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Commentary on The Capital Markets- Category [Market Musings]

Ok, ok, I thought I had said my peace (or is it "piece") on HFT and such years ago, repeating it several times.  But it appears that this is the story that the conspiracy nuts will not stop nattering about, and my emailbox keeps banging at me.

So I'll step up and take another swing at the ball.... let's see how I do this time around smiley

Goldman might close its dark pool.

Or it might not. If you doubt Goldman's public-relations genius, consider that it is a hero of "Flash Boys" for sending its orders to IEX for 51 minutes, and then stopping.

Uh, yep.

That makes them a hero.  Right.  Remember the "Muppets"?  No?

You're the Muppets, if you happen to have forgotten the lesson taught back in '07 and '08.

There really isn't a lot to talk about here up until people stop believing in fairy tales and unicorns.  The premise that someone in a negative-sum game can make money without another person concurrently losing the same amount of money is a fantasy.

Nobody wants to identify the losers and it's not because they can't.  The losers are all of those people who own stocks in other-than-HFT venues -- that is, pretty much everyone.  Yes, the losses happen a tiny fraction of a penny at a time, but then again so did they in the old classic interest-calculation skimming game that used to be played back in the days of passbook accounts.  That didn't make the loss any less real then and it doesn't now.

One has to understand that Reg-NMS made specifically unlawful providing preferential time access to data.  The entire purpose of Reg NMS was to provide one quote stream that was the most timely so as to level the playing field and publish a known and good "national best bid and offer."  The very premise of trading on material non-public information is that you obtain the information before anyone else and price is most-certainly not excluded from the definition of "information."  That the Department of Justice is "now" looking at this matter smacks of political expedience rather than what should have happened in my view, which is the immediate issue of indictments against both the HFT firms and exchanges the day they started selling and buying "better" data feeds than that which came out of the SIP.

So what to make of Goldman's move?  Well, not necessarily much, seeing as they haven't actually done it yet.  But is it really a surprise that Goldman would shut down something that has a decent shot at being ruled unlawful in the first instance?  I think not, nor should anyone else be particularly surprised if that comes about.

My reaction to all this?  

Wake me up when the DOJ indicts everyone involved in this crap and puts a stop to it, demanding that the SIP have actual and undamaged time-stamps on quotes.  In addition, let me know when a rule is adopted that one cannot cancel a quote until the entire market has been able to react to it (that is, something similar to my "2 second" proposal) irrespective of where people in the market may physically be, and in addition that all open orders must be able to be cleared with either cash or committed margin.

Individual investors have had to live with those rules forever, and still do today.  You cannot place an order at a brokerage through their electronic systems that you cannot clear; their computers will not allow it.  In addition, you cannot place an order and cancel it before the confirmation of your order comes back to you, which by definition means others in the market have had enough time to react to it and can hit it.

I suspect, however, that I will be eaten by worms long before anyone in the regulatory apparatus actually bothers enforcing what are supposed to be black-letter laws that bar concocting conduits for preferential information flow and then using it to trade -- despite the fact that it is allegedly unlawful to do exactly that.

The truth is that as long as the schemes make the stock market go up -- and for the last few years they have -- nobody has or will care in the regulatory world.

Even if the money they're stealing in the process is yours.

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The "high flyers" have been getting pounded pretty good as of late.

But recently a number of these names -- like Netflix -- have taken some fairly-severe technical damage.

These names have not, as of yet, violated critical levels -- but several of them are close to doing so.

Netflix, for example, is close to violating it's 200MA.  It has not traded under the 200 day since late 2012!

Amazon has violated it's 200MA with authority.  It poked there a few times in 2012 and 2013, but since 2012 it has not traded below it to any material degree or for any length of time.  This is no longer true.

Facebook hasn't traded under the 100MA since mid 2013.  It has now broken that level.

As I write this the Nasdaq 100 is off 81 handles, or 2.25%.  That's a decent move, but not a "plunge."  


But there is something to pay attention to here, because when momentum stocks that are trading on field of dreams visions instead of actual earnings roll over it is not unreasonable to believe that they may have no price support floor under them at all since their businesses are not generating material profits in the form of earnings per-share.

This is the same process that got going in 2000, and the triggering event was a little company having a wee restatement problem -- utterly unconnected to all the other names in the space.

The point here is that you don't need an actual reason for these stocks to break, and thus for the market to break hard.  You only need some critical mass of people to wake up one morning and realize that they just paid $10,000 for a tulip bulb, and it all goes to hell.

One final point: Margin debt is at all time highs, which means that if this picks up steam the odds of it accelerating dramatically due to margin calls is quite elevated.

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I spat my coffee this morning....

Eric over at Nanex has been on this for a number of years.  I've been on it too.  And now there's a new book and suddenly CNBC is talking about it to all three of their actual viewers.

At the end of the day the problem is that providing someone a way to cut in line is against the law.

But that doesn't bother the so-called "regulators" just like nothing else does, provided you make them enough money for them to look the other way.  The price of that willful blindness can be shockingly cheap; in general the revolving door between Wall Street and Washington DC turns both fast and profitably for both cities.

Everyone wants to wring their hands on this but the simple fact of the matter is that the exchanges, which are regulated entities, actually pay for so-called "quote traffic" under certain circumstances and they have set up structures that encourage this sort of behavior.

The defenders of this behavior claim they're providing a "benefit" to investors usually related to alleged "liquidity."  But as I pointed out years ago if you and I trade 100 shares of a stock back and forth 1,000 times there is the appearance of 100,000 shares of liquidity in that name but in fact there is only 100 shares of liquidity present.  If some third party comes in and tries to buy or sell more than 100 shares this will become immediately apparent, because neither of us is willing to transact in more than that number at any given point in time!

I said this back in 2010, nearly four years ago:

Two ways:

  • Force all orders to be valid for one second.  That is, once you place an order, you cannot cancel or modify it for one second.  It must remain "exposed" for at least that period of time, during which it may be executed against.  This makes placing tens or hundreds of orders in the book beyond what you truly wish to transact extremely dangerous, in that a sudden price move can leave you owning (or short) all of those shares you represented as "available" to buy or sell. 

  • Impose a exponentially-increasing cancellation fee as the number of cancels rises against the number of executions for a given market participant in a reasonably short period of time (e.g. 10 minutes.)  Permit one or two cancels per filled order for a given number of shares in an issue over a reasonably-short period of time without penalty.  From that point forward impose a fee that begins at 1/100th of value of the order and doubles for each successive cancel without an execution, up to the entire value of the order.  This makes the tactic of placing 10, 20 or 30 orders for each one you intend to execute extraordinarily unprofitable and stops that practice immediately.

I have since changed my mind slightly -- the first bullet's interval should be two seconds instead of one, and I've added a third point.  Why?  Because any order you place into the market should be able to be executed against by any human making a manual decision, which means that the quote should have to be valid until either it executes or all humans can physically see it with their eyes, react to it, and get a message back to the exchange with instructions for execution. Human reaction time is about 1/2 second and since people do trade from anywhere on the planet you must have two round-trip message times around the planet accounted for (once to see the quote, once to react to it and receive confirmation that your order was accepted.)  Two seconds accounts for all of this; one might not.

Second, all orders you have out must be able to be executed.  This means you must have the margin capacity to clear every quote you have open.  If I wish to have open 10,000 shares worth of a $10 stock I must have $100,000 worth of buying power in confirmed and available margin capacity and during the time those orders are pending.  If this is not in cash then I am functionally borrowing the funds during that time (and that is never free.)

More than eight out of ten "trades" currently executed are nothing more than gaming the system.  There's no social benefit to this, and the idea that there is no "harm" to others that comes from it is fanciful.  Nothing ever benefits someone without there being a concurrent cost somewhere.  That the cost is diffuse and a tiny fraction of a cent per person who actually trades whether it's you in your 401k or some Wall Street bank is immaterial to the fact that someone's paying for these distortions.

Finally, there is simply the law to consider.  The Securities and Exchange Act makes unlawful "market manipulation" and Reg-NMS mandates that the consolidated quote be the actual best and time-sync'd feed of quotations. Selling a higher-speed feed is arguably a direct violation of the law.

None of this is difficult to figure out, but in a world where legislators pass laws that legalize bribery in various forms by calling it "campaign contributions" and people walk between writing laws and allegedly living under them via the revolving door between Wall Street and Washington should we really be surprised that chief among these people's goals and accomplishments are ways to exempt themselves from behavior that would, for anyone else, land them in the slammer?

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So this morning there's the "news" that NY's AG wants to do something about HFT firms taking unfair advantage, and Steve Liesman over at CNBS is nattering on about this and that, none of it displaying a scintilla of original thought - - or for that matter any sort of analytical capacity.

Guys, this is easy.  In fact, it's trivial, as I pointed out back in 2012 (and in fact myriad other articles going back to 2009):

  • All market participants must have margin available to clear all orders they have open at any instant in time on an unaggregated basis.  Since you may only enter an order you intend to execute under black-letter law you must be required to have the margin capacity through either cash or secured and proved-available credit, to clear the trade.  Period.

  • All orders must be exposed to actual execution risk by all market participants.  Since you may only enter an order that you intend to execute the market must be able to act on each and every order you place into the market.  This requires that each order, once placed, by valid for a reasonable minimum period of time so that it is exposed to a a reasonably-large percentage (for all purposes all) of the market.  This means that the minimum human reaction time plus the round-trip time for all reasonable technologies in use must be the minimum order validity time; an order must either be valid for that time or it must execute.  A reasonable definition of this time is 2 seconds.

That's it.

Now any order you place (1) must be able to be cleared if it is executed and (2) must be valid until it is either executed or the entire market can see it and choose to execute on it.

That is, you cannot cancel or replace an order until it has been "exposed" for 2 full seconds and you cannot have more value in outstanding orders than you have cash with which to clear them.

End of problem.

And -- the end of any "advantage" that HFT offers.

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