The Public Market's Sweet Spot

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Includes: CBOE, CME, ICE, NDAQ, SPY
by: Kurt Dew

Summary

Recent financial innovations too often add complication to the trading environment.

But the sine quibus non of market efficiency are maximum volume; minimum cost.

The bold change that will revolutionize trading will be a replacement, not an add-on.

So please, go all the way…

-- Raspberries

There is too much fiddling around with market efficiency. Not enough Alexandrian decisiveness. Like Alexander the Great, who unraveled the centuries-old insoluble Gordian Knot with a slice of his blade – market change, to really matter, must destroy the cluttered old system, not meddle with it.

And the time is ripe. In itself, the hype surrounding the slew of new futures contracts based on Bitcoin is much ado about nothing. But the current Bitcoin futures brouhaha has been revealing to people interested in the development of public markets more generally. The reaction of market regulators, to the exchanges’ proposed Bitcoin-based mainstream financial instruments such as futures contracts and ETFs, revealed the enormous disparity between the two regulators’ attitudes – CFTC and SEC – toward new products.

The SEC has bucked back hard on equity trading platforms’ submissions of proposed Bitcoin ETFs. The CFTC, on the other hand, immediately approved the Bitcoin-related applications of each and all exchanges, startup or otherwise, wishing to trade instruments that the CFTC deems to be within its jurisdiction. The CFTC is satisfied to receive a postcard from the applying exchange; a postcard promising only that the proposing trading venue will obey the law. With a pro-business Congress and President, the CFTC seems bound to get the better of the SEC in this struggle between regulators for jurisdiction, perhaps becoming the ascendant regulator.

CFTC permissiveness opens a door. If a trading platform wants an opportunity to snatch volume from the competition, introducing something the world’s traders would find appealing – the iron is hot. This article discusses the market’s sweet spot. Where are the existing markets vulnerable? How would a platform attack these vulnerabilities? Where is the low-hanging fruit?

Bold Plans and Meek Plans

Most fintech creations are meek plans. The innovator mistakenly seeks to gild existing lilies; not to replace them. That is why upstart developments such as the surge of high-frequency trader (HFT) profitability appears to have already become a flash in the pan; recent performance of these firms has disappointed.

The reason; HFTs do not replace inefficient markets with more efficient ones; instead, they exploit inefficiencies resulting from shortcomings in existing markets. This summary of the entirety of HFT strategies – as far as I know, is characteristic of all: HFTs take advantage of multiple versions of the few markets that generate significant risks in the global economy through arbitrage created by superior knowledge of price disparities.

The source of this knowledge for HFTs is their speed advantage. Thus the HFT strategy is inevitably self-destructive, a meek plan since all traders are limited by the same maximum speed – the speed of light. Hence the declining performance of HFT-driven stocks as revealed by the graph above, provided by Tabb Group for the Financial Times. Over time, the once-lucrative race attracts added speedy competitors until the prize money is divided among too many.

A second factor that has led to the decline in HFT profitability: the exchanges that created speed-related arbitrage opportunity by selling colocation are squeezing the HFTs – increasing the colocation fees HFTs are charged for the speed advantage the exchanges provide.

What does a bold plan look like?

The future lies with more efficient, better regulated, trading platforms. Trading platform competition, in the absence of government protection, is a winner-take-all proposition in the long-run. Today, the low-hanging fruits are the rapidly growing and coalescing markets for global commoditized risks. Roughly speaking, there are seven such markets: Short-term commercial debt (Eurodollars), US stock indexes (S&P), currencies, a generic bond market, energy, agriculture, and gold.

What are the vulnerabilities of the existing versions of these cherry markets? Most importantly, the existing market providers are too slow to react to opportunity; their feet are stuck in cement. As opportunities to soup up these markets arise, the existing custodians are not reacting. The bigger trading platform providers: CME Group (CME), Intercontinental Exchange Inc. (ICE), Nasdaq Group Inc. (NDAQ), and CBOE Global Holdings (CBOE); are compromised by two factors. First, they are hamstrung by the vested interests of their big broker-dealer clientele. Second, they have been protected by SEC and CFTC regulation to the point where they have become fat and sassy – easy pickings for an aggressive new player. One reason for established market provider complacency is their recent experience with competition from smaller newcomers.

As the two electronic providers, Island and Archipelago, displayed their superior efficiency in the trading of the highest volume markets; ICE and NASDAQ simply bought them out. The old-line firms’ bloated capital, the result of SEC protection of their revenue stream from exchange feeds, puts these old-line firms in a position to simply buy off the competition, thereby extending the SEC’s turf to ETFs.

For competition to replace old inefficient markets with improvements, the battle must take place outside SEC castle walls. Potential invaders exist in abundance: light-footed new electronic trading platforms.

But the real barrier to climbing out of the detritus and clutter of current market tech; climbing out of the welter of proposed wannabe new trading platforms/vehicles lying about in financial markets – avoid providing traders with markets that only add a wrinkle to the central high volume market. Instead, entirely replace the central market.

Equity trading, for example.

A “smart” ETF; an ETF that varies the basic SPYDR S&P 500 ETF (SPY) in an attempt to outperform it, is counterproductive, ultimately doomed to mediocre success at best, because it cedes central position to SPYDR by design. Instead, to drive markets to a new level of efficiency, what market participants want is a replacement – an instrument that replaces SPYDR; one that further strips the away the costs of trading the S&P; not an ETF that self-validates by comparing its performance to the assumed-dominant SPYDR itself. Create an instrument that can guarantee better performance than SPYDR. That change will rock markets to the core.

But to get there, a new vehicle must do more than improve the competition. It must also cross the dread jungle of regulation. How? Introduce an instrument with no clear regulatory identification. This can be done by listing an instrument that is not a conventional security, not a futures contract, and not an option – an instrument that coopts the most desirable properties of each of these three primary financial instrument types. The instrument design will choose the most desirable characteristics of each.

Be bold, be bold, and every where Be bold… Be not too bold.

-- Edmund Spenser

Spenser had it right. It is one thing to wander off the SEC’s reservation. It is another to defy the country’s regulators. Be not too bold. Present both the CFTC and the SEC with the proposed new instrument. Let regulatory officials determine appropriate rules. This permits the regulators to improve their own functionality along with that of the market.

In the next article, the properties of the ideal instrument in these commoditized mega-markets will be defined.

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. I have no business relationship with any company whose stock is mentioned in this article.