OTC Derivatives Reform (While the crashes of 2001 and 2008 were bad, they pale in comparison to damage done by the Flash Crash. While some blame circuit breaker alignment, others data volume and latency, and still others point at high frequency traders pulling liquidity, the macro question remains - how do we create a market that doesn’t fold under duress.
Senator Kaufman came out with a very thoughtful response to May 6, proposing a nine-point plan, focusing on accelerating the Securities and Exchange Commission’s market structure analysis and rule making, greater regulation of high frequency firms, reallocating market infrastructure cost based on message traffic, streamlining market data, centralizing and harmonizing market center rules, incentivize deep markets over speed and tight spreads, eliminating payment for order flow and market center rebates, draining dark pools, and eliminating the ban on locked markets.
While I don’t agree with all the Senator’s recommendations, he is clearly asking the right questions. How do we make the public markets safer, more stable and less volatile, especially during high volatility when natural liquidity is scarce?
The goal is to build a market that allows investor orders to interact in a non-intermediated way, provide liquidity when needed, and to allow investors of all stripes to trade fairly.
Today we have a fragmented structure where the markets are fast. Orders that can naturally match are intercepted by the speedy. Larger orders hide in dark pools. Market maker liquidity is temporal and algorithmic machines are the only way to safely trade.
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24 Comments to "Re-Thinking Our Markets: A Few Ideas for Structural Change":
sarnuk
16 November 2010
I agree with a great deal of what you just wrote. We issued a "moratorium on approving new exhanges" a few months back. Depite what we wrote, and what you say here, we hear through the grapevine that exchanges are putting out feelers for additional exchanges. Amazing. Senator Kaufman was an unconflicted man that lobbyists could not get to. He will be missed. His views, whether one agrees with all of them or not, were formed out of the sheer desire to serve the public well by fixing what he thought was wrong. We can all hope that whoever takes up the cause for fixing our market stucture does so with the same zeal as Ted did, and with their heart in the right place. Thank you for your thoughtful article.
Comments (166)
agrody
16 November 2010
Well said - we do need fundamental market reform thinking - likes yours and Senatot Kaufman's. We have proposed that the SEC get sumulation modeling capability, like we use for ourselves as practitioners, to model all of these alternatives, to see their repucutions before they become imbedded in the real markets. An indispensable regulator's tool for our modern electronic markets. Specific recommendations, like your and others can then be modeled to see their impact. Beats doodling on pieces of paper. To comment on CATS, the audit trail proposal of the SEC, it would seem that before the SEC puts out an RFP, they should resolve the politics of separate, propritary identifiers now used by market places operators - simple things like market center IDs, market participant IDs, broker ID's, institutional trader ID's, et al. The fine work done by Gregg Berman of the SEC and Andrei Kirilenko of the CFTC to understand the micro reasons for the flash crash took months to complete, primarily because of the need to map the non standardized ID's, and synchronize the data feeds of completed transactions with quote data and last sale and volume data. No amount of money will solve this problem, nor brilliantly architected technolgy. The industry needs to come togther on this, like the three exchanges, NYSE, NASDAQ and the CME did to synchronize individual circuit breakers.
Comments (42)
jeley
16 November 2010
Great piece. However, RE market makers, I think you have the order reversed. if we are going to ask more from market makers, we need to first insure that there are additional incentives. Additionally, capping exchange applications will likely stifle innovation. I do not think this is a desirable outcome.
Comments (8)
jsaluzzi
16 November 2010
Sal, This post from Larry Tabb seems to disagree with a letter that he published in the FT back in August where he was pretty critical of Sen. Kaufman (http://kaufman.senate.gov/press/in_the_news/news/?id=ADE0090D-5056-9502-5D23-E5E0BE420572). Glad to see that Larry has turned the corner and can now see the forest through the trees. Joe
Comments (9)
kurtkujawa
16 November 2010
I'm glad your comming around to the fact that all the fragmentation is a bad thing. I would however disagree with you on the market maker aspect. As far as i'm concernrd, why even have them. The only good thing to come out of breaking down the duopoly was making specialists and market makers irrelevent. There is no need for them to get in the way of natural order flow. The market is a 0 sum game, buyers and sellers will always meet at a price. As for algos being "safe" If you ask me, between "algo's" and irresponsible, and i use this term lightly "traders" ( more like non thinking, math junkie, quant, button pushers), was the cause of the flash crash. I had several orders i was working, once they started getting out of whack, i pulled in the reins. No problem. I waited then eventually got my price. As for the whole "flash crash" that whole thing has been blown out of proportion. It was a great big non event. at the end of the day, if you were smart, you made money.
Comments (172)
Steve Wunsch
16 November 2010
I, too, will miss Senator Kaufman, if for no other reason than that he dared to question a central tenet of the National Market System: the narrow ticks of decimalization. But I wouldn't assume that we are yet outside the box in figuring out how to solve the problems of May 6. In particular, your goal statement, "to build a market that allows investor orders to interact in a non-intermediated way, provide liquidity when needed, and to allow investors of all stripes to trade fairly", with which I am sure Senator Kaufman would agree, is a succinct restatement of NMS in all its utopian glory. The dream of non-intermediated liquidity is causing all of the ills you outline, from fragmentation to dark pools. As bad as these problems may seem, though, things could get far worse. All of the current ills came about from eliminating the old block trading form of intermediation via NMS's electronic transparency. Wait until we see what happens when we mandate instantaneous non-intermediated liquidity by saddling HFTs with a variety of obligations and circuit breakers. At the very least, we should acknowledge that all of the remedies currently bandied about as part of the SEC's market structure process are right in the middle of the box we're in and are, therefore, as likely as all past NMS reforms to lead to very bad unintended consequences.
ltabb
16 November 2010
Joe, I still don't agree with a lot of what Kaufman said, but at least his comments have become more educated and articulate and as he is leaving office, he is beginning to understand the implications of what he is proposing. At first, he had a feeling that the markets weren't safe and had no idea of what he was talking about. It has taken 2 years for him to actually understand the problems, articulate a plan and begin to understand their implications. If you read his Forbes interview of earlier this year - he was all over the place. As for his 9 point plan - it is much more articulate than the Forbes diatribe. Now what he is proposing seems closer to an OTC market than a listed market so if all of his proposals were accepted - I am not sure we would really like the outcome - and he himself said it - that maybe we should be paying more for liquidity - and maybe we should. But given May 6th we all need to re-evaluate our market structure ideas. As for him being a truly un-conflicted - maybe he was, maybe he wasn't. Seems like there are a lot of banks that are located in Delaware, and banks would certainly benefit from a market with fewer new-style liquidity providers, wider spreads, slower markets, and a more OTC like market. Banks pre-Dodd Frank (when much of his ranting was going on) would have also benefited from diverting attention from the credit crisis by placing more scrutiny of the equity markets and less of the OTC markets (especially pre May 6th - when markets seemed to be a bit more stable). But that is my own psychotic Mel Gibson conspiracy theory rant with no basis in real fact.
Comments (311)
jsaluzzi
16 November 2010
Ahh, Larry. Welcome back. We thought someone had hacked your account and posted that very Luddite-like piece.
Comments (9)
ltabb
16 November 2010
Hey, I am open to changing my mind. My thoughts and our business model don't push me in one direction or another. Everyone tars us as HFT supporters. We just call them as we see them. And we may be wrong, and if so, I am happy to write about it. Like the piece above - we absolutely do need to do something to make our markets more safe, and better for raising capital. I am not sure what we have now works. And post May 6th I am less sure our structure is good than before. As for TABB Group, our research is bought by all sorts of folks, from banks, to mutual funds, exchanges, to ATSs and HFTs to vendors, integrators, and PE firms. No matter what position I take, there is one thing I am certain of - I will piss off one of my customers. I am not so sure that others can say the same thing.
Comments (311)
sarnuk
16 November 2010
Senator Kaufman had two short years to examine, study, form an opinion on, and courageously speak out on a very complex subject. If you don't think it is complex, reference the Bachus Ensarling letter, where they wrote a thinly disguised letter in favor of Flash Orders, and thought that the Flash Crash was named the Flash Crash because of Flash Orders. The lobbyists didn't get their moneys worth with that lettr LOL. To say that Kaufman's view became more informed the more he read and examined, would be natural. I contrast that with the legion of folks who know that things are wrong, and yet keep advocating for what is wrong because it lines their pockets.
Comments (166)
biancamano
16 November 2010
Larry, Great thoughts. While I feel that your proposals are based on the altruistic principal of creating a better market and level(er) playing field, this approach will probably result in an “innovation desert” which will favour outdated business models to the detriment of all market participants. Further costs will skyrocket one way or the other if some of these proposals are enacted. “Fragmentation must slow or go backward. We should start capping exchange and ATS licenses and allow existing medallions to be sold and incentives for them to be retired.” How would you propose this be changed going forward? The current market already allows various entities to vote with their order flow. I can point to several models (including our own) that were introduced and led to better results for all participants. I think the incentives in place should be addressed, but inhibiting innovation because no “medallions” are available will not help anyone. Imagine a market structure without some of the innovations of the last 30 years if we were “capped” at a "Duopoly". Imagine the access fees if there was no “alternative”. “To reduce dark pools and internalization, let's change the pricing of printing non-exchange-matched orders to the tape. If printing becomes more expensive than matching, maybe exchanges become the first choice rather than the last choice to trade.” The average order size of an Institutional order is close to 190,000 shares; the average size print is less than 300 shares on the NYSE. What you are essentially proposing is a “tax” on an institutional order, one way or another. Making it more expensive to print is a tax, making Institutions trade their orders in the “open market” is a tax as well due to market impact costs. Innovation and freedom of choice need to be encouraged not inhibited, the last thing we should be talking about is going backwards, or inhibiting a free market.
Comments (33)
ltabb
16 November 2010
Jay, no question you are right on these points. It does become a tax on institutional flow. But on the other hand, if the public markets crash - that isn't good either. There needs to be liquidity somewhere accessible. Also about innovation - that is true too - if you limit new ATSs/Exchange liquidity pools you limit innovation. But can we really have so many matching venues? Maybe we need to get rid of top of book protection and allow blocks to trade at whatever price they need to clear instead of taking out the top of books everywhere and tightly linking all lit markets. That way if one market goes astray, the others don't need to follow. Tying in Sal's last comment - yes folks talk their book but it also this stuff isn't easy and while there are many positions, I am not sure if there is a right and a wrong answer. Just look at this conversation. You want to pool liquidity so when market orders hit the books there is enough liquidity so the market doesn't crater but you don't want to tax institutions who don't want their orders in the public market. You also want innovation, because someone may have a better model. Who is right? Who is wrong? Beats me. That is what makes the markets wonderful - hopefully folks vote with their flow and the market figures it out - that is, except when it crashes :-(.
Comments (311)
eville
16 November 2010
Sal, perhaps you can find time in between postings and white papers to teach partner Joe how to be less smug and sarcastic, if not self-serving (or having side conversations with you and you alone), when he's out in public. Not agreeing with another person's POV is your right, true, but know that it tends to get rather tiresome when one or both of you act like nasty, little attack dogs when someone/anyone disagrees with your position(s). As I see it, TABB's an independent (I repeat, independent) research firm that takes the pulse of what the industry is doing and plans to do, providing the analysis / interpretation around it. Maybe it's time you two forget about your clients and start a research firm, putting your personal PsOV behind it. If not, your choice but apparently challenging the messenger gives the two of you great satisfaction. if not a few minutes of fleeting fame - but frankly, the sarcasm's unnecessary if not borish.
sarnuk
16 November 2010
Natan is that you? :)
Comments (166)
kurtkujawa
16 November 2010
biancamano, the last thing we need are more exchanges. All this fragmentation is a pain in the ass for anybody that trades institutional orders, unless your happy breaking up your order and trying to be 10% with an average price and not take any risk and trying to create prformance by saving a few mills by routing your orders thru whom ever has the beast deal that day. I understand competition is a good thing, we just don't need it via exchanges. The ideal situation would be 1 general exchange, a utility of sorts. Let the competion for order flow come from the brokers, size be gets size. If all the orders are in one "place" and not fragmented, you will get greater size and truer price discovery. I understand you wouldn't need 100 different algos anymore, and so sad to bad for that.
Comments (172)
biancamano
16 November 2010
Kurt, Agree about fragmentation and exchange competition is a sticky wicket, especially in the equities markets. I honestly don't believe one is the answer because then you have listing requiremenst that may inhibit the formation of capital. We can't look to our other listed markets as models either. For example, the Options markets are just as fragmented but do not allow third market prints, which many believe inhibits competition and Institutional size, which increases costs. The Futures exchanges think they have the answer because of their exclusivity and "non-fungibility", but the other side of that argument is, that it is a monopoly which raises costs and inhibits competition. I won't even get into the OTC and Forwards markets. Suffice I believe one is too little, but have no idea how many is too much, but I'd rather let the market decide. Think about this, if we "limit" exchanges, what's next? Brokers? Institutions? Might sound absurd, but crashes will always occur, we just need to ensure that our Capital Markets remain sound.
Comments (33)
asussman
16 November 2010
There is hardly any fragmentation or competition. It is an illusion promulgated by the 12 barely distinguishable exchange entities all running virtually the same matching engines with slightly different tweaks on pricing model. Exchanges have been turned into discount stores. What we need to encourage true competition is the following: a) lift out what remains from the block trading desks across all the banks (and a couple of the independents) and form an exchange (w/mutualized ownership for next 10 years) b) make Sen Kaufman the CEO c) get a no-action letter from the SEC allowing the exchange to be excluded from Reg NMS requirement d) run some variant of the specialist system
Comments (159)
kurtkujawa
16 November 2010
biancamano, i agree that crashes will always occur, which is why it is stupid to try and blame market structure for them. That is my whole point. As for the formation of capitol, when listing requirements mattered it might have made some sense, when OTC, NYSE, ASE all traded certain stocks, now it is just a hodge podge of crap exchanges that all trade the same stocks, so what do listing requirements have to do with anything. When was the last time an exchange actually brought a company public? Exchanges aren't there to form capitol, that is what investment banks and veture capitolists are for. Exchanges should only be a meeting place for buyers and sellers to meet. We need to quit worring about how fast we can execute and start worring about the quality of the execution. If you get rid of all the exchanges, you can reduce the arbitration, which will reduce the HFT's which will reduce the volotility which will equate to a much more orderly market. Granted it might not be as fast to sell 100 shares, wupty do! remember speed kills, just ask the idiots that got killed in the flash crash when they left there machines on auto piolet and by the time they could shut them off it was to late. I just feel bad for the guys on the other side of the trade that they busted.
Comments (172)
ltabb
16 November 2010
Kurt - that is an interesting view that exchanges don't raise capital - that VCs and IBs do. I have to think about that more. I am sure the exchanges don't view it that way but, you not sure what besides brand distinguishes the exchanges now that they all have UTP and trade the same products pretty much in the same way. I wonder if that is one of the reasons there has been a dearth of IPOs? Besides the market has been lousy.
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kurtkujawa
16 November 2010
Larry, they can view it any way they want, but I ask you, when was the last time any exchange was part of the underwriting syndicate? When was the last time an exchange did a road show? The NYSE,OTC and ASE used to compete for listing the companies AFTER they became public. They had no part in the formation of the capitol, other then giving them a place to trade. But now that any stock can pretty much trade on any exchange, there is no need for all of the different exchanges. In reality, they are just brokers fishing for flow, they just hide behind the "term" exchange, so that they can avoind the rules and regs that apply either to BD's or market makers.
Comments (172)
dclark
16 November 2010
Jay your argument regarding an inovation desert is interesting. In theory you are certainly correct, we should be incenting inovation. Unfortunately a combination of regulation and game theory have resulted in the vast of majority of marketplace inovation being aimed towards the marginal flow rather than the traditional long term investor. Meantime brokers that have tried to implement out of the box innovative products and strategies are continually frustrated by nanny state regulation. The IOSCO paper on Dark Orders is a perfect example of this. The regulators are clearly pushing order flow back to the visible markets rather than addressing the issues that have incented flow to move away in the first place. (After all in a functioning market there is no good reason for 200 share prints in dark pools). We need to understand that transparency of marketplace logic and systems is good, but transparency of order intent is not.
Comments (21)
KBurke
16 November 2010
Wow! Serious discussions, sarcastic commentary and business adverts all in one thread. My principal question is who is going to stand up and be willing to absorb more costs to trade because eliminating the potential volatility that occurred on May 6th will increase the costs of all trading. Another is can we hope to simultaneously deal with the structure issues that have greatly diminished the markets ability to support smaller companies and therefore its capital formation function? Finally, is there a structure that can equitably accomodate the differing needs of institutional versus retail customers?
sharath
19 November 2010
WOW!......
Comments (1)
dleinweber
30 November 2010
Good and thoughtful comments. The degree of fragmentation, tight NMS coupling, automated orders, and vanishing committed market makers are a recipe for more flash crashes. Nanex posted a collection of hundreds of miniature flash crashes in single stocks - short lived price anomalies. Some go up, some down. Not a pretty picture for those fond of stable markets
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