Jamil Nazarali, senior managing director and global head of the electronic trading group at Knight, spoke with Traders Magazine recently about several issues affecting equity trading. Among the topics discussed were the "flash crash," transparency in order routing and the role of market makers.
Traders Magazine: What trends have you seen in the area of algorithmic trading since the May 6 flash crash?
Jamil Nazarali: One development [we’re seeing] in algorithms is the incorporation of risk protections. This would be to help prevent another May 6, where something that in most situations performs fairly well could perform poorly in extreme situations. No one wants his algorithm to be the next algo that causes a market disruption. Everyone should have in place on their algorithms either a price limit or, under severe market situations, some kind of pause mechanism to kick the algo back to the sender.
This is related to the Securities and Exchange Commission recently passing the sponsored-access rules-you can’t send an order straight to floor using someone else’s MPID-which was considered "naked access." It seems to me, if you are allowing a firm to use your algos to access the market, then just like the sponsored-access firm that now has to incorporate risk checks, you should also be responsible for the risk checks. Whether they are using your algos or your lines, it’s really the same-you’ll have to be responsible for putting in risk-check mechanisms.
TM: And away from risk controls?
Nazarali: More algorithms are encompassing other asset classes beyond cash and options, and in a more seamless way. They’ve also improved their global capabilities, simultaneously executing trades in both the U.S. and in foreign markets. For example, [you can use] one algorithm to buy a technology stock in the U.S. and sell a U.K. banking stock. But there are still a host of different clearing and custody issues to contend with.
TM: Do you feel market makers should have stricter market-making obligations?
Nazarali: We think the current regulatory framework in the U.S is very comprehensive. However, if the SEC believes additional regulations are required, then we support the proposed market-maker obligations. I think market makers provide an important intermediary function in the marketplace. But over the last five to 10 years, high-frequency traders and other players in the market who don’t have the same requirements and obligations have taken a much more prominent role in the market.
Right now, there are a lot of people who call themselves market makers, and they don’t really do anything other than put out a two-sided quote, which anyone can do. But at the same time, they’re able to get affirmative determination, which means they don’t have to locate a stock before they short it. What we’re advocating or saying is, "Look, it should mean something to be a market maker." It should mean something more than putting out a two-sided quote, which until recently, meant you could put something in at a penny by 10,000. Now, at least, it means something more.
TM: What would you like to see as criteria for market makers?
Nazarali: We put out a letter to the SEC that talks about requirements like percentage of time at the inside and depth within the national best bid and offer. We think these things would be helpful to the marketplace. But at the same time, market makers should get some relief to allow us to perform our duties a little bit better.
For example, there are many situations where there is retail-buying interest in a stock on the Reg SHO list. Unfortunately, because we can’t short the stock, the buy must be sent to the market-and that hurts the retail investor because he ends up buying at a higher price. Were we able to provide an intermediary function, then we could short the stock, sell them the shares and then have some time to cover that short.
TM: Should HFTs be required to register as market makers?
Nazarali: I do not think they should be required to register. But I do think if they do register as market makers, they should be bound by the same requirements, and if they do not register, they should locate stock before they borrow it, as only market makers are exempt from this requirement. I think it should mean something to be a market maker. But again, there is no reason they should be required.
TM: Why?
Nazarali: High-frequency is just a different business model. If they just want to be in the marketplace and trade, they shouldn’t be restricted from doing just that. I think they provide a valuable function to the market-like providing liquidity-and I think that is good. I think if they are not going to avail themselves to any of the benefits of being a market maker, then they shouldn’t have to become market makers.
The marketplace is really competitive, and we’re not looking to reduce the competition or innovation at all and force people into certain buckets. However, we do think there is a role to be played by market makers, and the SEC is considering that.
TM: Then what is the real role of the market maker?
Nazarali: The real role of the market maker is to primarily facilitate trading, make orderly markets and provide liquidity in the marketplace to the best of its ability. On May 6, there was no one who had enough liquidity to be buying from every seller. And so I don’t think you can mandate someone to be there all the time. However, I think you can provide incentives to be in the market more. Incentives could be in rebate form, or relief around short sales.
TM: Can you give an example?
Nazarali: I think one example is the NYSE’s DMM and SLP program-where they said, "We’ll provide economic incentives to be at the inside. And if you are a supplemental liquidity provider and come on our platform at the inside at ‘x’ percentage of the time, we’ll give you an enhanced rebate." And guess what happened? Lots of people came on their platform, and they started adding a lot of liquidity, and that resulted in an increase in NYSE market share. If you provide those types of incentives, people will respond to them and the market will be better off.
TM: The SEC has voiced concern over dark pool trading and internalization. How do you view their concern? Opponents say internalization hurts public price discovery. Do you agree?
Nazarali: The short answer is no. But it’s right to ask that question. Are we at a place where the amount of trading off exchanges has impeded the price-discovery process? But some of these questions are being raised by certain business models worried about losing market share. It’s a very competitive market, and investors have benefited from that competition. In the U.S., there is a lot more stock traded off exchange than any other market.
Yet the last five years, when dark liquidity and dark trading developed, has been a period of extraordinary robustness in the marketplace. Whether you’re looking at things like tighter average spread, higher volume at the inside, lower explicit commissions for retail and institutional trading, lower average market impact-by almost any measure you use, investors are trading better, faster and cheaper now than they were five years ago. The data support the fact that competition has been good. I’m concerned certain players, whose business models have been hurt by competition, could use the regulatory process to stymie that competition.
TM: Do you see internalization growing in 2011 from the current level of 30 percent? Or what about growth in dark pools’ share of that percentage? It is now around 12 percent.
Nazarali: I see them growing a little, yes. I don’t see the explosive growth we’ve seen over the last few years, though. Broadly, I think the overall rate could grow to 33 percent from 30 percent, and that’s assuming no major regulatory burdens or changes. The dark pool percentage will drive most of that growth, moving within the 12 to 15 percent range.
TM: How do you address the buyside’s concerns about transparency on how their orders are being routed?
Nazarali: The buyside should certainly have the ability to understand better how their orders are being routed by their sellside brokers. They should be able to say both, "Tell me where you are sending my order," and at the same time, "Don’t publish to others what’s being done with my order."
TM: What do think about the amount of message traffic going through the system? What should be done about it? The SEC has floated a minimum quote time idea. Or do you think there should there be a fee for excess cancellations?
Nazarali: It seems that a handful of firms are generating a large amount of message traffic, and all firms are incurring the cost of parsing this traffic. So, you have this breakdown in economic efficiency because you’re creating costs others have to bear.
TM: So what do you do?
Nazarali: There are a few things you can do. If this is a cost issue, then you can try and internalize those costs, so that when you develop a new strategy you take these costs into account. However, you should be careful to charge only what the "true" costs are to the system. You also have to make sure you credit the firm for the "benefit" to the system of the additional quote, since the quote adds liquidity and therefore benefits everyone in the market.
You could also charge for cancels. You can charge for excess message traffic. But, it’s very risky to put something like caps on message traffic and cancellation rates, or implement minimum quote duration. These things, I think, will lead to a number of unintended consequences. It’s also risky to charge more than the cost you create for the entire market.
Rather, regulators can continue to go after firms that engaged in illicit activities, such as quote stuffing. I think that’s something they should do. You could do things like in options, where you don’t update quotes at the inside as often. You could only update if the price changes, not the size. However, I do think a lot of this is a smoke screen for people looking to go after high-frequency trading.
TM: BATS’s new exchange is going to reward liquidity takers (3 cents per 100 shares). Would that encourage you to send order flow to BATS, or send more?
Nazarali: We’ll do whatever is in the best interest of our clients and shareholders. If there is a very attractive rebate out there, then we prioritize accordingly.
