A Flash In The Pan

An appeaser is one who feeds a crocodile, hoping it will eat him last.

                             - Winston Churchill

Senator Chuck Schumer has warned the SEC that, if the Commission does not act to halt the new “flash orders”, he will introduce legislation to ban the practice.  The New York Times obligingly ran a front-page story (23 July, “Stock Traders Find Speed Pays, In Milliseconds”) and followed up with stories about Senator Schumer’s assault.

Flash trading takes to a new level the algorithm-driven model known as “High Frequency / Low Latency” trading.  Traders with the most powerful computers and the most sophisticated algorithms – “algos” in trader-ese – capture significant advantage by identifying patterns of buying and selling literally as they emerge, and in many cases before trades are even printed.

Free markets are predicated on the notion that those who are smarter, faster and more diligent than the rest also get to make more money, even at the expense of the rest.  No one compels us to trade stocks, and we do so with eyes open to the risks.  Including especially the risk of trading against someone smarter than ourselves.

But the flash order double-dips the advantage already enjoyed by the smart guys.  First, the market venue where you enter your trade attempts to fill your order by sweeping available inside bids or offers – preferencing its own members – then they flash the unfilled portion to their biggest customers.  Only then does it get routed out to the broad market.  We always knew that money talks.  Now we learn that it also front runs your order.

The Times reports that on July 15, trading in the shares of Broadcom surged.  The Times story indicates that buy orders in Broadcom were flashed to the Star Wars crowd for 30 milliseconds.  This 0.03 of a second was enough for the algos to determine out not only the direction of interest, but the upper and lower price limits, and to scale their orders accordingly.  The times reports “the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.”

A profit of $7,800 on transactions valued at $1.4 million may not seem like a lot of money, especially when factored over all the High Frequency / Low Latency guys in the flash realm.  It is a return of 0.0056, or a little over one-half of one percent of the total amount that changed hands.

Multiply that by the billions of shares that trade in the markets every day, factor in the news stories, rumors or just plain market momentum that drives trading swells, and you see this can add up.

As a random example, for trade date 30 June of this year, NYSE Group daily dollar volume was reported as $45.6 billion.  One-half of one percent of numbers of that magnitude – $228 million – adds up quickly.  How quickly?  The Times article cites a report indicating the high frequency traders as a group took in $21 billion in profits in 2008. 

At the time of this writing, the SEC is looking at flash orders and it looks like the kibosh will soon be applied.

Buried in the Times story, almost as a throwaway, is the following:

“High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.”

The exchanges, in an attempt to attract business, pay incentive fees to traders who execute on their facilities.  Everyone in the business acknowledges this practice. It even has crept into trader-ese, where they call it “incenting.”  For those of you who have forgotten, this practice – Payment For Order Flow – is how Bernie Madoff built his business.  It worked for him, and it has certainly worked for the exchanges.  NYSE average daily volume is up some 164% since 2005, even as other exchanges and trading venues have proliferated.  By some estimates the Star Wars guys account for over half of all trading volume on all exchanges.

This is touted as being good for everybody.  Markets need depth.  All other things being equal, the more volume on an exchange, the more robust that market should be.  But by paying for order flow the exchanges induce firms to place orders in trading venues, regardless of the quality of execution.  Exchanges are supposed to offer depth, liquidity, transparency, and protection of customer orders.  Firms should trade based on the robustness of that venue – not on the basis of who pays them for their business.  By “incenting”, exchanges create a false impression of market activity – the activity is real; what is false is the underlying reason for that activity.

When this type of activity occurs in individual securities, it is called Painting the Tape.  Traders buy and sell the same securities repeatedly, artificially pumping the trading volume in order to create public interest in a security.  When individuals do it, it is a criminal activity.  When an exchange does it, it is called promoting liquidity and market depth.  Now, even incentive fees are not enough to hold onto the Star Wars traders, but they need an early peek into the order book to top it off.  The bigger they are, the more clout they have, and the more the exchanges have to offer them to stay.  Some traders even have algos that calculate maximum loss scenarios, then enter losing orders as long as the incentive fee will be more than the loss on the trades themselves.

In a reversal that should take no one by surprise, the NASDAQ Stock market, which introduced Flash Orders on 3 June, now characterizes these types of orders as “order types that do not support price formation” (Reuters, 28 July, “Nasdaq Backs Ban On “Flash” Trading: Schumer”).  For the lay person: we tried to give an excess unfair advantage to our biggest players, because try as we might, we couldn’t incent them enough, but too many people figured it out too quickly.

So it looks as though the flash order will end up as a flash in the pan.  This looks like the regulators once again giving away the store, then making a big fuss about taking back a little, while still leaving the big boys free rein to dominate the marketplace. 

The Star Wars world of high frequency trading is here to stay.  Anyone doubting this need only look at the Wall Street Journal report (WSJ, 31 July, “”NYSE’s Fast-Trade Hub Rises Up In New Jersey”).  The NYSE is creating a 400,000 square foot mega trading starship at a secret (we’re not making this up) location in Mahwah, NJ, to house Star Wars traders.  The physical proximity to the NYSE trading floor, we are told, will make a difference in time of order transmissions, as traders are now executing not in milliseconds – thousandths of a second – but in microseconds – millionths of a second.

Winston Churchill once observed that no government in history has ever gone to the vast logistical trouble and financial expense of a broad military mobilization without subsequently going to war.  Once the armies are massed on the border, too much money has been spent – and too much political capital – to ask that they stand down.

The NYSE is betting on the future of Star Wars, and it looks a safe bet – though whether the NYSE’s Starship Frequency will be the fleet’s flagship is anybody’s guess.  The article says the NYSE hopes to attract certain established players in the high frequency world.  “Worries about high-frequency trading aren’t focused on” Goldman or hedge fund Citadel.  No surprise there.  Indeed, the only thing the NYSE is worried about is whether Goldman and citadel will actually book aboard their starship, or if they will be off on someone else’s DeathStar.  Count on the NYSE to offer free rent – otherwise known as “soft dollars” – as another way to “incent” the big boys, at the risk of undermining the integrity of the marketplace.

As Senator Schumer leads the charge, the flash order may look like a dead issue.  But have no fear: the Empire will strike back.

Got Them By The Shorts

If you’re gonna set somebody up, it’s gotta be a surprise, you got that?

-         Chili Palmer, “Get Shorty”

What a surprise!

It isn’t every day we get to praise securities regulators, so let us not let pass this opportunity to congratulate SEC Chair Mary Schapiro on the announcement of new initiatives on short selling.  The high points of SEC Release 2009-172 (27 July, “SEC Takes Steps To Curtail Abusive Short Sales And Increase Market Transparency”) are: a requirement to deliver stock, and enhanced transparency by making short interest data more widely available. 

In addition, there are significant political offerings.  These include “a public roundtable… to discuss securities lending, pre-borrowing, and possible additional short sale disclosures…”, and assurance that the Commission is “continuing to actively consider proposals on short sale price test and circuit breaker restrictions.”

The SEC’s brief is market integrity, and investor protection.  Anyone who ever earned their living selling anything to anybody will tell you that the incidence of truly informed consumers is statistically insignificant.  Therefore, the best any market regulator can possibly do is require maximum market transparency.  Added to that, it would be helpful if every brokerage account statement came with a warning similar to those displayed on Canadian cigarette packages, which feature large full-color photographs of gangrenous limbs and active cancer tumors.

Chairman Schapiro has not always contented herself with hoping for the best.  She has acted affirmatively in the public interest before.  While at the NASD she oversaw the creation of the Investor Education program – you may remember the silly photos from the NASD website, like the pudgy gent wearing a tiny hat under the caption “Small Cap”.  The pictures were goofy but memorable, and they were right there on the NASD’s home page under a header that shouted INVESTOR EDUCATION.  If you got as far as typing in NASDR.COM you couldn’t miss it.

Of course, even Mary Schapiro could not force you to read the material – but until she came along, no one else had even bothered to publicize it.

We now get to watch Chairman Schapiro as she joins the cast of Get Shorty, where people who are harder working, more focused, and better informed than average investors get punished for being… well… harder working, more focused, and better informed.  This has been true of hedge funds, and its latest targets are the High Frequency / Low Latency traders.  But there has always been a special place in the hearts of the American public – and legislators – for the Shorts.

Chairman Schapiro, herself no stranger to the Politics of Politics – to coin a phrase – has neatly thrown the short sellers into the briar patch by calling for a roundtable and promising “ongoing” and “active” consideration of other proposals.  With any luck, the political process – the septic interface where Hill and Street meet – will slow this debate down to a 16 RPM screaming match that will drag on until nature takes its course: either speculative frenzy will overtake the markets and no one will care about silly things like short sellers and hedge funds, or we will forget about short sales as we queue up to swap our dollars for Yuan, meanwhile hoarding water, bread and bullets.

It would be nonsensical to make a type of transaction illegal.  Cocaine is illegal and is distributed through a sales network.  Would it be a stretch to think the way to halt the widespread use of cocaine was to introduce legislation making it a crime to buy something?  (We may regret suggesting that – please don’t forward this to anyone in Washington!)

No politician will defend short selling against all the nonsense coming down the pike – that would make them look like they were in the pocket of the hedge funds.  But we note the issues Chairman Schapiro chooses to avoid. 

It is well and good to make delivery mandatory.  We expect there to be a few high-visibility and hard-hitting cases brought in short order, where firms will be punished for not making timely delivery.  Thus will the SEC show the press it Means Business.

Our market, large and complex as it is, runs on certain presuppositions.  At any given time, there is not enough stock available for borrowing in the marketplace to support all the short sales that are done on any given day.  Active traders in a volatile market may recycle a short multiple times in one day, shorting, covering and re-shorting stock against the same locate.  Would a “hard borrow” require them to make multiple deliveries, even if their position is flat at the close of business?  (Don’t send that to Washington either…)

We all know that the Easy To Borrow lists make unrealistic quantities of stock available for shorting, and that at any given moment there are phantom shares in the marketplace as a result of aggregate short sales that exceed prime broker Easy To Borrow lists.  But the probability is that not all these shares will be required for delivery at the same time.  To introduce a hard locate, or pre-borrow and deliver requirement would be to clamp down on volume and liquidity in the market so drastically, the US would no longer be the marketplace of choice for equity traders.  Talk about reneging on your handshake.

This aspect of the market appears to be here to stay.  If you had any doubts, footnote 29 of the Release quotes several Exchange Act Releases regarding issuers’ attempts to protect their shares from naked shorting.  Issuers have tried issuing shares that are only available in physical certificate and can not be “held” electronically, or simply withdrawing from the industry-wide DTC clearinghouse, making their securities no longer available for book-entry transfer.  “Withdrawing securities from DTC or requiring custody-only transfers would undermine the goal of a national clearance and settlement system designed to reduce the physical movement of certificates in the trading markets.”  Translation: self-help is not available to issuers.  Liquidity of the markets is more important than the woes of individual issuers; short selling is here to stay.

Even the absolute delivery requirement, which reads great in the press, is not absolutely absolute.  We note that the expression “ex clearing” does not appear in the SEC document.  What does appear is an immediate close-out and deliver position “if a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency…”

Outside of the registered clearinghouses, there appears to be no record of how many trades remain uncompared at any given time.  Thus, there seems to be no clear way to challenge those corporate executives who rant in public about collusion between firms to run up and maintain invisible short positions in their stock.  If the SEC were serious about rooting out naked shorting and other abuses, they would require firms to record ex clearing contracts, to mark them to market, and charge them against regulatory capital. 

Thus, the new short selling release accomplishes a measurable increase in transparency – a good thing.  Outside of that, it makes permanent a prohibition against naked short selling – no one will argue there.  For the rest, as one market participant said, this monumental exercise appears to be “a fix in search of a problem.”

Or, to put it another way: this is the way the markets work.  You got a problem with that?

The Congressional Meddle Of Honor


Politics are very much like war.  We may even need to use poison gas at times.

- Winston Churchill

He’s Baaaaack!  Barney Frank, who once said it was worth taking on unknown risks in order to spur growth in the housing market, has now said it is advisable “to err on the side of caution” in imposing regulation and restrictions on the commodities, futures and derivatives markets.

The ban on naked trading of Credit Default Swaps (CDS) now under consideration may have the incidental effect of dramatically increasing the costs of borrowing.  To the extent the overblown CS markets represent an aberration – and even dramatically increased costs going forward would therefore be merely reversion to the mean – this is almost a a non-event.  For those who earn their living pushing these things around, though, it is big, big news.

As frightened as we are of as yet undiscovered abuses in the markets, we are far more scared of Washington.

Consider: our colleague, Andrew Barber, points out that, unlike securities regulations, “once you allow the camel’s nose into the tent on commodities, it gets international and global real fast.”  It is bad enough watching as Washington sinks its meathooks into the securities markets.  As anecdotal evidence that those charged with making our markets function properly do not understand those markets, we offer the latest news reports of Fed Chairman Bernanke’s net worth, which has fallen to perhaps under a million, from a reported range up to $2.5 million in 2007.  This is along the lines of our CEO Keith McCullough’s observation this morning (3 August) highlighting Nouriel Roubini now going bullish on commodities – copper is up over 90% year to date.

If Ben Bernanke can not parlay his market smarts into a substantial seven-figure portfolio – or if he can not parlay his banking and Wall Street connections into eight, or even nine figures – then why are we entrusting the world’s money supply to him and contemplating handing him an unprecedented level of control over the nation’s financial system?  Hank Paulson, now there was a guy who understood how money and markets function.  Why should a tyro be entrusted with the keys to the vault?

Following up on Andrew’s “nose of the camel” metaphor, it is now zero hour – midnight at the oasis.  We may want to instruct Sheikh Barney to send his camel to bed before it’s too late.

We watched Venezuela nationalize oil.  Will Chairman Frank give Chavez the opportunity to nationalize oil futures as well?  One thing we are comfortable predicting: once the Capitol Hill Pitchfork Brigade forces standardization and exchange trading of derivatives contracts, these contracts will become the next big product.  Watch for billions of dollars of issuance of derivative contracts aimed at the retail investor.  You were uncomfortable with Grandma buying oil and gas ETFs?  Wait until her broker puts her into CDS based on commercial mortgages. 

FINRA finally came forward with a timidly worded warning that certain ETFs are fiendishly complicated and possibly not appropriate for private investors.  They better start sharpening their pencils against the day when Series 7 registered stockbrokers start pitching CDS.  Many an average customer does not understand how a margin account works – alas, many an average broker either never bothered to explain, or can not explain to their customers.  Hands up, how many of you want these guys pitching derivatives to the public?


For the record, since January we have been raising questions about ETFs.  In addition, our conspiracy theorist paranoia has led us into speculation tying these sometimes complex critters to the political tension – between, say, the US and Switzerland, which was not playing ball.  We don’t mean that Switzerland was not playing ball about tax cheats – that’s old news, and we wonder whether some lawmakers have had to scramble to shift their accounts to Liechtenstein or Vanuatu in advance of the assault on bank secrecy.

If you recall, our theory was that the US was leaning on Switzerland because they were dramatically under-invested in US Treasurys, at a time when our debt needed all the bolstering it could get.  Once launched, we speculate the tax inquiry took on a life of its own.  The announcement this week that UBS reached a settlement with the IRS came on the heels of the announcement that UBS was discontinuing the marketing of leveraged and inverse ETFs.

Not a moment too soon, as Massachusetts state regulators have started issuing subpoenas requesting (Wall Street Journal, 1-2  August, “Subpoenas Put Pressure On ETFs With A Twist”) “requesting information on sales of products, the revenues generated from those sales, and broker training and marketing materials.”  Followers of this Screed will recall, this is exactly what we have been warning about.

Tough break, UBS.  If only we could convince Barney Frank that these things are a good idea…

Moshe Silver

Chief Compliance Officer