Interactive Brokers' Peterffy Lashes Out Against The Broken Market, As Nanex Conclusively Proves HFT's Were Cause For Flash Crash

Tyler Durden's picture

A recent speech by Interactive Brokers' CEO Thomas Peterffy at the World Federation of Exchanges may just be the watershed insider conversion event that finally opens the eyes of all those who have been living for years with the delusion that modern markets are fair, honest and transparent. As the Interactive Brokers head says: "It is not so much anymore that the public does not trust their brokers. They do not trust the markets, the exchanges, or the regulators either. And why should they, given our showing in the past few years? I must confess to you that I was an ardent proponent of bringing technology to trading and brokerage. Unfortunately, I only saw the good sides. I saw how electronic trading and recordkeeping could be used to force people to be more honest, to make the process more efficient, to lower transaction costs and to bring liquidity to the markets. I did not see the forces of fragmentation and the opportunity for people to use technology to keep to the letter but avoid the spirit of the rules -- creating the current crisis. It is vitally important that we bring an end to this crisis of trust before it spreads any further; that we bring back order, fair dealing and trust in the marketplace." And if there is anything that the 23 sequential outflows from equities demonstrate, it is precisely that the average investor no longer has any trust in either the markets, or its regulator. Furthermore, the latest piece of evidence from Nanex, definitively confirms that not only was the Waddell & Reed's order not the catalyst for the May 6 flash crash, but it was the HFT buyers of this sell order, that "transformed
a passive,  low impact event, into a series of large, intense bursts of
market impacting events which overloaded the system
. The SEC report uses an
analogy of a game of hot-potato. We think it was more like a game of dodge-ball
among first-graders, with a few eighth-graders mixed in. When the
eighth-graders got the ball, everyone cleared the deck out of panic and
fear." At this point, to the SEC's chagrin, there is nobody left to watch how this particular game of dodgeball, or the latest propaganda scapegoating campaign for that matter, will end.

Before we focus on Nanex's latest report, let's focus on just what it is that catalyzed Peterffy conversion into one of the few who sees the fragmented stock market for the broker-dominated scam it has become: internalization.

The root of the problem, as always, is short-sighted greed on the part of the brokers. Transparent commissions are not enough for them. They want to take more from their customers but without the customers seeing exactly what it is that they are paying. This is done by what is called internalization, which is easiest to illustrate with OTC products. The banks simply take the opposite side of the customers' orders at prices that leave the banks with undisclosed but huge profits.

How do we know that the profits are huge? Just look at the banks’ quarterly financial reports on derivatives dealings. Even the more modest estimates exceed $100 billion per year, worldwide. Customers are on the other side of those trades. Customer losses are on the other side of those bank profits. The amazing thing is that those banks are able to convince their customers that this is good for them and moving these contracts on to the exchanges would harm the customers.

How do they do this? What dark arts do they employ to maintain the status quo? I think their magic consists of such mundane things as million dollar paychecks to the salesmen, golf outings, tickets to games, dinners, Cuban cigars and probably some other blandishments that should not be discussed in polite company.

And of course, the fact that most OTC derivatives "customers" are not playing with their own money. The customers are finance or investment staff that work for large corporations, state or municipal governments, pension funds and insurance companies. These end-user employees get to drink the fine wines, but it is the shareholders or taxpayers that pay for the overpriced derivatives.

This same thing is happening in more subtle ways in exchange listed products. In Europe, investors have a long tradition of investing through their banks. Smaller banks work with larger banks that sit on exchange boards. The boards make rules for the exchanges that allow the trades to take place not at the exchange but somewhere else, merely being reported to the exchange for clearing. As long as the price is anywhere between the lowest bid and the highest offer that was posted on the exchange any time during the day, it is accepted. Some exchanges will accept a trade as long as it is priced anywhere within 10% of the posted bid or offer.

In these scenarios the exchanges’ traditional function -- matching competing bids and offers, resulting in price discovery -- is not used by the brokers, but the brokers are willing to pay the same amount in fees to the exchanges just for the clearing. So the exchanges get the same revenue either way. But I ask you: Is this sustainable? Is there real value added? Is this a healthy, vibrant business model? Or will these exchanges atrophy like unused limbs?

Who cares what will happen in the future? Obviously not the banks, for whom each and every day of continued existence is a taxpayer-funded gift from god, or in this case Bernanke and the administration, which allows them to pay another batch of record bonuses for a catastrophe well done. They know the game is over, and it is now just a matter of when. If they can get paid one or two bonuses in the meantime, so much better.

For those still confused how internalization perverts stock trading, here is a good explanation:

Brokers internalize stock trades and put them up at the clearinghouse. They at least are supposed to provide best execution, but best execution is vaguely defined and poorly enforced. Brokers in the U.S. must post reports showing where they route their customers' orders. But do you suppose that brokers care what's reflected in those reports? They do not.

It should be shocking, but it probably is not, that according to the Rule 606 reports mandated by the U.S. Securities and Exchange Commission, no major online broker, with the sole exception of Interactive Brokers, sent more than 5% of its orders to an organized exchange. More than 95% of their orders go to internalizers!

These brokers ignore the exchanges and sell the orders to internalizers, thereby avoiding exchange fees and getting a nice little payment from the internalizers in return. This payment for order flow adds up to real money after millions of orders are taken into account. The internalizers are supposedly matching the best prices prevailing at the exchanges, so that they can argue that the customers get the best prices.

Luckily, since those using brokers for the most part do so using other people's money, nobody really ends up caring about what the actual execution cost is. Which means billions in revenue for Wall Street firms. It turns out the incremental cost in the US, but especially in Europe, is massive:

If they did, an independent study would not have found that the one broker that actually routes the vast majority of its orders to public exchanges -- and I will not name this broker again -- obtains executions that are on the average 28 cents better per 100 shares in the U.S., and an absolutely stunning 2.84 Euros better per 100 shares in Europe. As much as I love this brokerage firm, it may not be doing anything all that special. It is mostly just quickly routing each order, or parts of an order, to the public exchange with the best posted prices for that order, and quickly rerouting if another exchange becomes more favorable.

So who is left trading on exchanges? Almost nobody... and SkyNet of course.

On exchanges now we have old style market makers stubbornly clinging to the idea that they will be paid for providing liquidity, trading with High Frequency Traders of various kinds--some providing liquidity, some picking off slow quotes, or playing tricks like quote stuffing or manipulative algo trading -- such as suddenly sweeping the market, lifting all offers and as all the machines run for cover, selling it back for a profit.

Where are we heading? These fast money players will eventually burn out. Sooner or later the regular losers will leave and the regular winners will have nobody to trade with except when they make a mistake. The result will be that spreads will widen, which will be welcome news for the internalizers because they will now be able to take the other side of the customer order flow that they buy on a wider market.

As indicated in the recent flash crash report by the U.S. CFTC and SEC, internalizers suck off all the customer orders, but when an imbalance develops they are unable to handle it and they throw the switch to route the orders back to the exchanges, which no longer have the liquidity to deal with it. Since the bulk of the volume is now being traded at prices relative to a displayed market that is no longer driven by real supply and demand, sudden imbalances of buy and sell orders will occur more and more often, giving our industry more and more reputational headaches.

In an environment in which stock trading has become a side effect of what is essentially a tolling operation, in which exchanges keep up appearances that there is liquidity, when there is merely volume churn, and brokers syphon off tens of billions of investment capital with the complicity of the buyside asset managers, in exchange for a lap dance and $500 bottle of wine, is there even a need for market makers?

Are market makers necessary in mature markets? I am not sure. Many futures exchanges have functioned well for decades without designated market makers. On the other hand, if an exchange would like to be assured of the continuous availability of buyers and sellers, it should have registered market makers with serious affirmative obligations. But if you want them to assume those obligations you must give them something in return, preferably something that will not cost you any money, such as modest preferential access.

Market makers, not so much in stocks as in options, must maintain tens of thousands or hundreds of thousands of quotes at the exchanges, and when some input makes them move those quotes they must move them in a matter of milliseconds. On the opposite side, we have High Frequency Traders who are waiting for just such an input signal to quickly grab those quotes that have not yet been moved. This is not an even playing field. It obviously takes much longer for the market maker to move thousands of quotes than for the HFT to hit a handful.

If you want to have market makers you should give them some modest preferential access. Hold every order for a tenth of a second with the exception of market maker quote updates for products in which the market maker is registered and has affirmative obligations. There is simply no other measure that can protect market makers against being picked off. If you do not do this, market makers will either make wide markets or just cease to be registered as market makers.

In return you should require market makers to provide liquidity and not take liquidity in some very high percentage of their trades and give the market makers strict quoting requirements.

Peterffy's conclusion is in some ways sad, as it confirms everything we have been warning about for almost two years now:

The financial markets of at least the world's developed countries are at a turning point. Technology, market structure and new products have evolved more quickly than our capacity to understand or control them. The result has been a series of crises over the past few years that have caused many investors to lose confidence or to think that the whole system is a rigged game.

This is a very dangerous development because the purpose of our financial markets is to guide the evolution of our economies by allocating capital to industries and companies that we want to grow, and to allow businesses and investors to efficiently manage risk. If the public comes to perceive that the financial markets are a con game and that they are the marks, then companies and entrepreneurs will not get the funds they need to grow our economies, provide jobs and raise living standards.

Alas, the public already perceives the con game nature of markets, and refuse to be the marks any longer. And nobody in charge cares. At this point capital markets are no longer the fuel for entrepreneurial innovation and economic growth. They are a parasite whose only purpose is to make the bankers even richer before the next, terminal flash crash. And those who would accuse Peterfy of merely being a hypocrite pushing his own agenda, we read in Barron's that he "said in an e-mail that Timber Hill's next step, should market conditions merit, will be to gradually widen quoted prices, and cut the size of trading commitments. Many market makers use Timber Hill's prices and liquidity—the number of stocks or options market makers are willing to buy or sell—to refine prices. If Timber Hill steps away, others are likely to follow, and investors will find many options prices worse than market conditions may merit." Of course, this would also be the beginning of the end for those most hated of all market parasites, the High Frequency Traders.

Which brings us to the second topic: Nanex' final resolution on who it was the caused the Flash Crash. Spoiler alert: it was not Waddell & Reed. It was High Frequency Traders, it was the HFT buy response to a sell roder, and by implication, it was the SEC's criminal negligence in allowing this market aberration to persist as long as it has.

From Nanex:

Our analysis of the Waddell & Reed e-Mini trades led us to an unexpected break-through. By process of elimination, and with the SEC report for context, we finally have a crystal clear understanding what caused the May 6, 2010 flash crash.

First of all, the Waddell & Reed trades were not the cause, nor the trigger. The algorithm was very well behaved; it was careful not to impact the market by selling at the bid, for example. And when prices moved down sharply, it would stop completely.

The buyer of those contracts, however, was not so careful when it came to selling what they had accumulated. Rather than making sure the sale would not impact the market, they did quite the opposite: they slammed the market with 2,000 or more contracts as fast as they could. The sale was so furious, it would often clear out the entire 10 levels of depth before the offer price could adjust downward. As time passed, the aggressiveness only increased, with these violent selling events occurring more often, until finally the e-Mini circuit breaker kicked in and paused trading for 5 seconds, ending the market slide.

Because of arbitration, when the e-Mini changes price with high volume, many ETFs are repriced (quotes updated, trades executed). The component stocks of ETFs are also repriced, along with many indexes. And finally, all the option chains for the ETFs, their components and indexes are also repriced. The entire system simply cannot absorb the impact of a sudden move in the e-Mini on high volume. A sale (or purchase) of 2,000+ contracts which rips through one-side of the depth of book in 50-100 milliseconds, will immediately overload many systems. The impact reverberates for a much longer period of time than the sell (or buy) event itself.

The first large e-Mini sale slammed the market at approximately 14:42:44.075, which caused an explosion of quotes and trades in ETFs, equities, indexes and options -- all occurring about 20 milliseconds later (about the time it takes information to travel from Chicago to New York). This surge in activity almost immediately saturated or slowed down every system that processes this information; some more than others. The next sell event came just 4 seconds later at 14:42:48, which was not enough time for many systems to recover from the shock of the first event. This was the beginning of the freak sell-off which became known as the flash crash.

In summary, the buyers of the Waddell & Reed e-Mini contracts, transformed a passive,  low impact event, into a series of large, intense bursts of market impacting events which overloaded the system. The SEC report uses an analogy of a game of hot-potato. We think it was more like a game of dodge-ball among first-graders, with a few eighth-graders mixed in. When the eighth-graders got the ball, everyone cleared the deck out of panic and fear.

The chart above shows the high and low prices of the eMini for each 100ms interval (light blue). The green line with green dots and numbers shows the total number of Waddell & Reed contracts sold up to that point. Red price bars indicate the range of prices of W&R trade executions during that period. The light blue bars in the bottom section indicate the volume of eMini contracts traded in that interval. The scale for the volume is below the scale of the prices. Finally, the light green line in the chart above, shows the total number of equity trades in all equities during that 100ms interval -- there is no scale for this line -- it is shown to illustrate the correlation with the eMini contract volume traded during the same interval.

The chart below is the same as the chart above, except in place of the trade counts (light green above), it shows the quote counts for all equities during each interval (light gray).


We have been calling for everyone to pull their money out of this broken market. Now, finally, industry insiders are joining our call. How much longer before everyone realizes the truth and says never again to a casino so broken it will have no choice but to cannibalize itself very, very soon?

h/t Prophet

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Mongo's picture

HAH, you can take that to the SEC...

cossack55's picture

Take a cartfull of downloaded porn also, that way they won't have to work so hard during business hours.

Porkbellytrader's picture

Bring back the pits and the floors, bitchez!

vanorton's picture

agree with you, if you are/have been there i guess you have seen "Floored".

dont know if it has been posted before, nevertheless its a "must see"



plocequ1's picture

A little too late. Dr. Max Keiser and Sir Gerald Celente said this a couple of months ago. 

bada boom's picture

cannibalize itself very, very soon?

As long as the fed is creating food, junk food that is, no need to cannibalize.

SheepDog-One's picture

All the Twinkies in the world doesnt matter to a starving man, still starve to death while bloated after gorging on sugar high empty Twinkies.

sweet ebony diamond's picture

Don't forget the conflict of interest issue.

I am speaking about Goldman's financial enema retail services.

Goldman says they have only your best interest in mind as you hand them your life savings.

Then it disappears.

RobotTrader's picture

What's up with Amanda today?

Looks like she is wearing a straight-jacket today.


Ethics Gradient's picture

Watching this is like watching someone overwind a clock to keep it ticking.

October 08 was a call to arms to anyone who had it within their grasp to do something about the future. It was fudged and forgotten for the sake of a few politicos careers and the idiot bankers who felt that they could and should play god.

All the while, the general public lives on in ignorance; faces buried in facebooks trying to stimulate their senses by giving away as much privacy as they can bear. As long as no-one bets the farmville, everything will be OK.

Now the spring on the clock is as tight as it will go. Nothing has been remedied and there's no plan B.

Maybe, just maybe, they can fix it all with just one more turn on the spring...


SheepDog-One's picture

Thats right, all these whiners who now see their business hurting were ALL FOR the FED's print and pump intervention policies 2 years ago! Should have spoken out against it then, you youre in deep trouble OH WELL sucks to be you!

Ethics Gradient's picture

I may have misunderstood, but I don't think I agree with that one.

At the time it was print and pump or time to call in CDSs.

There was an opportunity to resolve an awful lot of problems, but it would have been extremely painful. There would have been squid ink everywhere. They opted for what's coming next instead.

MrTrader's picture

Amazing how many idiots Paulson and companions have found on their way to armageddon.

TimeToChange's picture

"In summary, the buyers of the Waddell & Reed e-Mini contracts, transformed a passive,  low impact event, into a series of large, intense bursts of market impacting events which overloaded the system."

The SEC's report says some of this.  Andrei Kirilenko's paper says exactly this.  See


wiskeyrunner's picture

Oh know stocks are up again, to bad all the doom and gloomers here just stand around kicking the dirt and mutter under there breath as the rally powers higher.

Sudden Debt's picture

They are waiting for the DOW to hit 200 before they want to step in :)

SheepDog-One's picture

And you havent made a dime until youve sold, all youre looking at is on-paper profits, so the tale of those who count their chickens before theyve hatched comes to mind here before the mother of all bagholder events plays out one day soon. Be quick on that sell button whiskeyguzzler! You might find an umbrella in a tsunami doesnt do very much good!

homersimpson's picture

Spoken like a true bulltard. Your name again - what was that?.. Dumm hass?

Kat's picture

Peterffy lashes out against that which is not advantageous to his business and glorifies that which is.  How shocking.

Of course Peterffy benefits if all trades have to come to him first on a centralized exchange where he is a powerful enough to have the rules written to favour him and screw all the customers.  Those HFT guys are the natural enemies of Timber Hill and, as usual, this blog and the public know to little about how the sausage gets made to see through his thinly veiled rent seeking.

I will garauntee you one thing and one thing only - nobody will be providing you bids in a crashing market without getting major exemptions from the rules you're bound by.  That's why you didn't see any on May 6th and you won't want to pay the price for liquidity if Peterffy gets his way.




Tyler Durden's picture

It would appear that many are willing to pay for true liquidity, not the volume churn that the SEC and the HFTs are pretending is equivalent to true order depth. As for his rent seeking, many would also be willing to pay that as opposed to the much greater rent already paid to HFTs and internalizing brokers who provide nothing of value.

Kat's picture

Lofty words.  But, what you completely fail to understand is that the SEC has been busy crafting rules that suck liquidity out of the market.  That's the effect you're seeing.  The HFT shops are just the last man standing (except for the large, politically connected firms who can stop investigations of outright fraud by their SRO's with one phone call). 

There is no rent paid to the HFT's except the rent they create by having technology fast enough to take advantage of inefficiencies.  Most aren't even market makers and don't have the piddly exemptions.  The SEC has driven out everyone on whom you would like to rely to provide liquidity by making it too expensive to do so.  HFT's are the only ones that can survive. 

You also don't seem to grasp the concept of rent seeking very well or understand why people do it.  If the rent were greater in running an HFT shop, that's what Peterffy would be doing.  His advantage is leveraging America's ignorance of financial markets and the 9 million regulations that screw them at every turn (in the name of protection, of course) to his benefit.

Tyler Durden's picture

Somewhere in there you confirmed, I believe, that there is no liquidity left in this market. Thank you for that

i-dog's picture

"If the rent were greater in running an HFT shop, that's what Peterffy would be doing."

I wouldn't rule that out yet. "First they revile you. Then they call for legislation against you. Then they join you."

Sudden Debt's picture

Anybody watching BAC? :)

It looks like my friday call are working pretty hard right now :)

plocequ1's picture

Dow up 87. Hft is in full vigor. Let me know when there is a roadblock. In the mean time, Dr Bernanke says, Buy stocks and shut the fuck up.

SheepDog-One's picture

THE CURE for this crooked broken market is SIMPLE! Each trade must be made with a CAPTCHA correctly answered before the trade is executed! CASE CLOSED!

Dapper Dan's picture

Hey Thomas Peterffy were you a student of Black-Scholes?

" I must confess to you that I was an ardent proponent of bringing technology to trading and brokerage"

Mandelbrot was  highly critical of the world banking system, arguing the economic model it used was unable to cope with its own complexity.

wiskeyrunner's picture

Buy December sp 500 futures, make free money, the stock market will power higher till November 4th.

trav7777's picture

translation:  no brokerage fees boo hoo

janchup's picture

What's the payoff to SEC for intentionally doing a horrible job? Of course, they realize the American public is too clueless and distracted to really care but that's no excuse for a fabrication such as they presented regarding Flash Crash. So what is the payoff?

hbjork1's picture


"If I do nothing, maybe it will go away."  "If it doesn't, wait until the public outcry gets loud enough so that we can go after the perps with minimum backlash."

StychoKiller's picture

Round up Martha Stewart and the "Usual Suspects!"

Edwardo's picture

" make the process more efficient."

That may be the single biggest B.S. reason given to turn functioning industries-how many times have we heard this clarion call, "we need it for efficiency" into abbatoirs.

StychoKiller's picture

Meat grinders are efficient too, but I wouldn't wanna stick my hand in one!  Good point on your part!

NOTW777's picture

simple - outlaw HFT.  dont give me any crap about liquidity.  its fraud and unfair competition.

good for IB ceo

whomever is doing HFT last 6 mos should be banned from trading for life

TimeToChange's picture

"During the Flash Crash, the trading behavior of HFTs, appears to have exacerbated the downward move in prices. High Frequency Traders who initially bought contracts from Fundamental Sellers, proceeded to sell contracts and compete for liquidity with Fundamental Sellers. In addition, HFTs appeared to rapidly buy and contracts [sic] from one another many times, generating a “hot potato” effect before Opportunistic or Fundamental Buyers were attracted by the rapidly falling prices to step in and take these contracts off the market."

Kirilenko et. al., "The Flash Crash: The Impact of High Frequency Trading on an Electronic Market," page 2.



Buttcathead's picture

LOL It aint even fraud anymore.  It is just flat out free money for banksters.  Americans are dumb as hell.   They are just going to go bankrupt and then starve to death.  The future is so bright I am setting myself on fire. 

DosZap's picture

THis is like saying I am sorry, after you have been caught.

Not really sorry, just sorry your caught.

I do not see how any of you could trust them ever again.

Not me.

No More Bubbles's picture

It is vitally important that we bring an end to this crisis of trust before it spreads any further; that we bring back order, fair dealing and trust in the marketplace."

Too F*<king late!

NotApplicable's picture

No doubt! Like I'm going to trust any regime after this one...

Vampyroteuthis infernalis's picture

The sad reality is they will clean up this fraudulent mess after it is too late. The market will have crashed wiping the vast majority of investors out. Day late and a dollar short.

MarketFox's picture

IB was the best thing that ever happened to the RETAIL none....

The other RETAIL boxes such as Schwab, Amertrade, Scottrade...and others ...are an expensive JOKE for RETAIL....just as Peterfly just mentioned....

But we are the age of the INTERNET...and the internet has radically changed the securities business....

And yes...there is a better business based on the BATS model....especially in European stocks....they rape their customers...they are deftly inefficient....


The new structure has to represent RETAIL in a real virtual way...

1) Defragment the exchanges...

2) All public instruments must trade on the exchange...

3) There must be size limits....

Why ? What makes for a better marketplace...a billion RETAIL accounts pressing their own computer buttons backed by fact based wiki data instead of the public media propaganda that is paid for by those who have other ideas...and a handful of large self fulfilling account master bastards....


Banks should be allowed to service RETAIL...not game RETAIL....


Also ...this bullshit about RETAIL not being able to go long short is just that....

Any account should be able to go both ways....


Furthermore....the US is at a real crossroads...

One major problem is better distribution of wealth....and another major problem to re create RETAIL....

Because in all honesty...the Blankfein ilk has totally fucked up the markets...

Lots of heads belong on poles...LOTS OF THEM...


In short ...the US has got to dramatically reduce govt....and dramatically increase entrepreneurism...and the distribution of wealth....

The govt...and its big bank fascist bullshit need to step aside....

ella's picture

Is the author worried about the public perception and lack of participation?  Sounds to me like he is beginning to worry that the rest of the market players no longer trust the markets.  Now that is something to worry about. 

Diidier's picture

I endorse that quote :

"the financial markets are a con game"