January 27, 2016

Pricing Models

The 1,200 NYSE stocks supported by Barclays were the last redoubt of the old market-making guard.

Yesterday, New York City-based Global Trading Systems (GTS) said it will buy the Designated Market Maker (DMM) unit from Barclays at the NYSE. GTS joins KCG Holdings, IMC Financial Markets and Virtu Financial Inc. (which may have to call itself VFI to keep acronym pace) as the quad core making markets and setting prices for NYSE stocks trading at the home exchange.

Barclays likely exited the DMM business because it couldn’t compete. For one, banks are under regulatory pressure to quit trading for their own accounts. Second, rules on the floor prohibit DMMs from using customer orders to price the market. Barclays has customers. The rest were free from the task of sorting those from proprietary trades.

GTS is a high-frequency trading (HFT) firm like its floor brethren. KCG alone has an agency brokerage business with customers, but it’s the progeny of a marriage between Knight Securities and seminal HFT firm GETCO (the Global Electronic Trading Co., the first curiously anonymous massive volume-maker to grab our attention ten years ago).

DMMs pay roughly $0.03 per hundred shares to buy stock, and earn about $0.30 a hundred to sell it. It works poorly for a conventional broker-dealer like Barclays matching buyers and sellers, or crossing the transaction. Proprietary traders find it a money-minting model.

Lest you Nasdaq companies feel special, you’re no different. Prices at the Nasdaq are set by incentives and dominated by HFT too.  Real buyers and sellers rarely price shares – a fact we establish with Rational Price, our fair-value measure, which changes infrequently.

Virtu and IMC Financial Markets, like GTS, say they’re automated market-makers, an innocuous term implying a robotic form of erstwhile human effort. But GTS isn’t matching buyers and sellers.

In its own words: “Today HFT makes up approximately 51% of trades in U.S. equities, and technology-driven innovations continue to transform the investment and financial sectors in profoundly positive ways. At GTS, our advanced algorithms and ultra-fast computers execute thousands of transactions in fractions of a second.  This automation provides liquidity in all the markets we trade and enables our trading venues to provide lower transaction costs.  GTS is proud to be one of the industry innovators contributing to the evolution of the modern market.”

You see? Not a word about match-making. GTS hopes to convince us that its brilliant technology is profoundly positive when in fact it’s exploiting our ignorance.

Various markets for thousands of years have experienced arbitrage – capturing spreads that develop because of inefficiencies in pricing, supply, demand and information. Take theater tickets. Scalpers arbitrage supply and information asymmetries. They are intermediating intermediation. What if we were all forced to buy tickets from scalpers – somebody wanting to profit from owning nothing? Scalpers should be a small part of a market, not 51%.

There are four primary problems with a market priced by HFT:

Risk. If regulators think proprietary trading is risky, why then is 100% of the DMM model proprietary trading?  Why are regulators propagating rules that fashion a market inhospitable to firms taking companies public and supporting them with research and true market-making (carrying inventory, serving customers)?  Following the August 24 trading debacle, JP Morgan changed DMMs from KCG to Barclays because, rightly or wrongly, it lost confidence.

Volatility.  HFT claims to smooth volatility with rapid-fire transactions. That’s muddying the definition. Volatility means “tending to vary often.” Things vary often when they’re broken into fragments and bounced around. That’s intraday volatility, or the spread between high and low daily prices. Tally yours for a month. For AAPL over 20 trading days ended Jan 25, it’s 55.8% – or in dollars, $56.39. That’s the sum of spreads between highs and lows. The Fed shoots for a 2% annual inflation target (wrong but a separate story). AAPL changes more than that each day.

HFT isn’t intermediation but arbitrage. Intermediating by definition is fostering agreement or reconciliation. It involves a vested interest in outcomes. Customers are a tacit requirement. HFT firms have no customers and care not about direction. They create fleeting price-changes for profit.  That’s not market-making.

HFT distorts supply, demand and price. Deduct half your volume because it’s HFT (and over 48% of volume is borrowed so add that to the risk equation). But it set prices and created impressions of supply and demand.  These firms commit little capital, manage no investment portfolios and execute no trades for investors. They’ve devised proprietary pricing models that find short-term inefficiencies (fractions of seconds at once in equities, currencies, commodities and derivatives). They obscure the truth in effect, and in a crisis of magnitude, discovering that most of the prices and half the volume are arbitrage could have devastating consequences for multiple asset classes simultaneously.

Solutions? In Swiftian spirit, there’s the Berkshire-Hathaway Option.  If every US-listed company would reverse-split its shares to $200,000 each, the cost would force arbitragers out. Our serene market would lack arbitrage and intermediation and trade about 1.5 million shares daily. Of course traders, brokers and exchanges, even the regulators (the SEC budget depends wholly now on Section 31 trading fees), would go broke.

Moral of the story? If intermediaries are half our market, it’s a poor one. That should make us mad (why doesn’t it?). It matters not what altruistic oratory streams from the community of high-speed traders. Calling arbitrage market-making will not magically make it so, nor will a better deal materialize from a multitude of middle men.

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