The Power Of The Dark Side
If you only knew the power of the Dark Side.
- Darth Vader
The Efficient Market Hypothesis rests on the notion that all information is fully priced into the marketplace at all times. Like the human brain, the market does not need to be consciously aware of the information for this process to have its effect. This means there is no advantage to having inside information, or to running the billions of dollars worth of software and algorithms on which the world of finance revolves.
Not everyone agrees with this theory, and securities laws take a conservative approach to this academic debate and strictly prohibit trading on the basis of information not fully disseminated throughout the marketplace.
Except when they don't.
This week the Nasdaq marketplace implemented new "Flash" orders, with the SEC's approval. This was met by an immediate challenge from NYSE Euronext, pressing for legislation to impose exchange-type oversight on private order matching networks, or "Dark Pools" (TradersMagazine.com, 10 June, NYSE Euronext Asks Congress To Press The SEC On Dark Pools").
There are two kinds of flash orders. Routable Flash orders will be opaquely (read: "secretly") matched against the Nasdaq order book for half a second, then routed over Nasdaq's proprietary ITCH feed. The second type of order, the INET-Only Flash Order, appears to Instinet subscribers for half a second, with any unmatched portion of the orders being canceled back to its origin. The average investor might be forgiven for thinking this a tempest in an exceedingly small teapot.
Far from it. Orders executed in the marketplace in fractions of a second are increasingly the norm, and technology keeps up a frantic pace in an effort to continue to shorten the time of trade executions.
Algorithm-driven "high-frequency" traders run programs that route orders into the market, sometimes thousands of times a minute. Taking advantage of pricing inconsistencies, these statistical arbitrage programs buy stocks that their model identifies as underpriced, and sell them when they are overpriced.
Even highly liquid issues can become starkly illiquid in this fast-moving world. As more players, managing more billions of dollars, engage in the same trades - and with the inside market based on only a hundred shares on either side of the quote - it is not uncommon for a stat arb program to identify a stock as underpriced and, by its own automatically generated buy orders, drive the price up to the point where it triggers a sell signal.
It is a violation of market rules to enter transactions into the marketplace which create market action, but with no beneficial change of ownership. This goes back to the days when stock manipulators would create a false impression of interest in a stock by placing simultaneous buy and sell orders at different brokers. Trading volume in the stock surged noticeably. Meanwhile, the manipulator bore no price risk, as his orders would meet at the inside price, and the only cost was the commissions paid.
And hedge fund operators used to enter matched market-on-open buy and sell orders to reward brokers who had secured allocations on profitable IPOs, paying out commissions with no market exposure.
In the new electronic world, a program may buy back its own trades as the algorithm identifies the stock as underpriced, then triggers fail-safe sell orders to prevent a loss from widening. Sometimes program glitches cause this process to run in a ceaseless loop and among the tens of thousands of trades sent through in a day, it can be difficult to identify.
The exchanges have surveillance programs to identify and review these instances. Because of the functional lack of liquidity in many trades, transactions of 100 or 200 shares often lie at the heart of these inquiries. Regardless of the small trades at issue, failure on the part of a firm to have in place a compliance system "reasonably designed to detect and prevent" self-trading is grounds for regulatory action - fines, and perhaps censure if it is deemed a repeat violation.
One way to avoid these cross trades is to arrange with other market participants to meet in private to arrange trades. My algorithm says BUY, yours says SELL - let's make a deal. The new Flash Orders may become the secret meeting place of choice for high-frequency executions.
Meantime, the attraction of the established dark pools is the ability to execute large blocks without displaying orders in the marketplace. This cloaks the orders from stat arb traders whose "pinging" and "probing" algorithms identify large blocks and trade alongside them, "picking off" the larger and less liquid orders. Nimble-footed traders can short 600 shares in a fraction of the time it takes to sell a block of 400,000 shares. While these operators capture pennies by trading in front of the larger order, the rush of small sell orders disadvantages the market for the block, resulting in slower execution, worse pricing, and occasional inability to complete an order.
As the name "dark pool" indicates, this process is not intended to be transparent. The regulatory logic of the tradeoff is that cloaking these orders protects legitimate large market participants - mutual funds, pension managers and other entities managing large pools of investor capital - against predatory interference by professionals and speculators, ultimately benefitting the small investors whose interests the mutual and pension fund managers represent. Think of the large merchantmen of yore, and the swift-moving corsairs that harried them on the high seas. Wouldn't you want your ship to travel in a cloud of invisibility?
The NYSE has had its feathers ruffled by competitors for some time. Private firms also operate dark pools. Large brokerage firms trade for their own book and execute for customers alongside. Most of these operate continuous pools, giving them a perceived edge over the fixed hourly matching sessions at the NYSE.
Firms route customer orders to their own internal dark pool, while sending proprietary orders out to other firm's pools. Unmatched portions of a customer order are routinely sent, not to the exchanges or Nasdaq, but to other dark pools where the balance of the order will be matched and not displayed.
When a firm accepts an order from another firm's dark pool, it has no way of determining whether it is actually taking back the unexecuted portion of its own order. The practical outcome is that firms can never determine whether they are executing against their own orders, or for an arm's length customer.
How often does this happen? There is currently no way to determine, and firms do not want to know - because if they did, they would have to report trade violations.
The NYSE appears to understand this. One takeaway from the debate is that Flash orders are a next step in creating a multi-tiered market in which participants look down from the top to all underlying liquidity, but investors at the bottom have a very low visibility ceiling.
It should surprise no one that there is also a compelling commercial aspect to this dispute, as all these trading facilities compete with the NYSE's MatchPoint matching sessions, advertised by the NYSE as "the best environment for finding natural opaque block liquidity. Complete control of order information and execution remains in the hands of users."
The concept behind market transparency is exactly the opposite: failure to make full information available about every order unfairly disadvantages certain participants and encourages manipulation. One of the political realities is that, with so much private money being handled through large mutual funds and pension funds, it becomes a question of trade-offs to the investor. Which is worse: loss of transparency on individual trades, or being forced to show too much on large blocks where the individual's pension money or mutual fund investment is compromised?
Wherever you stand on this, the NYSE is not taking this lying down. NYSE Euronext EVP Thomas F. Callahan, testifying before the House Financial Services Capital markets Subcommittee, said "Through these so-called dark pools, alternative trading systems operators have been allowed to create private markets for securities transactions."
A "private market" that exists for half a second at a time. How big a problem might this pose?
There appears to be no control on the number of times the same order can be sent into the flash facility, and as the unmatched part is automatically canceled, orders will never be required to be sent to the open market until they are actually reported post-execution. Those of us who remember SOES are invited to speculate on what new forms of manipulation will arise here. Sellers - "customers", which was the way the SOES bandits flew beneath the radar - will be able to send out the same order until it is filled, without ever showing the broad market what they are doing. Large numbers of sellers can gang up on a stock, and we predict that someone will come up with a non-traceable way to be on both sides of a trade simultaneously.
In its rush to embrace every new wave of technology, and to promote the business of the marketplace, the SEC also must come up with new working definitions of Frontrunning and Inside Information.
"We ask the subcommittee to encourage the SEC to revisit its regulatory regime for alternative trading systems and assure that ATS are held to the same standards as organized exchanges," said NYSE Euronext's Callahan.
We suggest the SEC start by figuring out what the standards of today's marketplace are. On the hop.
Coming To AmeriKa
In the fight between you and the world, back the world.
- Franz Kafka
The Wall Street Journal (9 June, "Buddhist Monk Faces Worldly Green-Card Matters") recounts the tribulations of Phra Bunphithak Jomthong, a Buddhist monk who has been living in Southern California for four years, serving a community of émigrés from his native Thailand. In keeping with his vow of poverty, the 47-year-old Mr. Jomthong sleeps on the floor in the temple in Pomona where he leads daily rituals, runs a 24/7 family services emergency hotline, and teaches Thai language to the children of immigrant families. He is fed by donations from members of the community and owns nothing except his begging bowl, his robes and the blanket in which he wraps himself to sleep each night.
Mr. Jomthong entered this country under an R-1 visa, a designation created to permit religious organizations to import persons qualified to perform certain religious duties on a temporary basis. Mr. Jomthong became popular at the temple where he serves, and they requested an extension of his visa. The extension was duly granted by the Immigration authorities - but with a retroactive expiration date, which meant it had lapsed before it was even granted. Mr. Jomthong, who has applied for a green card, now faces deportation because, says Immigration, he "engaged in unauthorized employment" during the period in which his visa was no longer valid.
Or, perhaps to put it more succinctly, the immigration court asserts that Mr. Jomthong performed services for compensation during the period in which he would subsequently discover his belatedly-awarded renewed visa had been retroactively effectuated, with a prospectively accelerated term of expiry.
In other words: he followed the rules, as they were explained to him by Immigration, and now he is facing deportation.
In other other words, says a former immigration official, "we are dealing with a system in which it can be extremely difficult to play by the rules."
What was Mr. Jomthong's "employment", in violation of the terms of his R-1 visa? Referring to his acceptance of alms, the immigration court said he had been "remunerated... albeit on a modest, non-salaried basis..."
What policy purpose is served by expelling Mr. Jomthong from the US? Even we are not so cynical as to suggest that the government fears he may be a sleeper cell for some as-yet unheard-of terror organization.
Perhaps the Feds fear this is a clever ruse to bring foreign talent in under the radar. A Buddhist monk enters the US on a religious visa, without disclosing that he also has a PhD in computer science. Once he gets his green card, he throws off his saffron robes and goes to work for a Silicon Valley start-up where he will create several hundred new jobs. Or maybe he will move to Greenwich and run a hedge fund...
No, this is a backlash against the offshoring of American jobs. American citizens should come first - both as workers and as mendicants. We applaud the court's taking a stand to protect American beggars. There are those who claim that foreign beggars do not interfere with American beggars, because they accept pittances that any self-respecting American panhandler would spurn. We say that Americans who toss their quarters in a blind man's cup are entitled to know that those donations are going to support American indigents.
The insinuation of foreign beggars into the ranks of the indigent is a threat to our society. Now, Americans will unknowingly toss their nickels, dimes, and unwanted tuna sandwiches to smiling silent beggars who will go home and feed their children while speaking to them in languages like Thai, Hmong and Bengali.
This will undermine the hard-won stability of this nation, a nation that has grown great on the hard work and sacrifice of generations of citizens who grew up speaking German, Greek, Italian, Hawaiian, Yiddish, Tagalog, Polish, Cantonese, Spanish, Japanese, Slovenian, Vietnamese...
Too Many Chiefs
When everyone is somebody, then no one's anybody.
- W.S. Gilbert, "The Gondoliers"
The most sobering expanse of newsprint we have surveyed in some time was proffered this week by the Financial Times (12 June). Headed "Regulatory Battlefield", the page offers five separate articles analyzing aspects of US domestic and international securities markets regulation, plus a detailed diagram titled "US Financial System: Caught In A Regulatory Web".
Significant moves that we believe will be implemented include Secretary Geithner's "council of regulators", and the creation of a new office to oversee systemic risk. The council of regulators, though the child of a purely political process, may prevent a disaster, as it will set aside the proposed merger of the SEC and CFTC. If the current administration accomplishes nothing more than this, it will have been a worthwhile effort.
We wonder whether this will end up as the sole achievement of the Obama-Geithner program. The FT article quotes Senator Richard Shelby as saying "There are powerful forces at work that want to preserve the existing system." We find nothing surprising in that statement - a statement said by a politician, about politicians.
Speaking before the Council on Foreign Relations, Larry Summers raised five salient points of this Administration's approach to redrawing the map of regulation. We believe the most significant is Eliminating Regulatory Arbitrage.
"Can it surprise anyone," said Summers, "that if institutions choose their regulators and regulators compete for jurisdiction, that standards fall and that there's a race to the bottom? Instead of sponsoring races to the bottom, we need to drive competition to the top by insisting on strong standards."
We foresee an extremely noisy battle, a political Armageddon in which the forces of Total Regulation clash with the forces of Laissez Faire. While there is a highly popular move afoot for draconian measures, we recognize the immense power of inertia. The word "populist" has inexplicably vanished from the media, as the principle of Reversion To mean asserts itself. Sooner or later, assaults on the Status Quo spend their fury. In a world where practical dreamers seek to bring about fundamental change, the end result is usually most visible at the upper branches, least felt at the root.
The furor over hedge funds, for example, has already resulted in a tightening of custody and audit rules - all practices which were dismally lax, and where firms that followed Best Practices often did so pursuant to a consent decree. Hedge funds will be required to register - but the US is the only country where this type of entity does not have to register - and some small measure of enhanced market transparency will be introduced.
These measures are becoming more common now anyway, because the customer - from the largest state pension fund, to Mom and Pop retail brokerage account holders - are demanding them.
Hedge funds will probably be required to make notice filings - which are reports to state regulators announcing that the fund is now doing business in their state. This looks like a purely ministerial exercise, but may attain Summers' desired effect of blocking regulatory arbitrage by getting state securities regulators and AGs involved.
Banks and investment banks, meanwhile, are being coddled and sent off with a pat on the back. The TARP money is being repaid, which means even Vikram Pandit will likely get his bonus this year.
At the end of the day, only two factors can truly revolutionize our securities markets. One is investor education - which will not happen. (Let's face it: the biggest financial disaster in modern times is already fading from memory, giving way to stories about "recovery" and "upturn" and "when will it be time to get back in?" Shades of irrational exuberance...)
This leaves us to rely on the other curative, the appointment of strong regulators who make clear decisions and force implementation. Thus, the most heartening of the FT stories is "Bair Lobbies For Stronger Position."
Sheila Bair, in what has widely been seen as a highly principled, and highly effective tenure as head of the FDIC, has arrived at her Moment. In fact, we fear it is Make or Break, as she seems to be making the fatal political mistake of playing to her actual constituency, rather than to the twin entrenched interests of Washington and Wall Street.
We have not forgotten Mr. Geithner's very public criticism of Ms. Bair as "not a team player" when, in the Paulson Panic, she refused to turn her Agency's balance sheet over to Citibank. She has apparently not forgotten either. Her latest public statements have been to push for Citi CEO Pandit to be removed and replaced with an executive who has actual banking experience. This has renewed questions about her political viability. Apparently, just as in the previous administration, there is only room for one Decider, and Mr. Geithner has already arrogated that to himself. We wonder whether his boss realizes this.
Large and complex organizations - and a glance at the diagram of the US regulatory structure should convince any skeptic - are political battlegrounds first and foremost, and necessary programs fall victim to special interests on the outside. The only sure-fire way to keep these organizations on message is to place powerful individuals in key decision-making positions.
Bair is, as far as we know, the only regulator in charge of a federal agency who actually gets her hands dirty when things get ugly. Her agency confronts massive financial failures - failures that wreck communities, shutter industries, and ruin people's lives - and Bair has waded in to join the battle on more than one occasion. Bair's public image is that of a person more concerned with doing her job than with keeping her job.
She gets our vote. Let's hope she continues to get the vote of the Decider In Chief.
Friends Like These
In all my years in the business I have never seen a more toxic product.
- Angelo Mozillo
Fannie, Freddie, Bear Stearns, Merrill
AIG, Fair Value Accounting
Mortgage Cramdowns, Friends of Angelo
GM, Chrysler, UAW
Vikram Pandit, Goldman, Morgan
GMAC, JP Morgan
Chris Cox, Chris Dodd, Henry Waxman
Donna Shalala, Conrad, Jackson
Daschle, Richardson, Killefer, Geithner,
Barney Frank, Chuck Schumer, Paulson
Dick Fuld, Ken Lewis, John Thain, Jimmy Cayne
We didn't start the fire...