Thursday, June 26, 2014

Dark pools and high-frequency trading -- SHHH!!! Don't wake up the SEC or Congress!

The New York Attorney General sued Barclays Capital, Inc., a registered broker-dealer and investment advisor, and its U.K.-based parent company, Barclays PLC, for fraud. (Kudos to the excellent site,, for continued ongoing coverage of dark pools, etc.)

The complaint, if true, is another blood-boiler, because Barclays is portrayed a nest of lying thieves. But even if the lawsuit fails, the allegations are enough to scare the living you-know-what out of any broker-dealer or investment advisor that depends on retail brokerage customers to butter their bread. Why? Because if the average retail brokerage customer knew the perils of trading in U.S. markets today, he or she would take all their money out and put it into … oh hell, they'd probably leave it where it is and go back to sleep.

The complaint alleges that Barclays, which operated a dark pool (a vehicle for matching buyers and sellers of stock off the floor of the New York Stock Exchange), lied to institutional investors about the extent to which they would be protected against trading abuses by high frequency traders (HFTs) if they routed their orders to Barclays' dark pool.

This is 21st century fraud we're talking about with this case. We're not talking about lazy brokers recommending highly speculative stocks without adequate due diligence. We're not talking about accounting fraud creating inflated values for blue-chip stocks. We're talking about the "simple" matter of getting your stock trade executed at the best available price -- best execution. In other words, if you want to buy stock, that you pay as little as possible, and if you want to sell stock, that you get as much as possible. 

This blog post is not about the Barclays case. They either lied to institutional investors or they didn't. If they didn't, some other dark pool operator stretched the truth to attract order flow (a license to print money) did. This blog post is just a series of ruminations about dark pools, HFTs, and the ludicrousness of the idea that the SEC is effectively policing the markets to prevent trading abuses. 

Stock brokers are supposed to provide best execution to their clients. Stock exchanges are designed to provide best execution by letting all market participants know of pending buy and sell orders and by other means designed to promote transparency and liquidity. Stock exchanges are supposed to lead to best pricing (highest possible sale prices and lowest possible buy prices). But trading routed to the exchanges has dropped over the years, in part because institutional traders (with large blocks of stock to buy or sell) began seeing price transparency as a roadblock to obtaining best prices. 

The days when Mom and Pop could expect their stock purchases or sales to be routed by their stock brokers to a stock exchange are gone--long gone. If they want to, they can direct their broker to send their trade to an exchange to be executed. Except when the market is in great turmoil, there is only a small chance that it would make a big difference. If not "directed," the chance is that Mom's and Pop's order will be routed by their broker to a variety of "routing venues," such as electronic communications networks or"ECNs," alternative trading systems or "ATSs," over-the-counter ("OTC")market makers, and proprietary trading firms. Some are called "dark pools." 

An ATS is a non-exchange trading venue that matches buyers and sellers to find counterparties for transactions. "Dark pool" is not a term defined in the securities laws, but FINRA defines a dark pool as “an ATS that does not display quotations or subscribers’ orders to any person or entity, either internally within an ATS dark pool or externally beyond an ATS dark pool (other than to employees of the ATS).”  

Basically, dark pools are useful to traders of large blocks of stock who do not want publicity about their order to generate a price rise or drop in anticipation of the order's execution. As an SEC official explained to the Congress way back in 2009 in testimony presciently entitled "Testimony Concerning Dark Pools, Flash Orders, High Frequency Trading, and Other Market Structure Issues":

Traders are loath to display the full extent of their trading interest. Imagine a large pension fund that wants to sell a million shares of a particular stock. If it displayed such an order, the price of the stock would likely drop sharply before the pension fund could sell its shares. So the pension fund, assuming it could execute its trade at all, would be forced to sell at a worse price than it might have if information about its order had remained confidential.

In the not-so-distant past, the pension fund might have placed the order, or some part of it, with a broker-dealer, which would attempt to find contraside interest (whether on the floor of an exchange or by calling around to other traders), preferably without giving up enough information to move the market against its client. Information leakage about a larger order was a serious problem, and the "market impact" of large orders would impose a major cost on investors.

Historically, many dark pools developed as computerized ways of searching for contraside trading interest while preserving confidentiality. While early dark pools were designed to cross large orders, and such pools still exist today, most of the newer dark pools are designed to trade smaller-sized orders. 

Since the mid-2000s, brokers have been required to disclose to the SEC information concerning their order routing practices. What they show is that a small portion of the orders entrusted to brokers are routed to the exchanges. For many firms, the vast majority of trades go to "market centers" or other "routing venues". Often these market centers are affiliated with the broker. (Barclays runs a dark pool.) And much of the trading on all markets is now conducted by high-frequency traders (HTFs), who use advanced logarithms to place orders and pay for high-speed access to exchanges and market centers to gain precious milli-second time advantages over non HTFs.

High frequency trading, if properly limited by still-nonexistent anti-manipulative rules, can serve to make markets more efficient by providing needed liquidity to tighten spreads (the difference between high bids and low asks). But the biggest peril from the liquidity provided to non-exchange trading venues is that the liquidity can disappear immediately: HTFs can walk away from the market and stop trading on a moment's notice. But exchanges have specialists -- market-making brokers that are obligated to supply liquidity, i.e., to be a buyer when there are no buyers and a seller when there are no sellers. Exchanges can be the locus of giant price drops, but at least there is a regulatory structure designed to provide a good measure of market stability. But HTFs have no such responsibility. This can increase volatility -- the wide swings in prices in which the little guy, who is not glued to his or her computer screen, gets slaughtered. In addition, HFTs can engage in predatory practices, such as putting in mock orders that smoke out possible contra party interest, but are then pulled back--all essentially instantaneously. The SEC has long known about predatory practices by HFTs but has done little or nothing about it. It is "studying" things.

Brokers claim they monitor the trading that goes on in dark pools in order to prevent HFTs from gaining unfair advantages over other traders. TD Ameritrade, for example, claimed in an email to this blogger: "We monitor these market centers closely and very frequently, and we adjust our order-routing strategy accordingly." Maybe. But the fraud alleged in the Barclays complaint is that Barclays, in order to attract order flow from institutional clients to its dark pool, lied to potential clients about the extent of trading (labeled "predatory" or "toxic" by Barclays) by high-frequency traders in its pool. The more the level of toxic trading, the more the institutions were likely to pay more or receive less for their buys and sells.

High frequency trading and dark pools are simply products of the microchip's ability to flatten markets by getting rid of the middle man -- in this case, by narrowing the spreads between the highest bid (offer to buy) and the lowest ask (offer to sell). Unless the SEC proposes to abolish the use of microchip in the securities markets, HTFs and dark pools and the rest are here to stay. 

For what it's worth, we are probably talking about yesterday's issue. The HTFs' best days may very well be behind them, as competition among HTFs may have reduced spreads to the point where there is less money to be made by HTFs. It's part of the end of the OTC market as it long existed... middlemen squeezing a few cents from both buyers and sellers they brought together. 

Another thing is that dark pools grew into prominence because the securities exchanges allowed high-frequency traders to pay the exchanges to get special treatment and thereby trade ahead of pending orders. In the words of the New York AG's lawsuit against Barclays:

These firms pay a premium for “direct data feeds” from the public exchanges, which are high-speed data feeds that travel faster and contain more information than market data available to ordinary investors by other, less expensive means.

Those speed and technology advantages allow high frequency traders to profile
the pending orders on an exchange in order to detect the presence of large pending orders,
usually from institional investors. This “information leakage,” allows high frequency traders to trade ahead of an anticipated stock purchase or otherwise have an impact on price. Speed and technology advantages also allow for strategies that seek to exploit the small, temporary pricing dislocations in a security that occur because of differential and/or delayed access to market data.

In other words, dark pools grew partly as a refuge from predatory practices on the exchanges. Who could expect, or want, ATSs to go away under these circumstances? 

The last point is the utter irrelevance of the SEC in all of this. As usual, the SEC has been  lost in action -- just as it was in the early 2000s when another New York AG, Elliot Spitzer, "scooped" the SEC about a whole range of trading abuses, such as conflicted buy-side stock analysts, etc. 

Yes, the SEC Chair, Mary Jo White, in June of 2014, gave not one, but two speeches on HTFs, dark pools and other market centers, issuing the old bromides about protecting confidence in the market, and announcing that she had directed the SEC staff to start preparing rules designed to make things fairer. 

If anyone believes that the SEC will move vigorously and effectively and enact a set of rules that will make all better, please let me know so I can sell you some bridges. Or better yet, if you think that Congress will act, I'll sell you some dark pools after they've been overtaken by some extra-terrestial market thingy. 

In the meantime, go here for far more insightful, but somewhat dated, analyses of what has happened to the stock market in the past ten years. 

Kind of makes you long for the good old days of Bernie Madoff, market maker and execution broker extraordinaire, and the fight over decimalization. 

Thursday, June 19, 2014

Why You Should Put Quotation Marks around "Iraq" for Dummies (this includes you, W)

Obama is being blamed by the Republicans for losing "Iraq". They're the ones  who insisted on invading "Iraq" in 2003 with no basis and without paying the slightest bit of attention to what "Iraq" was and what would happen after the first days of "shock and awe." Not only was there no Plan A, there was no Plan B.  So they got rid of Saddam Hussein, banned his supporters from the new "government," and handed "Iraq" over to Shia Muslims and the bastion of Shia Islam, Iran.

The idea--propagated most recently by the GOP's leading college dropout and draft dodger, Dick Cheney--that Iraq was "won" by the Americans after the surge is so ridiculous that it should not have to be rebutted. 

Here's what you need to know. It's a little more complicated than this, but this is post-doctorate scholarship compared to the bilge that W and Co. had the US swallow.

1."Iraq" was created after World War I by the British and the French from the remnants of the Ottoman Empire (France got "Syria" and Britain got "Iraq"). Borders were drawn arbitrarily and without any recognition of who was located within the borders of "Iraq" or what would be the consequences of drawing the lines.

2. "Iraq" is not and never has been a nation-state. There is not and never has been any nationalistic loyalty or dedication to a unified state. There is no and never has been any self-identification as "Iraqis" by any of the three major population groups. 

3. "Iraq" is composed of three principal groups. According to the CIAMuslims make up about 75% of "Iraqis," of whom about 2/3 are Shia and the remainder Sunni. About 20% (all in the North) are Kurdish. The remainder are Turkoman, Assyrian, Christians, etc. 

4. The Shia hate the Sunnis, the Sunni hate the Shia, and neither group get along with the Kurds, who are massed in the north. Yes, Shia and Sunni are fellow Muslims. But their split goes back to the death of Mohammed. By God, that's over 500 years before the Magna Carta.

Iran is a Shia nation. Anyone with half a noodle understood that by our getting rid of Saddam, who was a Sunni, the main gainers would be the Shia within Iraq, and that, thereafter, the Shia, having been kept down by Saddam (and by his predecessor Sunni rulers), would ally with our enemy, Iran, and put their boot on the Sunnis' neck. And that the only real hope was a decentralized Iraq with each region consisting of and governed by one of the three main groups. (That's what's happened with the Kurds.)

Here's what Obama did wrong: instead of exposing the US to the truth--that the invasion of Iraq was stupid, stupid, stupid, and that unless the American people wanted to be exposed to the never-ending tribal strife within "Iraq," the only sensible thing to do would be to exit, stage left, and let "the market" take over--he mumbled meaningless bromides, expressed his "support for the troops," and crossed his fingers, all to avoid crossing the right wing. (Has Bob Shrum been hiding in the Rose Garden all these years?)  True, the American electorate hate to face up to the fact that sometimes there are no good choices. American "exceptionalism" creates a false sense that we never have to make choices if we don't like either option. Obama has lacked the guts to tell people the truth. Just like every other politician. Now it's his war. What a dummy.