start demanding more information from the exchanges on their stocks’ behavior.

We understand that technology has helped make markets more efficient. But we ask, at what point has the pendulum swung too far? At what point may for-profit exchanges begin to sacrifice investor integrity? How fast is enough? How small do you need the spread in an order-driven market to be (exchanges in Europe are now arguing for sub-penny price intervals)?

These are just some of the questions that all investors should be asking. Unfortunately, sometimes it takes a breach in security or a Flash Crash for people to stand up and start demanding answers.

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