Liquidity, as frequent readers know, is a fascinating topic to Zero Hedge. Liquidity black holes, as one would imagine, is doubly so. However, when a firm like State Street, which is at the heart of the multi-trillion dollar stock lending skeleton of the market discusses both of these concepts, one must pay attention. The below report is a State Street presentation from 2003 discussing what happens in those episodes when liquidity disappears and how that impairs all other axes of proper market function.
Of notable attention is the following section of the report:
The presence of liquidity problems in the largest of markets suggests that liquidity is not about size, but diversity.
In an illiquid market the same size of sell order will push the market down further than in a liquid market. Imagine a market where there is a large number of market participants, using the exact same information set, in the exact same way, to trade the exact same financial instruments. When one buys they all do and vice versa. Market participants would face volatility and illiquidity when they came to buy or sell. This would not be reduced by having more players, only by increasing the amount of diversity in their actions. (Indeed, on these assumptions it is possible to show that the bigger the market was, the less liquid it would be). Now imagine a market with just two players but with opposite objectives or opposite ways of defining value. When one wants to buy the other wants to sell. This market is small, but the price impact of trading would be low and liquidity would be high.
The referenced diversity is a crucial concept in today's market where an unprecedented amount of market trades occurs in undiverse dark and HFT pools. As Goldman is becoming the primary conduit of trading (whether principal or agency) in virtually all markets, the risk of a massive liquidity drain becomes exponentially larger, and the risk of an exogenous event approaches LTCM and Lehman levels. It is this key risk driver that regulators should be focusing on, instead of chasing and attempting to punish the perpetrators of the most recent market crash (we are not saying they should not, but they should prioritize and now should focus on what is most critical to maintaining a functioning market topology). The Too Big To Fail is a psychological construct which however does not have parallels in the market. Once Goldman reaches a tipping point of eliminating liquidity diversity, the potential fallout escalates. This is precisely the realm in which any x sigma events will occur in the future. And nobody seems to care.
Zero Hedge posts a weekly update of the Federal Reserve's bloated balance sheet as we believe it is critical to visualize the spiraling debt burden at our "central bank" especially since any day now the Fed will begin purchasing treasury securities outright in defiance of Geithner's lies to the contrary (China can't sell its planned Bills: at 0.925 Bid-To-Cover does anyone honestly think they will instead prefer to buy dollar denominated toiler paper and not roll out their own QE version momentarily?). As Cornelius pointed out earlier the dollar can't find a floor these days: rerisking is rampant the argument goes and that kills the greenback. However, the circular logic also holds: create dollar pain (by whatever means possible) and thus stimulate the market, Larry Summer's all time wet dream (would anyone like to wager that when hedge fund positional disclosure become mandatory DE Shaw will fight until the bitter end). And in this simplistic trilateral world (have fun gaming the yuan), the strength of any one of the trio in the dollar-yen-euro triangle results in implicit weakness of the other two. And vice versa. Yet aside from major broker-dealers who are axed in a given equity direction and thus have all the incentive to impact underlying currencies, is it possible that specific governments may manipulate currency strength via central bank positioning? Why yes.
Comparing the balance sheets of the Federal Reserve, the Bank of England and the ECB indicates that certain shanningans by the former two (and particularly massive agency purchasing specifically by the former former) may be responsible for persistent weakness of their respective currencies to the detriment of a (hyper)inflation allergic Europe (America's brush with the Weimar Republic was luckily offset by 3,000 miles of salt water, and even the UK had the Chunnel to thank). The bottom line is that while the Fed and the BE's balance sheets continue expanding, that of the ECB has been in shrinkage mode for a while now. Behold:
Federal Reserve:
Bank of England:
European Central Bank:
The most curious thing is that the absent the half a trillion reduction in foreign bank liquidity swaps the Fed's balance sheet would be in the stratosphere. But the premise is Europe is stable so Bernanke can rein those in. Ironically the more pressured Europe is to take up America's and Britain's economic slack, the more pronounced will be the pressure on Europe, both fiscally and monetarily, resulting in yet another eventual round of liquidity swap bail outs (and that is without even mentioning the "Eastern European Question"). But for now America is happy (the dollar is getting pillaged) and a disorganized Eurozone is dropping deeper into deflationary chaos (has anyone heard a peep out of Raiffeisen Bank lately? - speaking of RZB, it is enough to note that a Google search of the bank results in the first two hits being its Czech and Russian subsidiaries). How long can this persist? For a direct answer, the best proxy may, ironically, be the S&P500 yet again. Keep a close eye: the unwind of the central bank balance sheet game theory defection race (as well as every other unwind) will manifest itself there first.
Hat tip Andy Dufresne who seems to have found a good internet connection in Zihuatanejo
Recent news coming out indicates that investors are buying the indications from earnings reports, housing data and other tepid macro news releases - of course the resulting dollar and yen weakness is not ultimately surprising, no matter what our views on the "safe haven" theory.
The implication of a strong dollar/yen rebound in the event of another crash has been pretty well documented by various outlets but the more interesting story is any further downside risk to the dollar/yen. It's pretty clear that the somewhat linear relationship between say, EUR/USD and any number of bullish indicators (SPY, HG, the Big Mac index), until now is somewhat untenable going forward and is likely to at least slow down. If the bullish sentiment is ultimately right and we have returned to "normal", the ridiculously strong macro linkages we have been seeing until now are likely to break. However, if we see a bounce back south any gains posted can vaporize as quickly as they came.
On net, the risk/reward for further weakness in the dollar/yen is pretty unattractive going forward. We may eventually get back to the FX levels (1.6 EUR anyone?) that we know and love but for now, there are more attractive things to do than to short the dollar.
The most recent BLS State unemployment data is out. At this rate of job loss, Michigan will see 100% unemployment in about one year. Otherwise, state by state unemployment increased by 2.8% on average (unweighted) from May until June.
Some notable states June unemployment rates and May-June rate of change:
Chrysler's little parade in bankruptcy court to make sure a few hundred thousand unionized workers retain their jobs for another year or two is finished. And here is the bill to you, dear taxpayer (or rather the first of many): Jones Day's invoice is in the mail. Everyone take out their wallets and please split the $12,702,190.19 equally. After all, now that we are all benefiting form having a much leaner, much more competitive Chrysler around, we should all be happy to pay each and every lawyer who made it possible.
Jones Day has been kind enough to provide taxpayers with a breakdown of expenses incurred while working day and night to crack this determined from day one case.
And to get an itemized bill, er, perspective on the thousands of hours worked on the Chrysler case by virtually each of Jones Day's day lawyers, don't be shy and click on the fee detail below: 434 pages worth of itemizations are sure to provide countless hours of entertainment.
There is a curious article in the latest edition of Traders Magazine. It is curious mostly because it was allowed to be published, as it definitively peels off the cover of what truly happens at the pantheon of stock exchanges, that dominated by a private club of select high frequency traders, who obtain better and faster pricing than everyone else, and where the group of "select few" is seemingly legally allowed and even encouraged to front-run the "every-one else" (you, dear reader, are most likely in the latter camp). If you ever wondered why HFT generates profits of over $20 billion a year, please read this article.
As for Zero Hedge's intents, we would yet again request feedback from the proper authorities on whether one can derive more than superficial similarities between the method of operation of Direct Edge's Enhanced Liquidity Provider (ELP) program and NYSE's Supplemental Liquidity Provider program (aka, the Goldman kiss). Amusingly, it is none other than the NYSE's own Larry Leibowitz who raised the most ruckus about the potential abuse of the ELP program.
At an industry conference on market structure in May, a panel on market centers broached the subject of "flash" orders and almost ended in fisticuffs. In one corner was defending champion William O'Brien, CEO of Direct Edge. In the other was Larry Leibowitz, his hot-under-the-collar opponent from the Big Board...The head of U.S. execution and global technology at NYSE Euronext assailed Direct Edge's Enhanced Liquidity Provider or ELP program as the "enhanced look" program, comparing it to the advance look at orders that NYSE specialists used to get. That practice was seen as giving specialists unfair advantages over other market participants, and potentially disadvantaging order senders.
Wait, Flash orders, enhanced looks... What?
From the article:
Flash orders are also called "step up" or "pre-routing display" orders. The rationale for these order types is simple: Better me than you. They allow a venue to execute marketable orders in-house when that market is not at the national best bid or offer, instead of routing those orders to rival markets. They do this by briefly displaying information about the order to the venue's participants and soliciting NBBO-priced responses.[TD: frontrunning is not quite the right word here, but it fits so damn well] If there are no responses, the order can be canceled or routed to the market with the best price.
All four markets with flash orders treat these orders in a similar way. If they get a marketable buy order, for instance, that would otherwise be routed to a market quoting at the NBBO, they flash the order to some or all of their participants as a bid at the same price as the national best offer. Exactly who sees the flash, how that information is conveyed and the duration of the flash vary by market. The maximum allowable time for a flash is 500 milliseconds, or half a second, although most of the markets flash routable orders for under 30 milliseconds.
NYSE Euronext's anti-flash tirade didn't end with the SIFMA conference. The exchange operator, along with market-making firm GETCO and SIFMA, weighed in on the Nasdaq and BATS flash order types with formal letters to the Securities and Exchange Commission. NYSE and SIFMA urged the SEC to abrogate the Nasdaq rule filing and reject BATS's filing. All three pushed the SEC to study the potential impact of flash orders on the marketplace before deciding whether to give them free rein.
NYSE and GETCO charged that markets with flash orders were essentially running private markets of quotes for select participants that competed with the public quote stream. With Nasdaq and BATS rolling out new order types to combat Direct Edge, the upshot, in their view, was bad market structure and probably eventual harm to investors.
[read the following paragraph very closely as it is at the heart of the 4 month long tirade on Zero Hedge against the NYSE, against Program Trading, against the SLP and against Goldman Sachs]
These firms and SIFMA argued that flash order types call into question some of the basic tenets of the equities market structure. In various combinations, they claimed that the effort to keep flow in-house undermines the concept of a quotation, impairs the meaningfulness of the NBBO, jeopardizes liquidity provision by hurting liquidity providers quoting at the NBBO, and potentially upsets the pursuit of best execution.
So the NYSE is making a mega fuss about a potential market entrant that does what everyone else does - understandable, nobody like competition, especially not the New York Stock Exchange which has been losing market presence and top line revenue by the boatload recently. Yet the question stands just how much of this "best kept secret" protocol does the NYSE employ currently to facilitate Supplementary Liquidity Providers, or rather, Provider (singular) - Goldman Sachs. When one firm dominates 50% of principal HFT trading on an exchange and, according to the above logic, can legally front run the other half, what does that mean for the rest of the world?
Continuing with the article:
NYSE Euronext, despite frowning on flash orders, may wind up joining the party. Joe Mecane, executive vice president for U.S. markets at the company, notes that if the SEC allows these flash order types to stand, NYSE Arca would probably convert an existing order type into a flash-type interaction, and would look to more broadly disseminate that information. [TD: Or already is via the SLP?] "If the SEC is implicitly allowing private access to information, we'll need to do it to be competitive," he said. NYSE Euronext may decide to offer flash orders on the NYSE as well, Mecane said. Nasdaq, for its part, is implementing a flash-type order this month on Nasdaq OMX BX, its Boston equities market.
Wait, the NYSE is waiting for the deliberations of the same SEC after it did not even care to hear back on whether or not the NYSE's SLP deserves a comment period, objections, and traditional response time, and which waited until the last day to file an extension automatically assuming it would be granted...(And granted of course it was, as the only beneficiary again was Goldman Sachs.)
The primary argument against flash orders is that they create private markets and are therefore a step back for market structure. "These programs are creating a private locked market for a small group of participants, and they are holding up the execution process for that marketable order," Mecane said. He added that the Big Board operator isn't against dark pools, competition or innovative business models. "Our issue is that this creates a tiered market," he said.
Market maker GETCO told the SEC that by creating a two-tiered market, flash orders give professionals receiving the flashes a leg up over other investors. Non-public quotes could also "negatively affect the broader market, including retail investors who rely on the NBBO to ensure that their orders obtain the best, reasonably available price," the firm said. GETCO argued that flash orders, like dark liquidity that executes at the NBBO, also leave limit orders that established the best price in the lurch.
One wonders what the response of the SEC will be to this allegation. One wonders less, once it becomes painfully clear that any condemnation of two-tiering and flash orders would potentially automatically preclude Goldman from trading 1 billion PT shares a week for its prop trading accounts.
Ironically, NASDAQ and BATS already may be in enough hot water to really raise the temperature on not only Direct Egde but the NYSE as well:
Direct Edge's O'Brien draws a distinction between how the information his market disseminates is seen and what Nasdaq and BATS are doing. His flashes, he said, are sent out on a different data feed than the ECN's depth-of-book feed, while Nasdaq's and BATS's flash orders are not. As a result, the latter exchanges' feeds look like they're locking the market. (Last month, both exchanges added a flag to flashed orders to identify them for subscribers.)
In Selway's view, this argument clouds the point. The point, he said, is that order messages are being broadcast at prices that, effectively, lock protected quotes. This creates an elite tier of traders with access to better-priced orders than those receiving public quotes through the securities information processors, giving flash recipients an information advantage, he said.
Ok, so where are the plethora of voices claiming that advanced exchange looks are completely innocuous and nobody suffers as a result of a select few profiting massively... We are waiting.
Direct Edge's O'Brien argues that critics of his market's ELP program are twisting a successful innovation into a regulatory concern for purely competitive reasons. He said the ELP program gives participants a choice about how they want their order flow handled, and enables customers to lower their market-impact and transaction costs. He also notes that critics of the ELP program, which includes dark pools among its participants, are anti-internalization. Internalization refers to the ability of brokers to match customer orders away from public markets. But the ECN's flash orders, on the contrary, O'Brien said, have "democratized access to dark liquidity sources by enabling retail customers to choose to interact with that liquidity to seek larger-size executions and potentially better prices."
Would one be shocked that the NYSE would be so vocally against Direct Edge when it has the SLP in its back pocket effectively dominating what could be the biggest flash trading market in history? Many more questions remain unanswered, but we hope readers now have a much better sense of the continuing fight against the ever more evident extensive informational advantage that Goldman Sachs may probably have thanks to its monopoly of the SLP program.
Charlie Gasparino's recap of his behind the scenes meeting with Van Praag - apparently Goldman's most recent noble cause: "Providing liquidity" and their "proclivity for electronic trading." Odd... So odd.
Oh Michelle, as for the Nasdaq opening every morning just fine, maybe you should read this Bloomberg article from earlier today :
By Adam Ewing July 20 (Bloomberg) -- NASDAQ OMX markets in Sweden, Finland and Denmark have resumed trading after failing to open on time this morning, delaying the start of trading by nearly 30 minutes. ?The markets are up and running,? Anna Rasin, a NASDAQ OMX spokeswoman in Stockholm, said by telephone. ?There is still a problem with the data dissemination system, but if you are trading, you can still see quotes and prices.? Rasin said there was a fire in a data room over the weekend, adding it is unclear whether that was the cause of today?s problems. The Dow Jones Nordic 30 Index, a measure for the region, rose 59.16, or 1.2 percent, to 5,027.7 as of 9:59 a.m. in Stockholm. Norway?s OBX Index gained 1.7 percent, while Finland?s Helsinki 25 Index advanced 1.2 percent. The OMX Stockholm 30 rose 0.8 percent. The Copenhagen OMX 20 Index also increased 0.8 percent.
Seems Zero Hedge is not the only one in need of backup servers.
Whoever is buying stocks today sure ain't reading Moody's most recent REAL Commercial Property Price Index Report. Then again, robots aren't meant to read, they're paid to lead.
- CRE falls 7.6% in one month (May), on top of the 8.6% decrease for the previous month.
- Now -28.5% YOY and -34.8% from peak (October 2007).
- Transaction volume slows to its lowest level yet.
And this:
?This month also marks the first time that round-trip price-change returns on some properties have fallen below -40% per annum (that is, over the investment holding span between the buy and the sell dates). Two properties this month saw negative annual rates of return in the high 40s. One was an apartment property in southern Florida which was returned to the lender and sold thereafter to a third party. The other was an office building in Los Angeles owned by a company in financial distress, which contributed to the highly negative rate of return.? - ?In May, nearly 80% of all repeat sales transactions occurred in properties price less than $7.5 million, and there were no properties that sold for more than $100 million.?
Barney Frank puts on his indignation hat on after realizing that the President has decided he doesn't need congressional approval on funding international financial institutions including the IMF and the World Bank. Here is the ensuing response when Barney realizes that for all his posturing, he is a third (and quite overinflated at that) wheel: "During the previous administration, all of us were critical of the President?s assertion that he could pick and choose which aspects of congressional statutes he was required to enforce. We were therefore chagrined to see you appear to express a similar attitude." Most odd is why the President wants unopposed decision making with regard to these organizations: is Larry Summers smelling a massive, upcoming global bail out that the American people are not allowed to be heard on?
***
July 21, 2009
President Barack Obama The White House 1600 Pennsylvania Avenue Washington, D.C. 20500
Dear Mr. President,
We were surprised to read your signing statement in which you expressed the view that you are constitutionally free to ignore the conditions duly adopted in the legislative process regarding funding for the international financial institutions. As you know, there was a great deal of resistance to this funding during debate on the supplemental bill ? as there often is for these entities ? and the four of us worked very hard to support the inclusion of funding for the IMF and the World Bank.
The conditions that you have expressed your right to ignore are critical: each represents significant policy concerns, especially in light of the history of many of the international financial institutions that we believe have been insufficiently supportive of values that we know you share with us. In addition, these conditions were important in securing support in both houses.
During the previous administration, all of us were critical of the President?s assertion that he could pick and choose which aspects of congressional statutes he was required to enforce. We were therefore chagrined to see you appear to express a similar attitude.
Along with your assurances that you will respect these conditions, we request that you no longer assert the right to ignore provisions that Congress adds through the normal legislative process for funding for the international financial institutions.
If we are forced to conclude that you will not accept the terms and conditions under which the legislation passed, we must make clear that ? both as a matter of the personal preference of those of us signing this letter and as a practical matter from the standpoint of getting sufficient votes to pass these measures in the future ? it will make it virtually impossible to provide further allocations for these institutions. That is, the policy of using signing statements to assert the right of the White House to ignore certain provisions of legislation regarding the IMF, the World Bank, and other international financial institutions may result not in the invalidation of those various provisions, but rather in insufficient Congressional support for further funding of these institutions.
REP. BARNEY FRANK Chairman, House Financial Services Committee
REP. DAVID R. OBEY Chairman, House Appropriations Committee
REP. NITA M. LOWEY Chairman, House Appropriations Subcommittee on State, Foreign Operations, and Related Programs
REP. GREGORY W. MEEKS Chairman, House Financial Services Subcommittee on International Monetary Policy
Following up to the earlier post about Direct Edge's Enhanced Liquidity Provider program, it again makes sense to appreciate the practical aspects of high frequency trading. Joe Saluzzi provides a good example from today's program trading bag:
The three HFT horsemen are C, BAC and CIT. These three stocks traded 860 million shares today which is 10% of all US Equity volume. Think about that: 3 stocks in a universe of over 5000 U.S. stocks represented 10% of the volume. How could this be? Look at the intraday chart of all three of these stocks and you will see a something in common: an early morning move followed by a flatline with a very tight range (around .05). Meanwhile, while these stocks were flatlining the market was heading higher. The S&P 500 gained around 10 points in the afternoon (or 1%) but these 3 stocks did not move. There was a constant bid to these stocks yet anytime they wanted to lift there seemed to be a constant offer just a few pennies higher. This is what HFT looks like. The HFT?s made a killing in these 3 names today ? in addition to the .01-.02 spread, they collected about .005/share in liquidity rebates. Not a bad day for a supercomputer.
There is, on the surface, nothing with wrong with this... except that there is, and there is a legal name for it, which FINRA and the SEC use when they impose fines, bars and other nasty things - it is called churning. And what churning does, at least in this macro HFT context, is it creates the perception that the market is all good, trading with decent amounts of volume, when all that is happening is the HFT/SLP entities provide a shallow market on either side of the NBBO (which as the Traders Magazine article pointed out is a worthless concept in a world dominated by flash orders at the top hierarchical level), with little to no interaction by natural buyers or sellers (though if such appear, the algorithms, as the Direct Edge case demonstrated, can be easily taken advantage of by these same HFTs).
Furthermore, extrapolate a $0.0025/share rebate (or the $0.0032 that Direct Edge's Ultra Tier clients pay) and double that, as these were likely the same entities on both sides of the trade... and you quickly can see why mega churning in otherwise dead names like CIT suddenly become very, very profitable and can even mitigate marginal capital loss if such old-fashioned concepts like fundamental analysis were to kick in and reset the price to its true level. After all liquidity rebates plus spreads on 70% of all 8 billion shares daily adds up to a whole lot of money in one year. And surprisingly
1) STOP THE PRESSES! This "toxic equity trading" appears to be MUCH bigger than I thought (see the paper I sent around as part of my last email: www.themistrading.com/article_files/0000/0348/Toxic_Equity_Trading_on_Wall_Street_12-17-08.pdf).
Here's a REALLY interesting comment I received:
I?m writing to communicate that there is significantly more than a bit of truth to this paper. I can tell you from first-hand experience that predatory algorithmic trading, as outlined in your ?Toxic Equity Trading? attachment, is an ongoing and rapidly evolving practice. The bleeding edge in this field is currently well beyond the scope and level of sophistication discussed in this article.
More than a decade ago, I attended a presentation by someone who was attempting to perfect the latest iteration of an ?automated algorithmic trading system? he had concocted. After a short discussion, I was disgusted to realize that his ?investing system? was merely a mechanism to automate the front running of institutional orders. The program ?sensed? institutional orders via stochastics rather than ?pinging? for algos. He had already implemented his first crude version of the program, so you can extrapolate forward and imagine the current state of these techniques. In fact, you don't have to imagine. I know that co-located servers, predatory algos and funds set-up specifically to execute rebate strategies are all very real. I think you would be really shocked by the way some of the funds operating in the upper mathematical/technological strata conduct business.
The moral issues here are multi-fold; these ?high frequency? shops operate with a near constant information advantage (due in part to their co-location contracts) and their operations literally make the markets less efficient, all while systematically reallocating wealth away from normal market participants.
2) Another person's comment:
I just wanted to assure you that everything in the Themis paper is occurring in today's markets. It first started about 10 yrs. ago with the "rebate traders" and has evolved as the paper suggests. High frequency trading and automated market making has been a major growth industry on Wall St. the last few years. The exchanges have been courting them like mad, offering co-location of servers etc. The new push is into the options markets where the rebates are much richer, this is one of the toxic byproducts of "payment for order flow" in both equities and options. Some of the firms out there trading hundreds of millions of shares a day in these strategies are outfits very few have ever heard of, and they would like to keep it that way. The reverse engineering of institutionally used trading algos has been a booming industry. You might enjoy the following story regarding NYSE program trading transparency (or lack thereof) via the blog zero hedge.
Interestingly, both of these people VERY much wanted to remain anonymous. A lot of people who are making an awful lot of money don't want anyone to know what they're doing...
3) Here's a post from the Zerohedge blog (http://zerohedge.blogspot.com/2009/07/guest-posts-even-simpler-and-high.html) that explains what's going on in plain English:
Even simpler?
My partners frequently poke fun at me (ok there is a long line offolks doing this?), specifically for thinking too deeply about a topic,and expressing an idea with too much detail.
I would like to get real simple here. High Frequency Trading is proprietary computer trading with the goal of collecting rebates, and/or detecting real order flow (ie. instititional flow) and frontrunning it and making pennies. What bothers me? Two things:
First, whether the market is trading at a 16 P/E, or a 22 P/E, or a 30P/E? this is decided by 30% of the volume in the market. 70% of the volume is noise. In the ?olden days? there were many different types of market participants (Value players, MOMOGOGO momentum players, Chartists, GARP players, and so on). None of them were 70% of the volume. This made for an efficient market. This made for a market where we felt strongly that the pricing in the market reflected actual asset values. This new HFT 70% market share makes me very nervous. I hope it does you, as well.
Second, the HFT players are courted by the Exchanges, ATS?s, ECN?sand Dark Pools. They are given whatever they want, as these for-profitdestinations all want their volume. Would they (HFT) have grown to thislevel if the exchanges and trading destinations were not for profit?
Is there a national interest in insuring that (1) our exchanges are the fairest, with equal access for all to the best prices, and not just those with their servers located inside the actual exchange, (2) our exchanges are transparent, and (3) that the system is working as it should, where asset values are reflected in prices? Was it the beginning of the end when all our exchanges went to a for-profit model?
These comments further underscore the need for urgent regulatory action to put a stop to this blatent market manipulation.
A recent Bloomberg piece that for some reason was made available only to terminal subscribers, provides a very interesting discussion on the dangers of sponsored access, how the associated pre-trade vs post-trade monitoring deliberations by "regulators" will influence short selling curbs, and not surprisingly, the desire by Goldman to not only dominate this yet another aspect of high-frequency trading, but to dictate market policy at will.
What is sponsored access:
In sponsored access, a broker-dealer lends its market participation identification (MPID) number to clients for them to trade on exchanges without going through the broker's trading system, to avoid slowing down the execution. That places responsibility on the broker-dealer to make sure the participant abides by securities regulations, and that its trading, which can involve hundreds or thousands of orders a second, does not run amok.
Is it thus surprising, that none other than Goldman Sachs is muscling its way into providing not only a sponsored access platform to its clients, but a new form of sponsored access that needs the blessing of regulators:
Wall Street heavyweight Goldman Sachs, now launching its own sponsored-access service to lend clients its identification to access securities exchanges directly, said last week it favors monitoring client orders prior to execution.
"Our view is that there is a real need for pre-trade checks in the use of sponsored access to fulfill [broker-dealers'] regulatory responsibilities," said Greg Tusar, managing director at Goldman.
Goldman's stand in favor of pre-trade instead of post-trade monitoring of sponsored clients' activity is one side of a debate in which regulators may choose a middle ground. The regulators' decision on how to monitor sponsored access may also influence their deliberations on restricting short sales.
What is the difference between pre-trade and post-trade monitoring? In brief:
Pre-trade
Compliant with Reg SHO
Nip problems before they happen
View activity across exchanges
Post-trade
Faster order executions
Pre-trade systems still fallible
And another tidbit:
In traditional sponsored-access arrangements, a broker-dealer determines a client's suitability to access market centers directly and then allows the client to trade without monitoring its individual orders prior to execution.
In other words, the Goldman endorsed pre-trade approach will allow "monitoring of individual orders prior to execution." Whether or not pre-trade checks provide the capacity to observe not just wholesale exchange activity in the context of sponsored access but from a much broader market angle is a discussion for another time, although this could be one place where Sergey Aleynikov could shed an infinite amount of light, especially as pertains to Goldman's sponsored-access service. Conveniently, his gag order will prevent him from saying much if anything until such time as there is an appetizing settlement to keep him gagged in perpetuity. The bottom line is that with a pre-trade environment, the sponsored access providers will be able to have the potential to front run all those who use their platforms. The residual question of how far they go to comply with regulations to prevent this from happening, and remain true to their ethics standards is also a topic for another day.
Going back to the topic at hand. Here is why sponsored access could easily be quite a bother to capital markets sooner rather than later:
Unchecked errors or unintended repeat orders could deplete broker- dealers' capital, and potentially wreak havoc in the broader market. Concerns have arisen, however, about whether all broker-dealers are able to fulfill that duty in today's electronic trading environment, and according to which standards.
And here Goldman chimes in to not only promote their proposed architecture but to expound on the virtues of pre-trade checking.
"In the case of high-frequency trading, in particular guarding against technology failures, oversized orders and other situations where there's potentially systemic market impact, we believe strongly that pre-trade checks are a prerequisite," Tusar says.
Nasdaq's proposal as well as Securities and Exchange Commission officials' speeches a few months ago appeared to lean toward bolstering the traditional approach.
"We don't believe that's strong enough or what the regulators want now, because of the potentially dire consequences, and because we-as broker-dealers-bear much of that risk," Tusar says.
Now the reason why this is very relevant in the context of not just potential front running, but also market structure is that Regulation SHO, which is the primary regulatory framework for short selling (and the purvey of potential Uptick Rule reinstatement, which will happen once the market is allowed to hit a bid) is a post-trade architecture.
Wedbush [Morgan] routinely tests clients' systems to ensure they are compliant with Reg SHO. In addition, he says, the brokerage sets limits on clients available locates-as well as credit and trading limits--before the start of each trading day that its system tracks, prohibiting shorts without locates and providing a type of pre-trade check.
Or as has recently become the case, seeing rolling buy ins in the middle of the day as borrowable shares in even the most liquid stocks mysteriously disappear (look at today's market action for yet another blatant example of this practice).
Anticipating the regulators' likely response, one should not be surprised to see them siding with Goldman and against shorters:
As the SEC also seeks to appease investor concerns over rampant short selling, especially naked short selling, new sponsored-access standards may provide part of the solution. Given that day-traders may be the last remaining culprits of such activity,, increasing and standardizing scrutiny over their trading may reduce uncovered (and illegal) shorts even further.
How about appeasing concerns over rampant, unjustified buying? When will the downtick buy rule be implemented? But we jest.
And I digress again. Why should all this be concerning to advocates of stability of high-frequency trading:
The mother of all concerns is a sponsored firm's algorithm going awry and executing thousands of problematic trades across a range of securities and market centers.
Well, this is not really a problem when it happens to the upside as has been the case for months now - it is only a threat when Joe Sixpack's 401(k) may be impacted, i.e., to the downside.
And here is where a SEC Comment submitted by broker Lime Brokerage is a very troubling must read by all who naively claim that High-frequency trading is a boon to an efficient market (which doesn't provide . Well, yes and no - it is, until such moment that it causes the market to, literally, break. I will post a critical excerpt from the Lime submission, and leave the rest to our readers' independent analysis:
Lime's familiarity with high speed trading allows us to benchmark some of the fastest computer traders on the planet, and we have seen CDT (Computerized Day Trading) 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 timelag 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. The sheer volume of activity in a concentrated period of time is extremely disruptive to the process of maintaining a ?fair and orderly? market. This shortcoming needs to be addressed if the practice of Naked Access is going to be permitted to continue; otherwise, the next ?Long Term Capital? meltdown will happen in a five-minute time period.
And here is the punchline: our wise exchanges and broker-dealers have already set the stage for an outcome that will be extremely disadvantageous to anyone who is not a member of the "club." The strawman is total market collapse (which will happen sooner or later regardless) - just look at this chart from the CME indicating the phenomenal growth in prop trading across clients and the increasing domination of computerized trading:
So in essence the forced choice to regulators and traders by the likes of Goldman and exchanges it the following: pre-trade clearance, i.e., seeing ahead of all trades for entities who use sponsored access, a platform that all will soon need to be used be everyone who wishes to remain competitive in this day and age where one extra millisecond of latency over a long enough timeline renders a speculator (or basically trader, now that "buy and hold" is dead) useless, or the threat of complete market collapse. In other words: do what we want or the repercussions will destroy the free market.
It is time to call the bluff on all these alternatives by the administration and by Wall Street that have the apocalypse as one of the two options.
When the former head of product development in the electronic client solutions group at none other than JP Morgan, Carl Carrie, was last quoted on Zero Hedge, he had some very nasty words for High Frequency Trading. Today, in a podcast transcript by algotradingpodcast Carl shares much more light in just why any reform movement against HFT and PT in general will be met by a huge pushback by exchanges, brokers, infrastructure providers, telcos, and all derivative market players:
Clearly, algorithmic trading is a huge factor. High-frequency trading for Arbitrage's, indexes, ADRs, pairs, ETFs, interlisted trading, as well as automation around auto-working, have all been factors contributing to the growth of algorithmic trading and trading on exchanges.
The exchanges themselves have also been contributing factors. They've invested heavily in capacity and throughput. And the allocations of assets to European equities has also been a minor factor.
Carl also touches on another, so far undiscussed issue - the industrial oligopoly and the economies of scale advantages to the select few:
In the electronic trading space, you're seeing the beginnings of a fallout, and you're seeing larger scale players, some of them become clear winners. Not that they can permanently sustain their competitive advantage, but for a period of time, there is an economic advantage in being the preeminent, top scale player, and probably the next two rungs below.
Hey Christine Varney - if you can look away from Google for longer than 10 seconds, maybe you can focus on where the next real fight for monopoly is ocurring, with materially greater consequences than Firefox being bundled in with Windows 7.
Most notably, Carl discusses the emerging risk types with this new technology. Not surprisingly as Joe Saluzzi would attest, and much to the chagrin of program trading "specialist" Irene Aldridge, the key risk is liquidity, and much more so to the downside, i.e., when it disappears.
There are new risk types. I think, it used to be about timing cost and market impact. Those were two twin pillars that most algorithmic trading has been based on.
And I think, if you look at what's happened recently in the credit markets, it hasn't opened our eyes to liquidity risk, but liquidity cost and liquidity risk is perhaps a different animal. It's not just about price volatility. It's about volume volatility. It's about timing of that volume volatility. It may be there today, and when you want to get out of your position, it may not be there tomorrow. And how do you reflect that into your own trading and into, not just your alpha generation, but on the risk side of the alpha generation? Most risk models don't really take into consideration the kinds of anomalies that we may see on a yearly basis.
It's not a Six Sigma event, typically, that happens when we have a liquidity crisis. And a liquidity crisis very easily moves across from one market, as a class, to another. So, you've got this contagion correlation effect that's massive. So, I think, it's important for all of us to develop new science and new tactics to really deal with that. And particularly, as you talk about emerging markets, there's no sphere that is as liquidity-sensitive as emerging markets is.
Curiously, when Carl left JPM his parting letter had this to say: "Yes, I love equities but I think the biggest transformation in the market over the next couple of years will be in the OTC fixed income, credit and commodity markets that are both begging for more liquidity and transparency and are ripe for a major transformation. I want to be there at the genesis of that transformation." We at Zero Hedge completely agree with this statement and will be presenting some of our extended ideas on this matter over the next several weeks.
In what will likely be the flame war de jour for at least the next 24 hours, Gasparino responds to Tavakoli via Dealbreaker.
"I generally don't respond to people who don't matter on Wall Street. But any rational, sane person who hasn't been either hitting the bottle or smoking a joint would watch what I said about Goldman Sachs and come away with two things. 1) I am very tough on them-- they always complain about what I say. and 2) In the so-called 'caving' clip I was letting them give their side of the story because that's what journalists do. If someone named Janet thinks I'm selling out, she's entitled to her opinion, which I hate to break it to her, really doesn't matter.
Zero Hedge doesn't want to get in the middle of this, but would like to inquire just what question was it that Charlie had posed to Lucas that was tough on Goldman? Was Charlie specifically inquiring about Goldman's provisioning of liquidity? When is the last time that Charlie even uttered the word liquidity on air, at least when it did not involve vodka? Is Charlie aware that Goldman dominates over 50% of NYSE's principal-based program trading? But like I said, we are not getting involved in this one.
One feels the pain of New York City Comptroller Bill Thompson, Jr. Not only does he have to deal with the continuing lunacy over in Albany and the still ongoing power struggle in the wake of Spitzer's abrupt implosion, but he has to scramble to contain the fall out in the world's most financially dependent city. His only wildcard: hope, whether it be preached by 1,000 billboards across America, or Obama appearing on TV every 15 minutes to remind Americans that the only way out of a credit crisis is to max out their credit cards, or by watching comedy channels disguised as financial reporting.
In the meantime, underneath the still glitzy veneer, is a hollow core that is starting to shrivel at such an alarming pace that the $16 billion in projected budgetary shortfalls will likely double within 12 months at the current rate of deterioration.
A good indication of the real state of micro economy is a cursory read of the most recent edition of NYC's "Economic Notes", the Comptroller's inside view periodic report on the real pain in New York City.
Here are the bullet points for the attention impaired:
Real Gross City Product fell at an estimated 4.1 percent annual rate in 1Q09, after a 6.1 percent decline in 4Q08.
NYC payroll jobs have fallen by 108,000 since their cyclical peak in August, 2008.
NYC?s unemployment rate rose to 9.0 percent in May, compared to 5.1 percent in May, 2008, representing its highest level on a seasonally-adjusted basis since 1997.
For the first half of 2009, the city?s payroll tax withholding, a good indicator of worker incomes, was down 14 percent from the equivalent period of 2008.
General city sales tax collections declined 7.8 percent for the first five months of 2009, compared to the same period in 2008.
The Manhattan office vacancy rate rose to 9.6 percent in 1Q09, the highest since 3Q05.
The number of Manhattan apartments sold rose 28 percent in 2Q09 over 1Q09, but were down 50 percent from 2Q08, according to a report by Prudential Douglas Elliman.
Ridership on NYC Transit, an indicator of the City?s overall economic activity, fell 2.2 percent during the first four months of 2009.
And here is Bill's condensed message:
After enjoying a period of historically low unemployment, the city is experiencing a surge in joblessness. The recession?s impacts have fallen most heavily on men, on African Americans, on prime-age workers, and on the relatively well-educated. Income losses from unemployment are likely to be cushioned somewhat due to the preponderance of multi-earner families and an increase in self-employment, but thousands of families will see their incomes plunge.
Here is one for the PR specialists:
The severity of the current recession raises fears that the city?s job losses will match or exceed those of previous downturns. Except in 1980-82, the city always lost proportionately more jobs than did the nation, and national job losses have been mounting at an alarming rate for the past six months. If the city had merely suffered a proportional rate of job loss as has the nation since the beginning of 2008, it would have already lost about 165,000 jobs.
A point on unemployment:
Unemployment is usually measured at the individual level but its impacts are often felt by entire households. Nearly 70 percent of the city?s workers are heads-of-household, or are the householder?s spouse or partner. The rest are the child of a household head, the sibling, the unrelated housemate, or one of a variety of other relations. All told, the average New York City worker lives in a household with 2.2 other people, so each instance of unemployment typically affects the economic circumstances of at least three individuals.
And this:
During 2006 and 2007, new initial claims for unemployment compensation in the city averaged about 7,000 per week. During the first half of 2008 they rose to about 8,000 per week, and during the second half of 2008 they exceeded 9,000 per week. During the first half of 2009 they were averaging over 12,700 weekly. By February, 2009, the total number of beneficiaries in the city had risen to almost 119,000, an increase of 57,000, or 93 percent, over the previous February.
The conclusion: Strip club valuations are going down... way down.
Even if the city?s jobs base stabilizes, however, unemployment is likely to continue to increase, and by mid-2010, some 400,000 New Yorkers may be unemployed. That suggests that over one million residents will be living in households whose incomes are severely diminished by unemployment and underemployment.
So yes, while it is easy to wave the magic wand of generalization and hope at the overall broad and nebulous economy which is "stabilizing" simply due to a short squeeze in the markets, a drill down in regional areas exposes a lot more of the same truth that brought the market to its March lows. Alas, hope as a policy can and will only persist as there is one more marginal shorter whose forced buy in can lead the market that much higher. The question is what after.
Damage control... Or is Goldman a little worried what Direct Edge may disclose.
From the appended Schumer piece on Bloomberg:
?Goldman Sachs believes high-frequency trading should have an accompanying obligation to provide liquidity, and be subject to appropriate regulatory oversight,? Canaday said.
Ed, we have been giving you the chance to provide your side of the story for months. Please take us up on the offer.
Companies to watch: Allegheny, Altria Group, Amdocs, BancorpSouth, Bank of New York Mellon, CR Bard, Delta Air Lines, E*Trade, eBay, Eli Lilly, Genzyme, GlaxoSmithKline, KeyCorp, Lennox, Morgan Stanley, PepsiCo, Pfizer, SanDisk, The Boeing Co, The Mosaic Co, Tupperware Brands.
Recent Egan-Jones Rating Actions:
CATERPILLAR INC (CAT) COCA-COLA CO/THE (KO) BOSTON SCIENTIFIC CORP (BSX) LEXMARK INTERNATIONAL INC (LXK) CONTINENTAL AIRLINES INC (CAL) EI DU PONT DE NEMOURS & CO (DD) HASBRO INC (HAS) EATON CORP (ETN) UNITED TECHNOLOGIES CORP (UTX) BUCKEYE PARTNERS LP (BPL) CHARLES SCHWAB CORP/THE (SCHW) AVNET INC (AVT) JOHNSON CONTROLS INC (JCI)
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