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.
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?