Our friends at Themis Trading have put together another quite fascinating white paper which makes a disturbing observation: on an intraday basis, the widely watched market gauge indices such as the Dow Jones Industrial Avereage, the S&P 500, the Nasdaq and the Russell 1000, are based on less than 30% of all shares traded, therefore conveying incomplete trading data. The reason, which is intuitively known by all who follow the increasingly more fragmented and more compartmentalized into dark pools and other various ATS venues, market topology is that as Themis says: "the market has become increasingly dominated by trading volume from arbitraging index, ETF, and other derivative movements versus the underlying equities.... Nowadays, in a world of microsecond trading, these indexes have become phantoms - they reflect some trades involving their components, but not the majority of them." In other words it is becoming increasingly obvious why in a world of HFT, ETF, algo, ATS and everything else penetration, there is now a scramble between the legacy exchanges to merge. The alternative is a slow, painful death due to terminal obsolescence brought upon from unregulated trading venues, which often times see the alternative trading system operator have exclusive firewall and gateway privileges, where anything goes and where such obsolete constructs as Reg NMS are routinely ignored: after all how can the SEC possibly track down the billions of unique trades each and every day and catch all the transgressions. Themis provides a solution to this skewed motivation for all traders to increasingly vacate the actively regulated open exchanges: "indexes should be calculated based on every trade involving a component that crosses the consolidated tape, which includes trades from non-primary exchanges such as BATS, DirectEdge and NYSE Arca."
More take home points from Themis:
Would you bet on the Kentucky Derby (legally, of course) if the results reflected only some of the horses in the race? Would you have confidence in a publicly traded company that reported results from only some of the subsidiaries? This is currently the case with the major stock indexes in the US. The indexes that everyday retail and institutional investors rely upon are being calculated on an intraday basis without a full deck, so to speak.
In a post Reg NMS world, fragmentation amongst market centers has reduced the amount of trades that occur on the primary exchanges. The primary market alone is no longer a complete enough source of data when calculating an index value since it represents only about one in four trades. Index suppliers must adjust their methodology to accurately reflect all trades intraday in a timely manner. If they don't, they risk regulators or Congress doing it for them.
Below is Joe Saluzzi, explaining his findings to Bloomberg TV:
The full Themis Trading white paper is below.