Market structure issues lead to innovation

October 31, 2014 07:00 PM

When the book “Flash boys: A Wall Street Revolt” was splashed into our consciousness and CBS’ 60 Minutes interviewed author Michael Lewis, it created a huge controversy. The controversy was based on Lewis’ claim that U.S. equity markets were rigged. 

This created a huge backlash from equity markets and seemed somewhat counterintuitive. After all, in the decade since Reg NMS went into effect the cost of trading for retail traders has dropped dramatically. Commissions have decreased and bid/ask spreads have tightened. It wasn’t that long ago that equities  were quoted in eighths. The key to that progress was competition. The New York Stock Exchange no longer has a virtual monopoly in equity trading. Ironically, while this competition has led to many of the positive changes in terms of cost, it also has created many of the problems cited in Lewis’ book and is the reason Brad Katsuyama, a former broker at RBC Capital Markets, decided to launch his own exchange, IEX. 

Both Katsuyama and Keith Ross, CEO of dark pool PDQ ATS, say there are too many trading venues (see “Building a better market”). The key to liquidity is competition for orders, and with 50 plus trading venues, those orders and the market-makers looking to take the other side are disbursed across those venues. It is not like futures where nearly every market is traded in one location and all the liquidity in the world has to come to that market. 

In a sense that is what those two exchanges attempt to do. PDQ tells its markets-makers there is an executable order in a specific stock and asks them to give their best price and compete for it. IEX briefly delays orders into the market and fills out of the market long enough so that high-frequency traders can’t race IEX customer orders to the next venue if the order is not completely filled. 

Katsuyama acknowledges that traders have always looked for an edge, and high-frequency traders are simply using the tools of the day to do what traders have always done. But he says that technology can be used to even the playing field. 

As someone who has worked on a trading floor, I understand the frustration of having a broker quote a market,  then attempt to hit a bid or lift an offer only to be told that that bid or offer is no longer there. It did not happen often in the futures market, and when it did you expected to know why. So if this is something that happened consistently to Katsuyama, his frustration is understandable. But he seemed to have figured out a solution with his trading software, Thor, and now with IEX. Perhaps the democratization of trading technology has turned all traders into scalpers. In our conversation, Katsuyama said he would like to attract resting orders to his exchange, but nearly in the same breath he talked about executing at a mid-price peg. That doesn’t really square with ‘resting orders.’

Scott Skyrm’s piece, “How Power Peg brought down a Knight,” illustrates how complex trading has become  and the dangers of rogue algorthms.


One of the tenets of a fair market is that every order entered into a market is exposed to risk.  If any high-frequency traders have gamed the system to avoid their orders facing risk, they should be punished. But what Katsuyama has proven, as well as Ross, is that there are innovative folks out there meeting the needs of traders. Regulations could not have built Thor or IEX. 

Speaking of risk, it seems to have returned to equity markets. Last month we focused on risk as a lot of market participants feared a day of reckoning for equity markets. As of this writing, the major stock indexes have corrected 10% and there is real fear, which is healthy. When the balance between fear and greed swings too far in one direction, bad things tend to happen. 

Regardless of whether you believe the Fed acted appropriately during the great recession and its aftermath, there is something disturbing about endless QE and six years of zero interest rates. It is time to move past it, even if it will cause pain. 

Jim Rogers was somewhat pessimistic regarding the Fed’s ability to stay hands off, even in the event of a minor market correction. Well, his thoughts will be tested. Stock indexes have corrected a little more than 10% over the last two weeks, and there is talk of delaying the end of the Fed’s bond purchasing program (QE3) past this October’s FOMC meeting. That would probably be a mistake, especially since economic indicators have been relatively positive. 

The sell-off was triggered by weakness in Europe and may simply have been overdue. When qualifying its actions with ‘based on future economic data,’ the Fed should be looking at inflation and employment figures, not the movement in the Dow Jones. 

Markets change, which is a good thing, and the end  to this endless bull equity market sustained by central bank policy is good. Managed futures programs look to have turned the corner. We hope that investors haven’t pulled out of alternatives right when they are needed the most, though there has been evidence of this. The dollar has broken out of a long-term range and crude oil recently broke below $80. These are all positves for traders, even the equity correction. Change is not only inevitable, but a positve sign for markets.



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About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.