Financial Review

Financial Review for Monday, May 05, 2014 – Riggers’ Propaganda

Riggers’ Propaganda
by Sinclair Noe

DOW + 17 = 16,530
SPX + 3 = 1884
NAS + 14 = 4138
10 YR YLD + .02 = 2.61%
OIL – .38 = 99.38
GOLD + 9.10 = 1310.70
SILV + .13 = 19.69
Last week we told you about prosecutors and regulators preparing to criminally prosecute Credit Suisse and maybe BNP Paribas, and the slap on the wrist enforcement efforts of the past decade, and especially under the mis-guidance of Attorney General Eric Holder’s “Too Big to Jail” policy. The Swiss finance minister met Holder on Friday to discuss a US probe into Swiss banks that allegedly helped Americans evade US taxes, which includes Credit Suisse. Today, Holder posted a video on the Justice Department website saying that the DOJ is pursuing criminal investigations of financial institutions that could result in action in the coming weeks and months, and adding that no company was “too big to jail.”
A criminal conviction of an entity regulated in the United States could lead authorities to potentially revoke a charter, essentially a death sentence for a bank. In his video, Holder said prosecutors are working closely with regulators to address the issues before taking action, “Rather than wall off banks from prosecution, the potential for such severe consequences simply means that federal prosecutors conducting these investigations must go the extra mile to coordinate closely with the regulators that oversee these institutions’ day-to-day operations.”
It’s starting to sound like Holder is going after criminal charges without the consequences of criminal charges; maybe he can collect a slightly bigger fine, but still leave the bank charter in place. Otherwise, this is a big pile of baloney. And the proof will be in the putting. Until we see a banker jailed and a charter revoked, AG Holder is just spouting propaganda.
The propaganda mill is spinning fast in Washington DC these days. Securities and Exchange Commission Chair Mary Jo White flatly rejected claims that retail investors are being fleeced by high-frequency traders who can use their speed to jump ahead with buy and sell orders that fetch better prices.
White told a US House of Representatives panel last week, “The markets are not rigged.” White reiterated that her agency’s investigators are actively pursuing probes into high-speed traders and dark pools, or anonymous trading venues, but she also sought to dispel the notion that using high-speed technologies to trade ahead of others using stock quotes disseminated on public data feeds could meet the legal definition of “unlawful insider trading.” She acknowledged at one point that the market is not “perfect” and told lawmakers that the agency’s “data-driven” review of market structure issues surrounding areas such as order types, dark pool trading and data feeds was still ongoing. Even though the SEC has not concluded or barely even launched the investigation, White already knows the facts, saying: “I want to be very clear that the market metrics suggest that the retail investor is very well-served by the current market structure.”
The rather unusual reason why SEC Chair White and Congress are suddenly concerned about rigged markets is because of Michael Lewis’ latest book Flash Boys and HFT (high-frequency trading) and whether the markets are manipulated. What they’re not talking about is how the markets have been set up for institutionalized rigging. And they are rigged; have been for a long time.
It goes back to the time when the NYSE was the only game in town, and prices were quoted in fractions: a half, a quarter, an eighth. Buyers and sellers of listed shares used brokers to send orders to the NYSE Floor for execution. On the Floor, “specialists” are in charge of every stock. Their job was, and still is, to match up buyers and sellers and “keep a fair and orderly market” as they facilitate “price discovery.”
The specialist used to see all orders for the stocks they were in charge of because all orders had to come to them. Besides matching up buyers and sellers, specialists can also trade for their own account. That means they can try and make money trading the stocks where they are specialists. Here’s how the specialist makes real money, besides getting paid a small fee for matching up orders.
The key to being the specialist is seeing all the order flow. Because specialists have knowledge of who is buying, who wants to buy and how much and at what prices, and the same is true for knowing the sell side, the specialist essentially gets to trade on inside information. The specialist could raise the bid if he wanted to buy stock because he knew there were more buy orders coming into his book, and if he was right and the stock moved higher, he could sell his position for a nice profit.
And that is pretty much how the system works today. Eventually, investors grew weary of having the specialists slice off profits on insider information. Even though we got rid of the fractional system, we still have the insiders slicing off small profits on each trade. Now the Nasdaq doesn’t have a specialist system because there is no central trading floor where dealers meet and call out prices, but in the automated, cyberspace world, each dealer is his own specialist.
Eventually, electronic communications networks (ECNs) sprang up. ECNs were and still are networks where dealers who weren’t part of Nasdaq could place their quotes and buy and sell with each other. From there it wasn’t long before Nasdaq dealers wanted to get onto all the ECNs and demands were made to trade NYSE and AMEX stocks on the computer networks. That’s how technology changed the old specialist system into a mass of different trading venues that now includes entirely new exchanges like BATS, and dark pools where banks and crossing services trade for clients demanding anonymity.
The problem now is that there is no longer any one central place where all orders go to be executed. Orders are spread around based on cost, and services, and, most importantly, “payment for order flow.” So, now the online brokerage firms like Schwabb, and Etrade, and whoever, don’t have their own traders to execute trades and they don’t have their own trading desks, so they have to route those orders to an exchange or a couple of exchanges to match up buyers and sellers. In order for exchanges and networks that offer execution of orders to be successful, they have to have orders coming in so they can match up buyers and sellers. Otherwise, if there aren’t enough orders to allow matching of buyers and sellers at prices where customers want to transact, that exchange would have no “liquidity” and it would lose business.
So how do all these competing exchanges get orders? They pay for them. They pay Schwab, and Ameritrade and Scottrade for their “order flow.” That’s right; your order at your discount brokerage is sold to someone so it can be traded on their exchange. Who gets paid for your order? Not you. Your brokerage gets paid.
So, after the switch to decimalization in 2001, we had the rise of the market makers. Market makers are the same as specialists, except they are mini-specialists in the stocks they trade electronically for their broker-dealer or bank trading desk who trade on Nasdaq or on the ECNs or anywhere where an intermediary can interpose himself into a trade, and they will impose their trade ahead of your trade. That’s why they buy order flow, so they can create an internal “book” so they can have their own inside information on the order flow, so they can trade against it, or sell it to other traders.
HFT operators are looking at all the order flow going into all the different exchanges and trading venues they can peer into. They look into the total flow of orders, which no single exchange can see, and with their empirically modeled time sequencing of orders, spreads, and depth that they run through reinforcement learning algorithms, they come up with a trade that steps in to buy or sell shares before someone who intended to transact there gets a chance to.
Speed is critical to high-frequency trading. Exchanges rent HFT shops space next to their servers (co-location) so they get their data faster than everyone else. That’s legal. They couldn’t do it if there weren’t so many exchanges and trading venues competing for orders. You can thank the SEC for making that a reality without sensible limits. They couldn’t do it if there was no such thing as payment for order flow; yes, they get paid for their order flow too. You can thank the SEC for allowing that neat little scheme.  HFT shops can buy and sell at the same price (that’s a zero profit or loss), but because they provided some venue “liquidity” by sending their super-fast order there to be executed, they get paid. That’s not arbitrage in the traditional sense; that’s just playing the game. They couldn’t do it if they didn’t have all the information at the speed they get it at from the exchanges the SEC regulates.
And so you pay whenever you make a trade; you lose about a penny per share, sometimes more, and you’re expected to accept this little slice in the name of liquidity, but it isn’t really liquidity, it’s really just volume. High-frequency trading has nothing to do with what liquidity is, what liquidity means to the market. Volume is not liquidity.

Everything is usually fine when markets are moving up or are relatively stable. We won’t really notice HFT. But, in a wicked downdraft, when HFT players turn off their computers, we will see that there are no bids on any specialists’ books or parked with market makers. There will be no stopping stocks from falling for that reason. We saw it in the May 2010 flash crash. That’s what HFT has done to the market. It has made it a dark pool, and a dark pool is not required to yell out a price like the old-school specialists; instead prices come in at a more leisurely pace, when it suits the ECNs, after they scalped their share. What this means is that we don’t really know what the price is, and you can’t have a market without prices, which means one day we could have a catastrophic market failure; despite the propaganda otherwise. 
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