January 29, 2014

Reg Nemesis

Omaha!

Rather than Nebraska, we’re in Steamboat Springs enjoying spectacular slopes before this weekend’s big game between our Broncos and the Seahawks.

Denver quarterback Peyton Manning uses the word “Omaha” to change plays or alert his team to shifting defensive coverage. In football, both defenses and offenses try to confuse the opposition with different formations. It’s deception.

In the stock market, the principal purpose of algorithms is to deceive and algorithms execute 90% of stock orders now. The stock market isn’t supposed to contain “the opposition” but buyers and sellers who want to find each other. Why are they hiding instead?

Part of the problem is Regulation National Market System. If you didn’t see Wall Street Journal writer Jacob Bunge’s piece (if you can’t open the link, email me and I’ll send the story) on what’s popularly called “Reg NMS” yesterday, it’s required reading for every IRO, CEO and CFO at public companies.

Two vignettes from Mr. Bunge’s story:

T. Rowe Price’s head of US equity trading Andy Brooks and colleagues ran an experiment. They directed one of their brokers to buy 2.5 million shares of a heavily traded stock, then sought a step-by-step account of how the broker made the purchase.

What Mr. Brooks learned shocked him, he says. To hide the purchase from fast-moving traders, the broker placed and canceled many smaller orders all across the stock market, creating a dense smoke screen of phantom interest in the security. In total, the broker offered to buy 750 million shares of the stock while actually purchasing just 2.5 million.

And the second one:

Invesco’s Kevin Cronin (global head of trading for the Atlanta investment manager) found something similar a couple of years ago when he requested a detailed sample of his firm’s trading. A 1,000-share stock order, which is small for Invesco, traversed 10 separate exchanges and dark pools before it was filled. The order had also been sent to eight other venues where ultimately no shares were bought—but where other traders may have had a chance to catch wind of Invesco’s strategy.

Public companies expect the market to tell them how investors value their shares – and yet investors are engaging in crazy cat-and-mouse games to hide that view.

A big Dow 30 component for whom we provide daily market-structure analytics had a rising price into options expirations Jan 16-21, yet the data we track showed that big indexes/ETFs were leaving – the exact opposite of what the market showed.

You can’t believe what you see. Not even apparent buy/sell balances in the data. Intermediaries responsible for prices can buy from sellers and sell to buyers, and foster storms of deceptive signals to hide their intentions.

We track trade-executions by intermediaries. That’s how we know. You clients who read our commentary every day or every week hear us talking about how difficult it is for institutions to trade even a thousand shares without altering the market.

This is what we mean. Why does it matter to you, IROs? Because the market is not what it seems. If you don’t have market-structure analytics on investment behavior, and you believe what the price seems to indicate out there in the “displayed” market, you’ve been fooled. The market is a mirage.  You’re flying blind. You might as well just yell Omaha! Or something with four letters.

The nemesis of the market is this: Regulators did not believe customers in the stock market could determine for themselves if they were getting a good price. So trades are required to match at the best price – which turned the market over to arbitragers.

Nobody wants to fix it because any solution means regulators give up control to buyers again – who history hath shown ought always beware in the first place.

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