Wait A Second... Level The Trading Playing Field

Includes: BATS, ICE, NDAQ
by: Kurt Dew


The SEC claims it’s all about fairness for individual investors.

But recent events show it is more about settling buy- and sell-side disputes.

Institutions, not individuals, are the focus.

The SEC could easily create a level playing field for all market participants.

The market should clear through auctions.

You think I'm you fool.

Well, you may just be right.

But minute by minute by minute by minute,

I keep holding on.

-- The Doobie Brothers

The recent events in the business of exchange trading display the hypocrisy of modern market regulation in plain sight. According to Congress, the SEC, and to a lesser degree the CFTC, exchange regulation is all about protecting the individual investor. But no. It's really become all about the battle between the institutions of the sell-side and their love-hate relationship with the buy-side.

But the promise of electronic trading, full market access to individual traders, has not only been denied, it has been given only lip service as the ancient advantages of a few insider institutions in political battle with a legion of small outsider investors has asserted itself. This is a proposal with the purpose of resolving this imbalance.

It is easy to be complacent about individual investing. The internet has substantially improved the lot of the small trader. Commissions have fallen dramatically. But the brokerage community and market-makers still reap hundreds of billions per year from small investors. It may be invisible, but it's real.

This article resurrects an idea introduced here -a proposal introduced by academics at the University of Chicago that, I believe, would provide individual investors with an even playing field while smoothing over problems in the dysfunctional marriage of the buy- and sell-sides. We all need to take a few seconds - one is a round number - to think.

This article proposes discrete time trading. Discrete time trading is simply a series of auctions. Human beings would not notice the difference between the current continuous-time trading and this alternative, since the market could, for example, hold ten auctions in the time it takes you to type a key-stroke on your faithful laptop or cell phone. I myself would go to extremes however, and hold an auction only once a minute, to increase per-auction liquidity.

Recent Sell- and Buy-Side Fun. IEX.

The media feeding frenzy that preceded the SEC's ultimate approval of IEX, the new trading venue of "speed bump" fame, as described in Michael Lewis' riveting book, "Flash Boys," opened the eyes of the world. There for everyone to see, were the craven "old line" exchanges, NYSE (a subsidiary of Intercontinental Exchange, Inc. (NYSE:ICE), Nasdaq (NASDAQ:NDAQ), and Bats (:BATSBATS), and the underhanded ways they use the dark urge of the sell-side to feed on their supposed customers of the buy-side.

Actually each of these exchanges own multiple exchanges - "The better to eat you with, my dear!" - if you're into fairy tale metaphors. In this case, multiple exchanges exist to collect the otherwise unnecessary fees that investors pay for access to each exchange's data feed, as required by the SEC. This is one unnecessary exchange subsidy among the many unnecessary exchange subsidies resulting from the SEC's "National Market System" (NYSE:NMS), a rickety obsolete set of rules intended to promote investor fairness. Whatever the original intent, the NMS long ago became a turncoat, taking advantage of investors rather than serving them.

What the IEX fun displayed for all to see is that the non-IEX exchanges have become stooges of the sell-side, largely without so much as a glance from the SEC. And the incompetence with which they represented themselves during this episode has been stunning. Like all parasites, the exchanges have lost their survival tools to dependency on their hosts. This was revealed by several very public self-embarrassing exchanges between exchange executives and various advocates of IEX.

Prominent among these was the CNBC debacle, known simply as "The High Frequency Trading (HFT) Debate." In this multi-party interview; Brad Katsuyama, CEO of IEX; takes apart William O'Brien, briefly CEO of BATS. (This is a fun way to get up to speed quickly on the issue of HFT and, for those of you with a dark side, to watch William O'Brien destroy himself publicly. It's on YouTube. Google "the HFT debate.")

But this is far from the only foolishness from the sell-side exchange stooges. Jeffrey Sprecher, the CEO of ICE, called IEX "un-American," a phrase that conjures up the dark days of the McCarthy hearings.

NYSE, for its part, copied (as in photocopied) one of IEX' patented innovations, previously submitted to the SEC and called "the discretionary peg." The absurdity here was that by submitting IEX' photocopied idea, rather than understanding it, NYSE made a very embarrassing mistake. There is an equation in the IEX submission designed to adjust for the minuscule fractions of a second that data needs to get from the other exchanges to IEX - which depends on the distance from IEX to other exchanges. Of course, for NYSE, these distances are different. So when NYSE photocopied the equation, it got the distances wrong. Embarrassing.

Nasdaq has been perhaps the least coherent of the old-line exchanges. First it objected to IEX' use of technology to reduce the trading advantages that old-line exchanges sell. Then we discovered that Nasdaq has been using this same technology to increase the sell-side's trading advantages. Then Nasdaq threatened to sue the SEC if IEX was allowed to use its technology when it received SEC exchange designation. Lately it is conducting a poll among its users to determine if these users would like Nasdaq to do something with a speed bump of their own.

The old-line exchanges plainly regard IEX as an existential threat. The IT at the heart of the IEX debacle is known as the "speed bump." For the purposes of this article, I am not going to explain the speed bump, other than to say it is an attempt to reduce the "speed boosts" the old line exchanges are providing to those willing to pay for them, mainly the sell-side. These speed boosts give HFT traders advance knowledge of trading activity, an advantage over the buy-side, as well as the rest of us. IEX plans to reduce this sell-side advantage, and has overwhelming buy-side support.

The State of Exchange Trading. Fairness to Retail Investors.

Exchange trading is, and I believe will always be, a "Tale of Two Parallel Markets." One of them is the wholesale market, a source of liquidity. The other is the individual investor market, a user of liquidity, as markets are currently put together.

Over time, electronic trading has taken away what I believe was a valuable source of background information about the interaction between market participants, since you can no longer watch them at work. It was once very edifying to watch a trading floor during an open market; with institutional phones located next to the trading pit, and retail phones located 50 yards away.

There was no way a government agency could perpetrate the fiction of fairness to retail when the evidence of a double standard was so clear. Electronic trading provided the opportunity to redress this unfairness. But the opportunity has been frustrated to date.

This is important to the future of markets because institutions find exchanges desirable; individual investors find them essential.

Exchanges play a vital role for individual investors. For individuals, it is really dangerous to invest in illiquid things other than one's personal abode or personal business. Without liquidity, an investor needs to have eyes on, and a carefully considered plan to escape unexpected adversity. Yet every individual investor requires liquidity as well, if only to make necessary adjustments to personal property over time. And an individual has only one place to go for liquidity - exchanges. They may not access the institution's OTC markets - which is why OTC markets exist.

For institutional investors, exchanges are a tool. They are not the source though which institutions implement strategy. Strategy for institutions requires large transactions. This is done through IPOs, private placements, and other one-off transactions for the most part. The old reliable method, wholesale loans, are a declining part of this institutional process.

As with most ex-institutional traders, my investment experience follows two tracks. On one hand, there was my trading as a professional. This was very different from my trading for my personal account. The primary difference is leverage.

As a professional trader, I could not get enough leverage. I could not trade large enough size. My object was to multiply very tiny profit margins, margins that I was relatively certain to collect. Indeed, in my early years I was thought of, in some regulatory circles, with considerable justification, as The Leverage Prince of Darkness. I would get nasty phone calls from the CFTC near futures settlement days telling me I had exceeded position limits on the Eurodollar futures contract. "So sue me!" I told them. "I can't wait to get into court, so I can listen to you accuse me of forcing large banks to issue Eurodollars at rates that are unbearably low!" It is fun to trade a market that most people don't understand, when you are young and full of yourself.

But trading my own account is another matter. I avoid leverage because leverage is risk - and it's my money! This means I must form opinions on the future of my investments. I find that in the one area where I am comfortable using my own expertise, banking, my expertise consists of being able to make an informed judgment about the expertise of my peers. Fortunately, here at SA there are plenty of good analysts, and an informal way of disciplining them through comments. SA is a great source for individual traders.

What does this have to do with exchange trading? It shows the vast difference between the role of speed in individual investing and institutional investing. In my personal investing, I may be extreme, since I don't change my mind for years at a time. But I believe this principle applies in a less extreme version to most of us. If an individual investor changes her mind more than once a minute, she is likely a victim of brokers and sell-side trading games. The evidence of researchers is very clear that this is true for most.

Institutions need to trade more frequently, but speed also has different effects on the sell-side and the buy-side. The old-line exchanges that offer speed advantages to the sell-side have created a profit opportunity for IEX, which provides greater balance for the buy-side by reducing this speed advantage.

What is "Wait a Second?"

My proposal is to replace the current variable interval between order placement and fills - an interval that depends on the completely market-irrelevant issue of the distances between computer locations and the speed of light - with a time interval determined by humans.

I got to this point of view by pondering several considerations:

  1. Why did we ever trade continuously rather than hold periodic auctions? I doubt there was a conscious decision. Men - no doubt in those days it was only men - wandered into John Law's coffee house in London, asked what the going price was, then made a decision, perhaps shouting out a bid and waiting to see the response. But decisions took minutes and hours, long enough for a trader to think. Why would we, as a society, want to trade so frequently that more than 90% of trading decisions must be made by computers?
  2. IEX is, in essence, an effort by the buy-side to gain greater balance against the old-line exchange stooges' sale of speed advantages to the sell side. Although this can only benefit individual traders, it certainly does not create a level playing field for them.
  3. Waiting a second would completely eliminate the need for a speed bump. It would simultaneously eliminate the speed boosts being sold by the old-line exchanges. Now that would be really un-American!

As much fun as it is to watch the "real time" multi-colored charts amid fantasies of learning precious second-by-second factoids, it might be more fun not to lose the billions that we investors pay for this data. Who, by the way, generates trading data? We traders, or the exchanges who get paid to tell us the prices at which we traded? Why don't the exchanges pay us?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.