It will be some time before radiation levels return to normal, but the industry and its regulators are using this time in the media spotlight to educate the world about market structure and the inner workings of the Street. To that end I would like to dispel some of the lingering myths around trading, and comment on the steps forward that have recently been suggested by the Securities and Exchange Commission chairwoman, Mary Jo White. Let’s bust some myths.
Myth #1: Trading is a zero-sum game.
It’s not. In fact, the economic outcome of trading depends on the increase or decrease in value of the underlying asset. Anyone who has owned Apple for the last 10 years knows that asset values can increase dramatically. Apple created and delivered a successful group of products that have generated tremendous cash flows for the company and its shareholders. Wealth was created by Apple, which was reflected in its trading profile, and it’s shared by the stake holders.
Myth #2: Trades occur when the counterparties agree on price.
Contrary to popular opinion trading is not a “kumbaya” moment when buyer and seller hold hands around the camp fire and sing songs of friendship. Trades occur because the counterparties disagree on price. In that sense, all trading is predatory. Why? Because the buyer and seller are taking opposite sides of the same trade. At the moment of the trade, the buyer thinks the value is higher than the traded price, and the seller thinks it is lower. There could be many reasons for their disagreement. In the active trading world, the most common form of disagreement is the trader’s or investor’s time frame. A high speed trader is happy to supply liquidity if the trade can be completed in a very short time frame, typically in a few seconds, for scratch or better. A day trader or Stat Arb algorithm is more interested in the next 10 to 60 minutes, and Warren Buffet and investors with 401-(k)s and pension plans are thinking about the next 10 to 30 years. When venturing into the marketplace, it’s important to remember that trading is highly competitive and sometimes vicious; it’s not a forum for consensus and agreement.
Myth #3: High-frequency trading is successful because of its speed and rebates.
Actually, HFT has been successful because it provides a needed service: liquidity. HFT traders are willing to take short-term inventory risk so that they can offer immediate executions to those with a natural demand to buy or desire to sell the asset in question. When high-speed traders are successful it is because their algorithms have excellent risk management capabilities and perfect discipline. The faster they go, the faster they can adjust their risk and make better trades. The rebate issue is simply a function of where high-speed traders are going to be paid for their service of providing liquidity. If regulators eliminate the maker/taker model, the high-speed group would instead make their money through wider spread capture.
Think of it this way: If you go to a restaurant in the U.S., when the bill comes you add the tip, similar to a take fee. If you go to a restaurant in Europe, the service fee, or tip, is automatically included in the bill rather than itemized and collected separately. Without rebates or take fees, the European dining model would prevail. Traders would see net prices, but liquidity providers would still make profits. The existence of the “maker/taker” model doesn’t create the HFT industry any more than the “menu price + tip” model creates the restaurant industry.
Myth #4: Payment for order flow is bribery.
When retail brokers “sell” their flow to wholesalers it should more accurately be viewed as an investment in a partnership. At a Security Traders Association of New York conference in April, the panel of retail brokers that discussed the state of their business was effusive with praise over their relationships with wholesalers. Their comments included: “Our wholesale partners develop technology to help with our work flow”; “the quality of their product is constantly improving”; and “they are great partners.” The favorable economics of these payments have flowed up to retail customers who currently enjoy the lowest trading costs in history. Shortly after “Flash Boys” was released, an excellent editorial in the Wall Street Journal by Clifford Asness and Michael Mendelson concluded that for the first time, Main Street has the market advantage over Wall Street.
Myth #5: Order types are created to benefit HFT.
There may be some truth to the idea that HFTs are common users of more complex order types, but the important point is that the order types are developed to benefit the market overall by allowing more trades to occur between counterparties who wish to trade with each other. Much of the proliferation of order types started when many order senders opted out of the protections offered by Reg NMS. If trading participants did not opt out of Reg NMS, a significant number of the new order types would be useless. For example, “hide-not-slide” was successfully developed because the customer order had opted out of the price protection that Reg NMS mandates. The customer doesn’t want to “route out” to the protected market and pay additional fees. The customer decision to mitigate Reg NMS then creates the circumstances under which the special order types can be effective.
The SEC’s Response
Chairwoman White’s plan recognized that market quality is very good and that the market is not rigged. She observed that the markets have benefited from Limit Up-Limit Down (LULD), circuit breakers and new Market Access rules. Recognizing the need for continual improvement White called for the commission to examine and prepare recommendations on many topics including: improving risk management, examining the fairness of latency between direct data feeds and the SIP, and whether the migration of trading volumes to dark pools is harmful. Additionally, she recommended reexamining Reg NMS and possibly allowing crossed markets which could reduce the number of order types; exploring ways to mitigate conflicts between brokers and clients, especially over routing decisions; and considering different trading models such as batch auctions and experimenting with larger tick sizes. The proposal was put forth to create an “Anti-disruption Trading Rule” and non-FINRA traders may need to be registered.
Most importantly, the Commission appears to be open to market-based solutions.
Almost everyone on Wall Street would agree with Chairwoman White that market quality is good and that the market has benefitted from the implementation of LULD individual stock restrictions, comprehensive market circuit breakers and stronger Market Access rules. It is encouraging that the Commission is open to market-based solutions which many believe would be more effective than additional regulation.
A new proposal for an “anti-disruption trading rule” appears to give the Commission some fairly broad latitude to determine what type of behavior is not beneficial to the markets. Under the current rules, to convict a trader of manipulation, the prosecutor needs to prove intent along with bad behavior. Intent is difficult to show in an algorithm or on a silicon chip, but the output or behavior of the algorithm is easier to understand and measure for possible misbehavior.
The issues noted in White’s speech are exactly where the regulators energies should be focused. Creating a fair distribution of data by enhancing the SIP or requiring all participants to use the same high speed data feeds seems fairly straight forward. The study around migration of volumes to dark pools will prove to be very interesting, especially when considering that the purpose of Reg NMS was to give incentives for traders and market makers to display more liquidity on lit exchanges. A review and reconsideration of Reg NMS makes imminent sense and the impact of allowing crossed market quotes should be closely studied and hopefully allowed. The Commission plans to examine broker client conflicts and appears to desire more clarity in the handling and routing of orders, but some believe that clients should use the power of their business to hold brokers accountable, and so regulation may not be required.
The chairwoman also said that the Commission is open to different trading models, such as batch auctions. Batch auctions are certainly a different trading model, but they come with their own issues of scheduling and aggregation. We at PDQ would suggest that on-demand auctions, alongside a continuous market, may be a more effective model. Auctions have the benefit of subverting the winner take-all speed incentive in favor of rewarding those participants who can provide price or size improvement for a liquidity seeking order.
Where does all this leave us? I would say that it is okay to remove our special neutral density goggles and come out of the bunker. We have all been fixated on the mushroom cloud created by the “Atomic Flash,” but in reality the markets are healthy, and regulators are working diligently to continue to make them better. It is a good time to be an investor.
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D. Keith Ross, Jr. is CEO of PDQ Enterprises, the operator of PDQ ATS, a high-speed equity trading venue.
