Barrons: A Fairer Stock Market for All, By Jacqueline Doherty, 26 October 2009

IN THE PAST 10 YEARS, TECHNOLOGICAL innovation has radically transformed how and where stocks are traded. Regulation, however, has failed to keep pace, leading Wall Street to exploit its newfound liberty in the pursuit of fatter profits and to engage in certain practices that may be hurting smaller investors.

Now the watchdogs are waking up. Securities and Exchange Commission Chairman Mary Schapiro announced potential rule changes Wednesday that could curtail certain trading practices in so-called dark pools, or off-exchange trading platforms, that have sprung up — in part to help traders shroud their identities, and in part to hide transactions from competitors. The SEC’s proposals, including forcing some dark pools to make bids and offers public if their trades represent more than 0.25% of the daily volume in a given stock, follow its recommendation last month to ban “flash orders.” Those enable someone who hasn’t displayed a quote publicly to see orders a fraction of a second before the public can trade on such information.

It’s a safe bet Schapiro won’t stop here — nor should she. Spurred by critics such as Democratic Sen. Edward Kaufman of Delaware, who argues that the drive for more liquid markets “is trumping transparency and fairness,” the SEC has begun what its chief calls an “in-depth review of multiple market-structure issues.” In coming months the agency is likely to investigate whether computerized high-frequency trading confers unfair advantages on trading companies with superior technologies, particularly those able to situate, or co-locate, their servers at the major stock exchanges, enabling them to capture and process information ahead of other market players.

The SEC also is likely to examine and possibly restrict direct market access, which enables some investors, such as high-frequency traders, or HFTs, to pay for the use of broker/dealers’ identification to trade directly with exchanges in a way that bypasses the risk analysis and oversight that dealers provide. The inability of such a piggybacker to settle its trades potentially could put the entire system at risk.

Schapiro hasn’t signaled publicly her intention to study the growing practice among exchanges of offering rebates in return for orders, but this, too, would seem to warrant a closer look. In addition to the obvious questions such “pay for play” arrangements raise, some market participants say that capturing rebates, not buying and selling shares at the best available prices, has become the raison d’être of some HFTs.

Here is a closer look at several market practices that could face regulatory scrutiny — and at potential changes in each arena that could make today’s brave new world fairer for all investors.

THE STOCK MARKET’S MOVE in 2001 to price shares in decimals, not sixteenths, set the stage for today’s market structures, in which computers, not the New York Stock Exchange, play the starring role. By shrinking the difference between the best bid and offer on liquid stocks to a penny a share, decimalization hurt the profitability of the Big Board’s market makers. Many left the business, while others grew more risk averse and reduced the size of their trades. By the end of last year, the average trade had fallen to 250 shares, from more than 1,400 in 1997.

In 2005 the SEC enacted Regulation NMS, which linked all exchanges and market makers, allowing traders to see the best quotes available and trade in the market that offered the best price. This forced the NYSE to move to digital systems.

High-frequency trading, conducted by computers that place trades in less than a second, millions of times a day, flourished amid these changes; it now accounts for 70% of daily U.S. trading volume, according to TABB Group. Its explosive growth has led to greater volume and liquidity, and significantly lower trading costs. But technological superiority also may benefit the market’s biggest traders at the expense of other investors.

Institutional investors typically rely on the consolidated tape to provide the most recent quotes on shares. The tape gets information from all the stock exchanges, sorts it and “prints” the latest quotes within five milliseconds. It then transmits this information to data providers such as Reuters and Bloomberg. In their quest for speed, some HFTs now pay to place their servers at the exchanges to capture information milliseconds ahead of competitors.

Critics are crying foul. “It’s not a fair playing field if you need a massive infrastructure to have the same access to order flow,” says Ross McLellan, an executive at State Street Global Markets.

Others fear HFTs, with their superior speed and ability to gather information, are driving stock prices to the detriment of “legitimate” buyers. Bob Gasser, CEO of Investment Technology Group, which advises institutions on how well their trades are executed and operates a dark pool, offers a theoretical example: An investor hoping to buy 100,000 shares of a stock tests the waters by making two purchases of 500 shares each. An HFT, which has sussed out interest in the stock, steps in and accumulates shares at a slightly higher price. When the original buyer — your mutual fund, perhaps — re-enters the market, the HFT sells its shares at a profit, pocketing the difference between its purchase and sale price.

Technology inequality is a thorny issue in all spheres, not only trading. If the exchanges stopped selling co-location services, others would build server farms next door to the NYSE or Nasdaq. To combat the HFTs’ potential ability to trade ahead of other market players, the SEC ought to consider forcing the Consolidated Tape Association, keeper of the tape, to increase the speed with which it disseminates information to all traders. “CTA will continue to look at reducing the amount of time it takes to process messages from the exchanges,” says an association official.

Even so, HFTs are likely to continue to enjoy an advantage — albeit a smaller one. In return for that opportunity, some market participants think the SEC should require them to make better-than-posted markets a certain percentage of the time during the trading day. After all, that’s what market makers did in days of old, notes an executive at a broker/dealer.

TO ESCAPE DETECTION by HFTs, institutional investors have been flocking to dark pools. Thirty dark pools, the largest run by Credit Suisse and Goldman Sachs, now account for almost 10% of total equity trading in the U.S. They enable institutions to submit bids and offers that aren’t posted publicly, and that are crossed only if a matching order exists or buyer and seller agree to trade at the midpoint.

Only three dark pools — Pipeline Trading, Liquidnet and ITG Posit — trade “institutional-sized” blocks of 6,000 to 50,000 shares, according to Rosenblatt Securities. Most of the rest trade in blocks of 300 to 400 shares. This suggests they have opened themselves to HFTs, which also trade in small increments to minimize risk. Despite concerns that HFTs may be profiting by deliberately moving prices, Richard Gates, a portfolio manager at TFS Market Neutral Fund, thinks they’re welcome because they create the trading volume dark pools need to survive.

Unlike the New York Stock Exchange, whose share of U.S. trading volume has plummeted to 27% in recent years, dark pools don’t have to provide market surveillance. Thus, some fear they are attractive to potential manipulators.

“When activity is fragmented among multiple venues, it’s harder to police,” says Joseph Mecane, an executive vice president at NYSE Euronext, parent of the NYSE. What’s needed, he says, is a central regulator with access to data from all stock-trading venues — dark pools, electronic-communication networks and exchanges — with all parties shouldering the cost.

Yet cost is one attraction of dark pools to the brokerages that run them. By putting orders through their dark pools, these firms avoid exchange fees and get paid by both sides when they are able to match bids and offers, says Seth Merrin, founder and CEO of Liquidnet.

As more trading leaves the regulated exchanges, some fear the price-discovery role they have played will be damaged, and the efficiency of the capital markets harmed. The increase in trading volume executed through dark pools raises “the potential for dark pools to detract from the quality of public price-discovery mechanisms,” Schapiro said in a recent speech.

While the SEC’s latest proposals aim to expose some dark pools to more light, more action may be needed. If adopted, these proposals probably would stop dark pools from sharing indications of interest, or IOIs, the equivalent of bids and offers, with anyone. Regulators fear nonpublic postings of such information could lead to the creation of a two-tiered market that hurts those with access only to public best bids and offers.

Eleven dark pools use IOIs, according to one analyst. Pools run by Goldman and Credit Suisse don’t. The SEC’s move to require dark pools to publicize bids and offers above 0.25% of the daily volume in a given stock — the threshold currently stands at 5% — applies only to those sharing indications of interest. The agency also wants to compel dark pools to identify themselves when reporting trades to the tape.

Some exchange officials had expected the SEC to recommend lowering the threshold for publicizing bids and offers to 2% of daily volume for all dark pools. That likely would have driven more trading to the exchanges, but so far, it’s wishful thinking.

ONE WAY DARK POOLS and exchanges have competed for business is by making trading cheaper. Lower costs are especially attractive to high-frequency traders, who cross millions of trades a day.

Some dark pools, stock exchanges and other trading platforms are offering rebates to broker/dealers or others willing to post bids and offers. They charge those who take the other sides of the trades. Under such “maker/taker” pricing, rebates often can range from 10 cents per 100 shares to 30 cents, depending on the platform.

Rebates were supposed to incentivize traders and investors to post liquidity, thereby improving markets. But some fear dealers are going to venues that offer the biggest rebates, not those that give clients the best execution. “For some high-frequency traders, rebate trading is their business,” says David Easthope, a senior analyst at Celent, a financial-services-industry consultant. “The rebates have a huge influence on where the orders go.”

So far, the SEC has given no indication it is concerned about maker/taker pricing. But other payment-for-order-flow schemes have been curbed by regulators in the past. An SEC spokesman declined to comment.

BROKER/DEALERS VYING for business from high-frequency traders also have adopted some potentially dangerous practices. While HFTs such as Getco have registered as broker/dealers, gaining direct access to exchanges, other traders have gained such access through their dealers. HFTs seeking faster execution co-locate their servers at the stock exchanges and use the dealers’ identification to trade directly with the exchanges, an arrangement known as naked sponsored access.

Unlike their dealers, high-frequency traders enjoying naked sponsored access aren’t subject to capital requirements, or to SEC audits, says Larry Tabb, founder of market-research firm TABB Group. They can also sidestep the oversight and risk-management analysis that dealers provide before trades occur, and enjoy pricing discounts received by the dealer for high trading volume.

The lack of pre-trade analysis and risk-management could lead to severe problems. If, for example, a trading customer doesn’t have the funds to settle a trade, or its computers malfunction, sending unintended trades to the exchanges, the dealer must make good on the transactions. Some dealers themselves might lack the capital necessary to step in on a client’s behalf.

“Goldman Sachs believes that naked sponsored access introduces the potential for significant systemic risks due to the lack of appropriate pre/intra/post trade controls,” the firm recently wrote in a report provided to legislators. Goldman doesn’t allow its customers naked access.

Wedbush Securities is one of the largest dealers that does. The firm says all trades go through clients’ risk-management systems, which Wedbush inspects before giving them access. Wedbush tests those systems and does post-trade analysis to ensure clients’ risk-management systems have worked, says Jeff Bell, head of clearing and technology at the firm. So far, clients have managed risk well.

The SEC’s attempts to wrestle with the fallout of modernization are belated. But any effort to improve transparency and level the playing field is bound to benefit investors.

Overview Of Goldman Sachs Electronic Trading: Part 1

By Tyler Durden

Created 10/04/2009 – 21:04

Zero Hedge is starting a multi-part overview of Goldman Sachs’ Electronic Trading client-focused product suite, to demonstrate just how extensively embedded in modern market architecture are Goldman’s various DMA and “liquidity” facilitation schemes, and the depths of dark pool domination via Goldman’s global order router, and other specific topical offerings.

Our first focus is on Goldman’s DMA/liquidity/order router integrated suite, represented by REDIPlus and Sigma, as well as Goldman’s privileged access dark pool, SIGMA X.

A first and key observation is that Goldman’s Direct Market Access program accounts for over a whopping 1 billion shares daily, as disclosed to clients by Goldman itself. When one considers that the NYSE’s trading volume has recently been in the 1-1.5 billion shares per day range [1] (a number that has been consistenly dropping over the past decade, and explains the NYSE’s animosity toward other new exchanges such as Direct Edge, which however shot themselves in the foot by procuring clients thru the adoption of such shady practices as Flash Orders), and one can see how Goldman is becoming a dominant force in the market landscape, and why all other market participants are sweating profusely. This is true now more than ever, now that the Fed and the U.S. government have indicated that no matter what happens, Goldman Sachs will never be allowed to fail, no matter how great of a risk it takes. If in the meantime, it is allowed to gain an exclusive monopoly in any one aspect of the market, so be it.

Goldman increasing domination via DMA routing also explains its careful treading when it comes to DMA discussions with the regulators: any major change (which also includes any hits to Goldman’s well-greased machine that would result as a function of a ban on Naked Short Selling, and subsequent attempts by Goldman’s well placed lobby efforts to prevent such a ban [2]) would likely result in a need to dramatically overhaul its product offering which so far has been so efficient and attractive to new clients, it is on par to challenge the NYSE in share volume. For some very prophetic words of caution on how dangerous DMA could be if it were to go haywire, and slip out of control, we refer readers to the following discourse by Lime Brokerage principals [3]. And, as one can expect, the debate here is about so much more than pre-trade or post-trade monitoring.

Orders routed through Goldman’s router for the most part end up on various semi-dark exchanges, ECNs and crossing networks.

As Goldman itself discloses, the Objective/Strategy of its SIGMA Smart Order Router, consists of the following:

• SIGMA is the Goldman Sachs smart router
• SIGMA breaks up an order into smaller pieces with the objective of maximizing liquidity at the most favorable price
• Accesses every ECN and public destination under Reg NMS
• GSAT algorithms leverage the SIGMA smart router for all child orders
• 15-20% of SIGMA volume is executed within SIGMA X

A graphical representation of the order routing distribution can be seen below:

[4]

And here is the simplified explanation of the three primary tracks in the diagram above, direct from Goldman Sachs:

1. Algorithmic Orders systematically post liquidity to SIGMA X and other ATSs. Additionally, child orders are routed via the SIGMA router, accessing SIGMA X and other non-displayed liquidity before ultimately reaching the public markets.
2. SIGMA Smart-Routed Orders are DMA orders that pass through SIGMA X, benefitting from potential price improvement due to enhanced liquidity.
3. SIGMA X Posted Orders sit passively on the SIGMA X order book, where they can interact with pass-through DMA/algorithmic flow and other posted orders. Orders posted to SIGMA X receive full price improvement when interacting with opposite-side marketable flow.

In summary: Goldman keeps procuring more and more clients who use REDI, Sigma, etc., for the sole reason that Goldman now provides a practically alternative “exchange” to virtually every other full/major access venue. Obtaining “privileged access” to SIGMA X provides Goldman PB counterparties with what is quickly becoming the best populated and highest “inventoried” dark venue in the world. And the kicker: few if any know who trades what on SIGMA X. A major threat to technicians: open exchange volume is increasingly representative of exactly nothing, as all the real action occurs in the gray, and mostly dark, arenas (and of course, in OTC CDS). Which is why as the administration is transfixed on the DJIA, even that is becoming increasingly disjointed with whatever is left of the true market. And as Zero Hedge has been pointing out, the economy has long since stopped being represented by the stock market. It is only fitting that the market is only no longer representative of “itself” – compliments of Goldman Sachs.

In future posts of this series, we review Sonar, Sonar Dark, benchmark matching via OptimIS, PortX, VWAP, TWAP, dynamic participation, reactive participation, price and liquidity seeking, and other topics where Goldman has stealthily become the primary market force.

SEC Says Big Regulatory Initiatives Coming This Fall

Traders Magazine Online News, September 21, 2009

Nina Mehta

The Securities and Exchange Commission is engaging in a broad reassessment of equities market structure against the backdrop of an increasingly automated trading environment. This comes on the heels of a rule proposal last Thursday that would ban flash orders on equities and options exchanges.

“The securities market has experienced extraordinary changes over the last few years in trading technology and practices,” James Brigagliano, co-acting director of the SEC’s Division of Trading and Markets, said last Thursday at one of the Commission’s regular open meetings. “Some of these changes have led to serious concerns about whether the regulatory structure remains up to date.”

Broadly, the SEC is looking at how technology and automated trading have altered the landscape in the wake of Regulation NMS, which was implemented for exchanges in March 2007, and whether that has led to unfair trading practices. Reg NMS forced the New York Stock Exchange to become electronic, ending the Big Board’s monopoly over trading in its listed stocks.

As a result of Reg NMS and Regulation ATS, which became effective in 1999, the overall equities market has become more competitive as well as more fragmented. These big rule changes produced a bevy of alternative trading systems that do not display quotes publicly. Some of these ATSs are crossing platforms for block orders. Most, however, are broker-operated dark pools whose average execution size is several hundred shares.

Brigagliano on Thursday laid out many of the trading issues currently on the SEC’s plate. The SEC, he said, is “looking at the threshold levels of Reg ATS, looking at post-trade transparency for some of the dark venues so that investors can assess the relative levels of volume and liquidity [in particular securities in those venues]. We’re looking at the use of IOIs, which can have analogous features to flash orders, DMA, co-location, and high-frequency trading.” The comment about IOIs referred to automated indications of interest sent by some ATSs to one another to search for liquidity.

Brigagliano noted that several SEC initiatives “may be in form of proposals where we think prompt action is warranted.” He added that high-frequency trading is an issue that would most likely fuel a “big picture discussion,” rather than an immediate policy initiative.

SEC Chairman Mary Schapiro has said several times over the last six weeks that market and trading practices with “opaque features” are coming under greater regulatory scrutiny. Last Thursday, at the SEC’s open meeting that discussed flash orders, she said the SEC “is continuing to review other forms of dark trading that lack market transparency, and I expect that initiatives in this area will be considered in the near future.”

Flash orders are orders that enable a market center that is not quoting at the best price to execute that order by soliciting contra-side interest at the market’s best quoted price from its participants. The SEC said last week that flash orders unfairly give select market participants information that is not available to the broader market.

Larry Tabb, founder of research firm TABB Group, has thought for a while that a broad market structure reassessment is warranted. “Pretty significant changes in the structure of the markets are happening because of changes in the dynamics of trading,” Tabb told Traders Magazine last month. “Some of it is the result of decimalization, some of it is the result of advanced technology, and some of it is because of who’s provisioning liquidity and how. I think the SEC is thinking about all of these changes, how market structure impacts this ecosystem, and how that affects trading costs.”

Tabb said he didn’t know how extensive the regulatory changes this fall might be. “If the whole Rube Goldberg thing actually works and provides good executions for both individuals and institutions, you leave it alone, even if it is complicated,” he said. “But if we can determine that there’s a large group of people taking advantage of information, then we need to do something.”

At last Thursday’s meeting, Kathleen Casey, one of two Republicans among the five SEC commissioners, said she considers an overarching review of trading issues necessary. “I would like to see the Commission engage in a comprehensive review of the current structure of U.S. securities markets,” she said. “We are several years past [Regulation] NMS and, given the rapid change in technology and the market, I believe it is an appropriate time for a broad-based review of market structure issues.”

Elisse Walter, one of the Democratic commissioners, said flash orders were just the “initial step in a series of actions” the Commission would likely take in the coming months. She stressed the need to address dark pools and the automated IOIs they send one another, as well as “Regulation ATS thresholds.” The latter referred to both the display and fair access requirements for ATSs. In addition, Walter highlighted sponsored access, high-frequency trading and co-location as topics needing greater regulatory focus.

“The Commission is looking closely at all of these matters to determine whether they raise policy concerns that are analogous to flash orders or otherwise may be detrimental to the fairness and efficiency of the national market system,” Walter said.

The recent demand for a review of market structure developments has come from several sources. Senators Chuck Schumer of New York and Ted Kaufman of Delaware, both Democrats, urged the SEC to ban flash orders over the summer. Sen. Kaufman has also called for a wide-ranging review of a number of trading practices, including the growth of high-frequency trading and co-location. In addition, there has been a broad public discussion in the mainstream media and on blogs about how the equities market is evolving.

Robert Colby, a veteran regulator who left the SEC’s Division of Trading and Markets earlier this year and is now counsel at law firm David Polk & Wardwell, observed that the chief criticisms the SEC is currently facing are concerns about the potential lack of fairness in the markets, the fragmentation of trading centers and allegations of manipulation in the markets. He commented on these issues in a speech at a mini-conference sponsored by research firm Aite Group last Wednesday.

Colby addressed some of the public discussion that trading issues have generated over the last two months. Some of the fervor behind the widespread outrage, he said, amounts “to a kind of muddled jumble of important concerns and a misunderstanding of what trading markets are really like today.”

He stressed that there are serious regulatory concerns about some of the trading issues that have developed. A form of sponsored access called “naked access” or unfiltered access, he said, “raises really important and significant risks for the entire equities market.” At the same time, he suggested, some issues have been magnified in recent public discussions. “Flash orders have been added to the perp walk,” he said, noting that the internalization of customer orders by broker-dealers has existed for a long time, so “the concept is not new.”

On Friday, in a speech at Georgetown University about global finance, SEC Chairman Schapiro suggested that disclosure and transparency are the guideposts that will help the SEC update rules and practices in a range of areas, from oversight of credit ratings agencies to municipal securities and equities trading. She went on to note that the SEC’s decision to propose a ban on flash orders fits into the Commission’s “disclosure regime, because it’s about letting all investors have equal access to information.”

Many of the changes in the equities market now under consideration could affect trading volume as well as competition between market centers. Brian Hyndman, an executive at Nasdaq OMX Group, said last Wednesday at the Aite conferencee about high-frequency trading and other issues that his company worried about the unintended consequences of “some of the regulatory changes that have either come out or will come out.” Representatives of NYSE Euronext, BATS Exchange and Direct Edge, who were also on the panel, agreed with him.

For more information on related topics, visit the following channels:

• Exchanges and ECNs
• Crossing Networks/ATSs

Inquiry Stokes Unease Over Trading Firms That Shape Markets

I would like to extend a welcome to all of our past members from Wall and Broad.  As you all may recall, the Alliance of Floor Brokers has always been a group that has fought for the integrity of the marketplace.  I invite you to read the articles I have found from various sources.  Most of these focus around the much publicized topic of High Frequency Trading.  Currently the SEC is reviewing the practice of flash orders types, and the NYSE is on the right side of the argument.  Please feel free to comment on our blog.  Your years of service to the exchange can provide us with valuable input, as we continue to represent the floor community.

Patrick Armstrong

Co-President AFB

On The Cover/Top Stories
The New Masters of Wall Street
Liz Moyer and Emily Lambert 09.21.09, 12:00 AM ET

Daniel Tierney and Stephen Schuler share a lot of traits with many other enigmatic traders populating the financial world. Their firm, Global Electronic Trading Co., is tucked behind a nondescript door on the second floor of the Chicago Board of Trade’s art deco building. Until this summer, when it added some company specifics, its Web site contained little more than a reading list with recommendations like Reminiscences of a Stock Operator. Not a single photo is publicly available of either of its principals.

What distinguishes Tierney and Schuler is that Getco, as their firm is known, currently buys and sells 15% of all the stocks traded in the U.S., ranking it among the likes of Goldman Sachs and Fidelity Investments. Getco was reportedly valued at $1 billion two years ago and is rumored to have earned roughly half as much as that in net profit last year alone. Tierney, 39, and Schuler, 47, are among Wall Street’s super-nouveau-riche.

“We translate technology innovation into making financial markets more efficient,” Tierney says in a carefully worded interview.

Getco earns its outsize profits buying and selling securities up to thousands of times a second. This frenetic profession has come to be known as high-frequency trading, and in recent months it has emerged as the hottest ticket on Wall Street. Even as financial markets collapsed last year, high-frequency traders collectively enjoyed $21 billion in gross profit, according to Tabb Group. On the NYSE, daily volume surged 43% through June from a year earlier to 6.2 billion shares; high-frequency traders are believed to account for 50% to 70% of the activity and similar proportions in electronic futures and options markets.

In the process they have ushered in the most wrenching, and controversial, transition in the history of U.S. securities markets. For decades the New York Stock Exchange towered over U.S. equity trading, with its market share rarely dipping below 80%. Nasdaq and other electronic rivals slowly chipped away at it. But the real shakeup has come very recently at the hands of high-frequency traders and the band of scrappy exchanges that have popped up in their orbit. In the past two years they have collectively cut, from 50% to 28%, the share of equity volume controlled by the NYSE, even as it has sacrificed its iconic floor to the whims of the electronic crowd.

With their emergence as the predominant source of activity and profits, high-frequency traders have become the new masters of the Wall Street universe, reshaping financial markets in their image, just like the junk bond kingpins, corporate raiders and private equity powerhouses who reigned before them. High-frequency traders and their offshoots–the public trading venues that cater to them and the private “dark pools” that seek to shut them out–have become lightning rods for criticism among frazzled individual investors and grandstanding politicians who are shocked–shocked!–to find Wall Street trying to make a buck at a time like this.

Senator Charles Schumer (D–N.Y.) has demanded that the Securities & Exchange Commission prohibit the high-frequency gang from using something called flash quotes. SEC Chairman Mary Schapiro warned the lack of transparency in dark pools has “the potential to undermine public confidence in the equity markets.” Nasdaq’s Robert Greifeld has called for banning them outright. “America is destroying its capital market structure,” frets Thomas Caldwell, chairman of Caldwell Asset Management, an NYSE investor.

Here’s another viewpoint: All these scolds are missing the bigger picture. High-frequency trading adds liquidity, speeds execution and narrows spreads. This contrary view comes from, among others, George (Gus) Sauter, who oversees $920 billion in investments for the Vanguard Group. “We do think [high-frequency trading] enhances the marketplace for all traders,” he says.

Getco’s story parallels the changes afoot. Tierney, a cerebral economist and philosopher, began trading options on the floor of the Chicago Board Options Exchange in 1993. Schuler, a gregarious futures broker, started out in 1981 on the floor of the Chicago Mercantile Exchange and eventually opened his own firm. Acquaintances from the clubby world of Chicago’s financial markets, they started talking about going into business together in 1999 and set up Getco that year as part of a vanguard of floor traders migrating from the pits to “upstairs” computerized trading rooms.

Early on the firm operated out of space in Schuler’s firm barely big enough for a couple of desks and computers. For trading talent the partners scoured nearby Illinois Institute of Technology in search of skilled videogamers. As Getco grew, they bought gear from dying Internet companies and coded it to operate with ever less human intervention.

Sidebars:
High Frequency Who’s Who�
Trading for Dummies

Special Offer: Free Trial Issue of Forbes

From the get-go the strategy was to trade fast, furiously and electronically. Getco’s first point of attack was futures, which went electronic early. Tierney and Schuler programmed their computers, and the people manning them, to offer quotes and execute trades more quickly than rivals. Then, when the market moves, to do it again. By posting bids and offers for the same securities simultaneously, they are able to scoop up a spread of a tenth or a hundredth of a penny per share thousands of times a day while limiting the capital at risk. What Getco gives up by capping its risk it makes up for in volume. The company currently trades an estimated 1.5 billion shares a day with 220 employees and offices in Chicago, New York, London and Singapore.

Computerized trading is hardly new nor is the demonizing of its effects. The era of floor-based markets started drawing to a close with the popularization of Nasdaq’s electronic system in the early 1980s. Program traders were the early electronic whiz kids until critics pinned the blame on them for the 1987 crash and circuit breakers limited their influence. A decade ago people working the Small Order Execution System, a.k.a. SOES bandits, began minting money by arbitraging spreads created by lags in the speed at which disparate Nasdaq marketmakers updated their prices; the dot-com bust eventually laid them low.

Others have shown impressive stamina. Former math professor and code cracker James Simons founded algorithmic trader Renaissance Technologies in 1982. But his firm came to true prominence only with the hedge fund boom of the past decade. Last year its flagship Medallion fund (assets: $9 billion) was up 80%. Simons ranked 55th on FORBES’ 2009 list of the world’s billionaires.

Dissatisfied with the duopoly the NYSE and Nasdaq enjoyed, then SEC Chairman Arthur Levitt (now an advisor to Getco and Goldman Sachs) in 1998 pushed through Regulation Alternative Trading Systems. Reg ats gave rise to a plethora of so-called electronic communications networks that made markets in stocks, or simply matched buyers with sellers. Two years later the exchanges began quoting prices in decimals instead of fractions. Overnight the minimum spread a marketmaker stood to pocket between a bid and offer was compressed from 6.25 cents, or a “teenie,” down to a penny.

In classic Wall Street fashion traders set about finding new ways to earn a living. Some were nefarious. In 2004 seven NYSE specialist firms paid a quarter-billion dollars to settle charges of front-running clients.

Others viewed electronic markets as legitimate opportunities. The big wire houses hedged their bets by taking stakes in the various electronic communications networks that emerged in the 1990s. In 1999 Goldman Sachs paid $550 million for Hull Group, which used computer-based algorithms to trade equity options. “An unsustainable model” is how Duncan Niederauer described floor trading to forbes a year later. A Goldman derivatives trading exec at the time, he now runs the NYSE.

The final structural move that set the stage for the current electronic trading revolution was Regulation National Market System, put in place in 2005. Previously brokerages were, in theory, obliged to offer clients the best possible execution of stock orders. But it was left up to each firm to determine whether “best” meant the fastest or at the most favorable price. That left brokerages plenty of wiggle room to match buy and sell orders internally and pocket the spread, or send them to exchanges that paid kickbacks for order flow.

Under Reg NMS, by contrast, the SEC decreed that market orders be posted electronically and immediately executed at the best price available nationally. To Getco and its high-frequency brethren, Reg NMS was like catnip. Many began posting continuous two-sided quotes on hundreds of stocks. Some sought to arbitrage the tiny price spreads that existed at any given moment between buy and sell orders. Others, known as rebate traders, profited from payments for order flow the exchanges offered. Latency arbitragers, like the SOES bandits before them, sought to scoop up price differences resulting from momentary time lags between exchanges.

Today hundreds of firms are vying for a piece of the high-frequency action–huge ones like Goldman and Barclays Capital, hedge funds like Citadel and lesser-knowns like Getco and Wolverine Trading. Lime Brokerage, housed in chic lower Manhattan digs with a rooftop garden, handles trades for 200 high-frequency trading firms and individuals. Like hedge funds in the mid-1990s, high-frequency traders are popping up practically every day and attracting leading talent. Vincent Viola, who headed the New York Mercantile Exchange, recently opened Virtu Financial and lured away Christopher Concannon, former head of Nasdaq’s transaction services. Private equity money is rushing in, too. General Atlantic reportedly paid $200 million to $300 million for 20% of Getco (Tierney, Schuler and employees own 80%) in 2007. Last year ta Associates acquired a stake in RGM Advisors and Summit Partners bought into Amsterdam’s Flow Traders; deal terms were not disclosed.

Sidebars:
High Frequency Who’s Who�
Trading for Dummies

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With so many players, high-frequency trading has morphed into a technology arms race. In a well-publicized case, the FBI arrested former Goldman employee Sergey Aleynikov in July for allegedly stealing trading algorithms. Separately, Citadel claims in a lawsuit that Aleynikov’s new employer, Teza Technologies, may have got illicit access to trading software it spent hundreds of millions of dollars developing. Teza has not been accused of wrongdoing by the government.

Making it in high-frequency trading these days requires the latest technology. Lots of it. Getco won’t talk details, but others will. Infinium Capital is the biggest marketmaker in natural gas futures and runs its computers in 100,000 square feet near the Chicago River. The core of its operation is 40 racks of servers overseen by quant traders who man up to a dozen screens each.

Infinium’s operation runs on a piece of the public electricity grid backed up by two separate power substations and 196,000 pounds of batteries. Not safe enough. Infinium is paying to install a 2,000-kilowatt diesel generator just in case. Infinium taps into the CME Group’s computers, housed on the same floor of a data center, via dedicated fiber-optic lines capable of transmitting up to 5,000 orders per second with a lag time of no more than 10 milliseconds. Infinium has other servers strategically situated near exchange computers in New Jersey, London and Singapore.

The high-frequency boom is reshaping securities markets everywhere. Four years ago 13 people from TradeBot, a Kansas City trading outfit, left to form a new ECN called Bats Trading. Getco, Wedbush Morgan, Lime and seven big banks are now investors. Bats was granted full exchange status last year, adding a level of legitimacy and eliminating a time lag in reporting trades through another exchange. It now handles nearly 12% of daily U.S. stock trades. Direct Edge, a rival backed by Goldman, Citadel and Knight Trading, handles another 14%.

What’s not to like? From a narrow perspective, the robot traders seem to be enjoying an unfair physical advantage over other investors. One eyebrow-raising reality is that a big chunk of high-frequency profits derive from jumping into markets before small investors can. In the high-frequency world, the 20 milliseconds it can take quotes to travel from Chicago to Nasdaq’s market site in New Jersey (the flashy Times Square one familiar to the public is a TV prop) is an unacceptable lag. So interminable, in fact, that it gave rise to the entire strategy known as latency arbitrage.

The need for speed, in turn, has led to a rush for real estate as close to securities exchanges as possible. In Chicago 6 square feet of space in the data center where the big exchanges also house their computers goes for $2,000 a month. It’s not unusual for trading firms to spend 100 times that to house their servers, says Scott Caudell of 7ticks, which manages dozens of firms’ servers there. Now even the tradition-bound NYSE plans to open a 400,000-square-foot tech center in New Jersey and is taking orders for server stalls.

Does this institutionalize an unlevel playing field? It does and it doesn’t. Small-fry investors are cut out of the business of making 0.1 cent markups. But this isn’t what the fellow buying 1,000 shares of ExxonMobil should be worried about. For him, the risk is that he pays 5 cents a share too much, only to see the quote fall back a nickel a few seconds later, perhaps because brokers in the middle could see what he was doing but he couldn’t see what they were doing.

For years the regulators have tried to make trading fair by putting bids and offers out in the open. When Levitt took over the chairmanship of the American Stock Exchange 31 years ago, the talk was of a “composite limit order book” that would make it harder for middlemen to pocket undeserved spreads. That idea didn’t fly, but variations of it lived on in all sorts of rules designed to force transparency on the market. The trouble with such rules is that they can’t force anyone to really show his hand. A reg can mandate that a 10,000-share order be put on the tape within a certain number of seconds. It can’t mandate that the hedge fund trader placing it reveals his intentions for his other 90,000 shares.

No surprise that today’s order books are filled with feints and parries, made and withdrawn in a blink of the electronic eye–1,000-share bids and offers that are stalking horses for million-share moves. Unfair to the little guys? Not necessarily. Their salvation comes from volume. If enough shares move every second, it is less likely that they will be gouged out of a nickel spread.

Another controversial offshoot of high-frequency trading is sponsored access, which already accounts for 15% of Nasdaq activity. In the old world traders were required to send every order to a registered broker-dealer who passed it along to an exchange or executed it themselves. With sponsored access, traders send orders directly to exchanges. This has raised concerns that a lack of oversight could lead to the sort of disaster that overtook derivatives during the financial crisis.

Some high-frequency traders are sending out 1,000 orders a second. In the span of the two minutes it typically takes to rectify a trading system glitch, a careless trader could pump out 120,000 faulty orders. On a $20 stock that represents a $2.4 billion disaster. Without better controls, “The next Long-Term Capital meltdown will happen in a five-minute time period,” warned Lime Brokerage in a June letter to the SEC.

While many market centers have adapted to cater to high-frequency traders, dark pools have adapted to evade them. Seth Merrin founded Liquidnet in 1999 as a place where professional money managers can swap large blocks of stock anonymously. It’s the successor to the brokerage work that used to keep block traders at Weeden & Co., Goldman and First Boston busy decades ago, when the NYSE ruled Wall Street but a fair amount of its trading took place upstairs. The goal of Liquidnet is to avoid tipping off the market, including high-frequency arbitragers, that a big order is in the market and moving prices.

Merrin, even as he battles a bad market for new offerings and a legal dispute over patent infringement, aims to take Liquidnet public. The firm already handles 61 million shares a day, and Merrin views himself as something of a crusader who is enabling mutual funds, pension plans and other investors to trade at the best possible prices. All told, crossing systems like Liquidnet and Credit Suisse’s Advanced Execution Services (300 million shares a day) handle about 8% of stock trades and are expected to control 10% by year’s end.

The problem with such liquidity pools is that they are in fact “dark,” meaning they conceal their orders from public markets. What’s more, they piggyback off publicly displayed bids and offers rather than adding to the liquidity pools that determine them. That, in turn, has led to charges that they are depriving investors in both lit and dark markets of the best possible prices. Thus the calls for heavy-handed regulation or an outright ban.

Proponents of Big Brotherism should stop hyperventilating. The high-frequency engineers are already on the case, sniffing out when dark pools are trading at the midpoints between public bids and offers and posting their own prices around them (and, in turn, forcing the dark pools to come up with countermeasures to the countermeasures).

As this cat-and-mouse game plays out, trading is getting ever faster and spreads ever thinner. This probably isn’t the market that securities market overseers envisioned, but it’s working just fine.

Flashpoint of Controversy

High-frequency trading helps small investors by narrowing spreads and speeding execution. The same can’t necessarily be said for flash orders. Market center Direct Edge uses them to give a small group of clients a one-tenth-of-a-second crack at incoming orders before others get one. The practice has been criticized for favoring insiders, and the Securities & Exchange Commission may ban flash orders.

With all of the scrutiny that high-frequency trading is now under in the media and in Congress, the New York Stock Exchange is probably none too thrilled that the Wall Street Journal has uncovered fresh details of NYSE’s giant new datacenter, which the exchange is building in a former New Jersey quarry. The new datacenter will significantly advance the amount of computer-automated trading that already dominates global markets, housing as it will “several football fields of cutting-edge computing equipment for hedge funds and other firms that engage in high-frequency trading,” according to the WSJ. So if you were recently shocked to learn that an estimated 70 percent of stock trading is just computers trading against one another, get ready for that number to go even higher. 

The NYSE is reportedly already taking orders from firms that want to lease space in the datacenter so that they can co-locate their servers with those that run the exchange in order to execute trades more quickly. Actually building and running a datacenter of this size is new for the NYSE, which historically has rented space in others’ datacenters. As for the impact this will have on the markets, the debate rages.

Not everyone is happy that the NYSE is poised to massively boost the already overwhelming amount of computer trading. At issue is not the simple fact of computers trading against one another over electronic networks—it’s the speed with which they appear to be squeezing the humans out of the loop, and the potential instability and fragility that may result from increased automation of global markets.

Yes, there is actually something new here

For every technique or technology that comes under the heading of HFT, you can dig up an example of how people did this same thing on a much smaller scale without computers. Therefore, the argument goes, the relatively recent (see below) use of computers to do two orders of magnitude more of these activities in a given timeslice is “nothing new,” despite the fact that the computers are now doing this among themselves without human intervention. This kind of reasoning keeps cropping up all over the Internet in the current HFT debates, in some instances coming from very smart people. (Tyler Cowen’s response at Margina Revolution is the best statement of this view.)

Others, however, are concerned by HFT’s rise to dominance. Quant guru Paul Wilmott, in a widely cited NYT op-ed this last week, says that it’s exactly the potential systemic impact of the recent acceleration of the speed and volume of HFT activity that has him worried.

“There’s nothing new in using all publicly available information to help you trade,” Wilmott acknowledges, in an initial nod to the naysayers. But he continues: “What’s novel is the quantity of data available, the lightning speed at which it is analyzed, and the short time that positions are held… The problem with the sudden popularity of high-frequency trading is that it may increasingly destabilize the market.”

Michael Durbin, the man behind Citadel’s high-frequency trading desk, echoed this warning to Reuters’ Matthew Goldstein earlier this week:

“You have multiple HFT trading firms and sometimes their agendas are complementary and sometimes they’re not,” explains Durbin, director of HFT research with Blue Capital Group, a small Chicago-based options trading firm.

“There could be a time where these HFT programs unintentionally collaborate and you have a two- or three-minute period where the markets are going crazy. Then other traders respond to it and it simply gets out of control.”

My own take on the question was summed up in a recent note to Felix Salmon:

It’s quite remarkable to me that many of the econ and finance folks who insist that “HFT is the same thing we always did, just way faster” don’t seem to realize that frequency and amplitude matter a whole lot, and that for any given phenomenon when you suddenly increase those two factors by an order of magnitude you typically end up with something very different than what you started with. This is true for isolated phenomena, and it’s doubly true for complex systems, where you have to deal with systemic effects like feedback loops and synchronization/resonance.

What I’ve noticed anecdotally is that engineers and IT pros are more concerned about HFT than people who just handle money for a living. These guys have a keen sense for just how fragile and unpredictable these systems-of-systems are even under the best of conditions, and how when things go wrong they do so spectacularly and at very inconvenient moments (they get paid a lot of money to rush into the office to put out fires at 4am).

There’s an analogy here with e-voting, which I did quite a bit of work on. In the e-voting fiasco, you had people who were specialists in elections but who had little IT experience greenlighting what they thought was an elections systems rollout, but in actuality they had signed on for a large IT deployment and they had no idea what they were getting into. To them, it was just voting, but with computers, y’know? They found out the hard way that networked computer systems are a force multiplier not just for human capabilities, but for human limitations, as well.

In sum, the growing concern with HFT is not that computers are doing something that people used to do; it’s that they’re doing a whole lot of it, very rapidly, so that the market as a system-of-systems now has starkly different frequency, amplitude, and connectedness characteristics that may (or may not) give it a new, currently unknown set of emergent properties. And if a fuse blows while the machines are driving the bus, we’re all traveling so fast that we may hit a wall before the humans in the vehicle have time to react.

Reaction time, or what could possibly go wrong

If something does go wrong, the market moves so quickly now that by the time the humans intervene, the damage could already be too great to keep contagion and feedback effects from kicking in and pushing things further south. This is possible because HFT, by design, is capable of moving the markets much more rapidly than humans can possibly react to those moves. Again, speed matters, especially in activities where human judgment plays a critical role.

An example of what could go wrong happened on September 8, 2008, when a six-year-old news story about United Airlines’ bankruptcy was somehow republished on Google News with a current timestamp. A source tells me that the algo traders kicked in at some point and started dumping United’s stock, which eventually lost 75 percent of its value that day. About $1 billion of United’s market cap evaporated in 12 minutes, before the humans figured out that they were looking not at a bankruptcy, but at the type of GIGO problem (garbage in, garbage out) that’s well known in computer science circles. Much of the stock’s value was restored by the next day, when the market had sorted itself out, but experts worry that something like this could happen on a much larger scale, especially in response to a genuine external shock.

A paper on the dangers of HFT by Lime Brokerage (uncovered by Zero Hedge) paints the following picture of just how rapidly things might go awry in the present environment:

Lime’s familiarity with high speed trading allows us to benchmark some of the fastest computer traders on the planet, and we have seen [computerized day trading (CDT)] order placement rates easily exceed 1,000 orders per second. Should a CDT algorithm go awry, where a large amount of orders are placed erroneously or where the orders should not have passed order validation, the Sponsor will incur a substantial time-lag in addressing the issue.

From the moment the Sponsor’s representative detects the problem until the time the problematic orders can be addressed by the Sponsor, at least two mintues will have passed. The Sponsor’s only tools to control Sponsored Access flow are to log into the Trading Center’s website (if available), place a phone call to the Trading Center, or call the Sponsee to disable trading and cancel these erroneous orders—all sub-optimal processes which require human intervention. With a two minute delay to cancel these erroneous orders, 120,000 orders could have gone into the market and been executed, even though an order validation problem was detected previously. At 1,000 shares per order and an average price of $20 per share, $2.4 billion of improper trades could be executed in this short timeframe. (emphasis added)

A final point: when there is a chorus of Wall Streeters and economists telling us in regard to some new, very profitable milestone in complexity and innovation, “don’t worry, and the odds of anything going wrong here are passing slim,” does this really reassure anyone in 2009? I think the burden of proof should be on people like Cowen to demonstrate that long-term “buy and hold” can peacefully coexist with the degree of opaque, computer-driven hyperspeculation the markets are barreling towards.

Addendum: the landscape has changed just this year

One of the things that perhaps wasn’t clear enough from my previous article on high-frequency trading (HFT) is that, while people have been using computers to trade against one another for a decade or more, the bigger HFT picture has evolved rapidly in just the past few months.

This recent HedgeWeek article tells the typical story that you’ll find on various trading blogs, and it goes something like the following:

Algo trading trading was on the rise going into the summer of 2007, when the correlations that the algo traders depend on suddenly began to break down. The August 2007 “quant quake” was a shakeout that had a catastrophic impact on number of the larger funds, and statistical arbitrage strategies continued to perform very poorly throughout 2008. As a result of this underperformance, stat arb was generally out of favor throughout 2008, until the strategy started working again earlier this year. In the past few months, algo trading has enjoyed a resurgence in popularity, with current market conditions apparently very favorable to stat arbs in particular.

But the fact that, throughout the first half of this year, everyone has been piling back onto the algorithmic trading bandwagon willy-nilly isn’t the only major development in HFT. It’s also the case that the 2008 crisis had the effect of radically shrinking the competitive landscape, leaving the field to fewer out-sized players whose HFT efforts are being scaled up; Lehman Bros., Bear Stearns, and Merrill Lynch, all had announced major HFT plans for 2008, and in 2009 these banks no longer exist. Then there’s the flash order issue, which flared up this year and is right now creating a stir among the exchanges and lawmakers.

All of this together adds up to a significant shift in the high-frequency trading terrain just this year. And this is happening to markets that are still coping with the relatively recent rise of electronic communication networks (ECNs), which are largely (in terms of trading volume) a post-2000 phenomenon.

If we take a step back and look solely at the percentage of traditional “open outcry” trades (i.e., a crowd of traders, hollering and gesticulating at one another) vs. electronic trades on the major exchanges, we can get a sense for just how fast the market has changed in the last decade. In 2001, some 90 percent of trading volume on the NYSE and the Chicago Mercantile Exchange (CME) was carried out by humans on the trading floor. In 2009, the open outcry volume is under 10 percent on both exchanges.

Stock and commodity exchanges were based on the open outcry system for over 100 years, but in just nine years the ratio of open outcry to electronic trading on these two major exchanges swapped from about 90/10 to about 10/90. That’s a lot of computerization in a little time; and as the NYSE datacenter news shows, the pace of change is accelerating. The markets are different now, and they’re getting more different more rapidly. The post-crisis Wall Street of 2009 is, in effect, in the process of doubling down on the preceding 9 years of speed, automation, consolidation, and leverage.

  By Luke Jeffs and William Hutchings
   Of FINANCIAL NEWS

U.K. market regulator the Financial Services Authority is examining the impact a new breed of high-frequency trading firm is having on the U.K. equity market.

The regulator has in the past month approached as many as 10 asset managers to discuss the effect of these high-frequency companies’ strategies on the U.K .market, to establish whether intervention is needed, according to three sources close to the watchdog.

The FSA plans to speak over the next few weeks to investment banks about the rise in Europe of these specialist trading firms.

High-frequency traders, typically hedge funds or proprietary trading boutiques, use sophisticated systems and algorithms to generate huge volumes of trades that exploit instantaneously tiny price discrepancies between markets.

The FSA probe emerged a week after U.S. Senator Charles Schumer, a Democrat From New York, wrote to the Securities and Exchange Commission demanding the U.S. regulator ban “flash-trading”, a practice he claimed gave high-frequency traders an advantage over “retail and institutional investors”.

Financial regulators have become increasingly concerned about the techniques used by these firms as their activities have expanded rapidly in the past two years. High-frequency traders will this year account for about three quarters of all U.S. equity flow compared with 30% in 2005, according to research by consultancy Tabb Group. Their share in Europe has not been quantified but traders and exchanges estimate they generate about a half of orders in European markets such as the U.K., France and the Netherlands.

The FSA has begun talks to collect information on the complex techniques used by firms to enable the regulator to decide whether further action is required.

A spokeswoman for the FSA declined to comment on the initiative but said: “The FSA is working with its counterpart regulators to monitor these developments, and to respond as appropriate. We recognize that equity markets are continuing to evolve rapidly, partly because of technological developments, and partly in response to legislative and regulatory changes such as Mifid the European Commission directive that took effect in November 2007].”

City of London traders last week voiced concerns that their trading strategies were increasingly being “picked off” by predatory algorithms, complex computer programs used by some high-frequency firms to analyze trading patterns, spot rivals’ plans and trade against them.

The traders agree the algorithms are not illegal but insist they are detrimental to the market because they fuel volatility and exaggerate share price movements.

But Peter Green, chief executive of high-frequency trading firm Kyte Group, said he would be “surprised if there were a strong regulatory reaction”. He said: “It is difficult to see the FSA making fundamental changes to the rules just because some firms have a technological advantage.”

Xavier Rolet, chief executive of the London Stock Exchange, risks angering his high-frequency clients when he cancels on September 1 a tariff popular with these firms.

Rolet said last week: “In recent years, a new breed of customers has emerged promising they would provide substantial liquidity if the exchanges bought order flow. “We’ve revamped our fee structure after it became obvious the previous tariff was imbalanced in favour of a small minority of high-velocity trading customers at the expense of our largest clients.”

Web site: www.efinancialnews.com

Traders Magazine Online News, July 27, 2009

Nina Mehta

The London Stock Exchange’s decision to ditch its maker-taker pricing, seen as a bold move by some and as backwards by others, runs counter to the trend in European market centers. But it’s the latest volley in a series of pricing moves intended to alter the European trading landscape.

The LSE plans, on Sept. 1, to switch to a traditional fee schedule that has the same pricing regime for both sides of the trade. In doing so, it will scrap the maker-taker pricing it adopted in September 2008.

“We’re trying to ensure we have a differentiated approach that’s customer-focused and that extends greater awards to our largest customers, the more they trade,” said Patrick Humphris, a spokesman for the LSE. With competition among market centers heating up, the exchange is aiming for more volume from its biggest customers by enabling them to decrease their trading costs.

Citi is one firm that will see its costs shrink. “Overall, we’ll pay less to the LSE,” said Jack Vensel, head of electronic trading at Citi in London. “But it seems like a step backward,” he added. “The industry is progressing to a maker-taker model. [The LSE] may be giving up some opportunity to use pricing to motivate their members to behave in specific ways.”

Vensel noted that brokers nowadays have less discretion about where to send customer flow, given the fragmentation in European trading, the rise of smart-order routing and the need to pursue best execution. With access to an increasing number of venues, he said, more flow will continue to go to the newer venues.

Another electronic trading executive at a global broker-dealer in London agreed. “Hedge funds or proprietary trading shops doing automated market makers or running an arbitrage or high-frequency strategy may be more price-sensitive,” he said. “Their behavior will be more influenced by price than the behavior of a large bank with a diverse client base.”

“It’s a risky strategy the LSE has deployed,” this executive said. “We applaud it, it’s gutsy, they’ve said their core customers are traditional customers, but it remains to be seen whether it will be successful from a liquidity and market share perspective.”

“Europe is moving to a maker-taker structure,” said Phillip Silitschanu, a senior analyst at research firm Aite Group in Boson. “I’m hard-pressed to see the LSE’s logic.”

Multilateral trading facilities such as Chi-X Europe and BATS Europe have adopted maker-taker pricing to attract liquidity providers to their markets. This pricing has been used in the U.S. to win volume away from the dominant markets by appealing to price-sensitive firms. Some of these market centers are now experimenting with additional pricing and routing gambits in a bid for flow.

According to data published on the BATS web site, the LSE last week had two-thirds of the market share in FTSE 100 names, based on value traded. MTFs had the remainder. Earlier this year, the LSE’s share of trading in the FTSE 100 was more than 75 percent.

The LSE’s move comes at a time when MTF volume, based on value traded, is increasing across Europe. Aite expects MTFs to account for 20 percent of European trading by the end of this year, up from 15 percent in the first four months of this year. The research firm thinks that by 2013, half the industry’s volume could go through MTFs.

Maker-taker pricing is one of the main carrots dangled before participants by markets competing with the LSE, along with extremely low-latency infrastructure and trading platforms. “With that carrot, passive order flow is rewarded, while charges for aggressive order flow are commensurately higher,” Humphris said. “The risk with that carrot system is that you’re essentially penalizing one type of order flow.” The flow that’s penalized, in his view, is flow from the biggest customers.

Instead of using liquidity takers’ fees to subsidize the rebates for liquidity providers, the LSE will institute the same pricing schedule for both sides of the trade. The exchange will charge customers 0.45 basis points per trade for the first £2.5 billion of value traded each month. The fee drops to 0.40 bps for the next £2.5 billion, 0.30 bps for the next £5 billion, and 0.20 bps for trades once the firm has traded £10 billion in value.

The exchange’s current pricing ranges from a fee of 0.75 bps to 0.45 bps per trade for liquidity takers, with the marginal rate decreasing based on the value-traded pricing band. The first £7.5 billion of value traded each month, for instance, gets the base take rate, while anything above £30 billion is charged 0.45 bps per trade. The rebate for liquidity providers ranges from zero to 0.40 basis points, based on the value-traded pricing band.

In addition to drastically shrinking its pricing bands, the LSE, as a sign of the times, will cut its minimum fee per trade to 10 pence, from the current 25 pence. The LSE’s Humphris noted that this change reflects the market’s decline in asset values as well as the shift to smaller average execution sizes because of algorithmic trading.

Citi’s Vensel said the 10-pence minimum fee would likely be a boon for brokers and customers. “The decrease in the minimum charge should be very beneficial,” he said. As the FTSE 100 has lost value, the cost of trading, in absolute terms, has decreased. “But the current 25-pence minimum has remained a hurdle for low-priced stocks,” Vensel said. “The decrease to 10 pence will shrink the execution costs for those trades.”

Vensel also noted that the LSE is cutting tariffs by approximately 10 percent. “As fees come down, the friction to trades comes down,” he said. “For any firm trading algorithmically, this should help to lower execution costs.” However, he noted that algorithmic trading has become more sophisticated, with algos providing more liquidity, based on the market conditions for a particular stock, than they might have a year or two ago. As a result, the ratio of aggressive to passive orders has decreased for some strategies.

Aite’s Silitschanu pointed out that the LSE is appealing to investment firms struggling with lower asset values. “If you’re a portfolio manager or trader, when the markets are as tight as they are and it’s hard to find returns, you want to eliminate variables from your monthly costs,” he said. If you can reduce how much you pay in trading costs, you’d want to do that.”

Silitschanu also noted that the LSE might also be hoping to differentiate itself from the MTFs eyeing its volume, whether or not the new pricing boosts the exchange’s market share. “It’s an unusual step,” he said. “I don’t think this will affect the LSE’s liquidity significantly, but it could go a couple percentage points either way.”

The LSE clearly hopes its new pricing will draw more volume its way. “Customers will be rewarded based on how much they trade, so the more they trade, the cheaper it becomes,” Humphris said. He noted that some of the firm’s smallest customers currently pay more than its largest customers, because they collect a lot of rebates. “That’s a perverse system,” he said. “We think a different pricing structure will stimulate trading and stimulate our largest customers to trade more.”

But big banks aren’t so sure. “Pricing alone right now in this marketplace isn’t enough to move people to or from the LSE or another venue,” Citi’s Vensel said. “As more people have the option to use smart-order routing, it will be increasingly difficult for the LSE to hold on to its market share.” He added that 100 percent of people without smart-order routing go to the incumbent exchange.

The executive at the big broker that declined to be quoted by name added that the lack of a trade-through rule in Europe also boosts the importance of smart-order routing. To avoid missing liquidity, brokers must access more venues themselves, which encourages fragmentation.

He said he expects more pricing changes from the LSE. “If you look at the LSE pricing changes, they represent a decrease from where they were for large firms, but they’re not a substantial decrease,” the exec said. “We’d expect to see more fee reductions in the future.”

Automated market makers, statistical arbitrage firms and other high-frequency shops are also trading more in Europe. These firms’ black-box models rely on low-latency trading and, in some cases, rebates to help fuel their strategies.

The LSE said it isn’t forsaking this group. “We expect high-frequency traders will continue to use the LSE, partly as a result of the lower liquidity-taking pricing schemes and the execution certainty on our market, and partly because we remain the price-formation venue in the U.K.,” the LSE’s Humphris said.

To cater to those and other latency-sensitive firms, the exchange is upgrading its technology. The LSE plans to either upgrade its current TradElect trading platform or choose an alternative platform, according to Humphris. “We will keep on investing to ensure that our technology is fast and scalable to meet the needs of to high-frequency traders and expected growth,” he said.

The LSE is also building out its pilot co-location program for firms that want to be closer to the exchange’s matching engine. Over the next several months, Humphris said, the LSE intends to quintuple the co-lo capacity in its data center. He added that the pilot, which is already oversubscribed, has proven to be successful.

An article from Marketwatch on 7/28/09
By Jacob Bunge
The Securities and Exchange Commission will act in the near future to bar so-called dark order types developed by U.S. stock-trading platforms to grab more market share, according to persons familiar with the matter.

The expected move, on the heels of a Friday letter from New York Sen. Charles Schumer (D-N.Y.) urging regulators to end the practice, could throw the U.S. stock exchange landscape into flux, though the overall effect on the functioning of the stock market will likely be minimal.

At issue are order types that route trades through private liquidity pools before being sent onto other exchanges for filling. Those with access to the so-called “flash orders,” which are simultaneously made and taken away, can see how the market reacts to a flashed order and then place equities bets accordingly.

Critics have argued that having private-quote data available to some investors – those with access to the private liquidity pools – and not to all, creates a two-tiered system of investors where those with access could get a better price than those without.

Several people close to SEC discussions on the matter said that the securities regulator was moving to crack down on such order types even before Sen. Schumer’s letter last week.

“My guess is they are going to do it within the next couple of weeks,” said a securities lawyer who had discussed the matter with SEC officials, but was not authorized to speak publicly.

SEC spokesman John Nester said in an email that the SEC “is looking into flash orders… to ensure best execution and fair access to information for all.” The move is part of a broader overview, announced last month by the SEC, of dark pools, the electronic trading venues where money managers trade large blocks of shares anonymously.

While most major U.S. stock platforms have adopted some form of dark order type, many said they would welcome the end of the “flash” era, which has helped the upstart electronic platform Direct Edge rise to become the third-largest U.S. equity market operator.

Nasdaq OMX Group Inc. (NDAQ) and BATS Exchange in June implemented their own dark order types, but neither market operator relishes the practice.

In a letter to SEC Chairman Mary Schapiro on Monday evening, Nasdaq Chief Executive Bob Greifeld said the policy goal should be to “eliminate any order types or market structure policies that do not contribute to public price formation and market transparency.” NYSE Euronext (NYX) executives have lodged similar concerns with the SEC in recent months.

Nasdaq OMX has ceded the most ground to Direct Edge, with its market share slipping from27% in January to about 21% in June; Direct Edge now claims 12% of the market, up from 7% in December.

BATS Exchange, which was the third-largest U.S. equity venue prior to Direct Edge’s ascendance, is also open to regulators reexamining the issue, though officials credit its “Bolt” order type with driving more business to BATS since its introduction.

“We were gaining market share before we released Bolt, so we feel we were on an upward trajectory anyway,” said BATS spokesman Randy Williams. “We’ve been upfront about saying we released Bolt for competitive reasons, because the SEC was allowing flash orders in the marketplace.”

William O’Brien, chief executive of Direct Edge, made no apologies for the practice that fueled his market’s rise and said that dark order types “democratize access to dark liquidity.”

Though Direct Edge’s ELP program – its version of the flash order – accounts for only 10% to 20% of matched trade volume on the platform, it accounts for a greater percentage of overall revenue and helps Direct Edge offer competitive pricing schemes.

O’Brien said he was confident that SEC Chairman Schapiro would strike “exactly the right tone” with regard to dark order types, but said that if they were outlawed, it “wouldn’t have an effect” on overall business at Direct Edge, which has filed with the SEC for exchange status.

As for the broader market, a ban on flash orders is unlikely to be more than a minor blip on trading desks. Even some of the firms and companies that use flash orders as a part of their operations have expressed serious concern about the practice.

In separate comment letters to the SEC in June, electronic market-making firm Getco LLC raised concerns that the practice could make equities pricing less competitive and harm investors, while the Securities Industry and Financial Markets Association urged a longer approval process to the Nasdaq and BATS implementation of flash orders to allow for more testing.