Monday, July 13, 2009

Mr. Mauldin, I Respectfully disagree.

John Mauldin is one of my favorite writers and I find myself in agreement with his opinions far more often than not. On this occasion however, I completely disagree with one portion of his weekly letter. specifically this portion:

But first, I want to direct the attention of those in the US finance industry to a white paper written by Themis Trading, called "Toxic Equity Trading Order Flow on Wall Street." Basically, they outline why volume and volatility have jumped so much since 2007; and it's not due to the credit crisis. They estimate that 70% of the volume in today's markets is from high-frequency program trading. They outline how large brokers and funds can buy and sell a stock for the same price and still make 0.5 cents. Do that a million times a day and the money adds up. Or maybe do it 8 billion times. It requires powerful computers, complicity of the exchanges (because the exchanges get paid a lot), and highly proximate computer connections. Literally, the need for speed is so important that to play this game you have to have your servers physically at the exchange. Across the river in New Jersey is too slow. Forget Texas or California. This is a game played out in microseconds.

The retail world doesn't get to play. This is a game only for big boys who can afford to pay for the "arms" needed to fight this war. But the rest of us pay for the game, as that half cent is like a tax on transactions, not to mention the increased daily volatility, which skews pricing. Think it doesn't affect you? That "tax" is paid by mutual funds, your pension fund, and every large institution.

Frankly, this is outrageous. The more I read the madder I got. And it is going to get worse as computers get faster and software more intelligent. We need rules to level the playing field. Themis suggests one simple one: just make it a rule that all bids have to be good for at least one second. That would cure a lot of problems. One lousy second! In a world of microseconds, that is an eternity.

Goldman Sachs went after an employee who stole some of their latest and greatest software this last week. The US assistant attorney general said in the courtroom that the software had the potential to manipulate the market. Imagine that. I am shocked. There is gambling going on in the back room? Gee, commissioner, I had no idea.

All this "algo" (algorithmic) trading also gives a very false impression of volume. If you are a fund and see 10 million shares a day traded, you might feel comfortable that you could hold one million shares and exit your trade easily. But if 80% of the volume is false "algo" trading, that volume isn't really there. You may have a position that will be a problem if you want to exit, and not know it.

"High-frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don't even know it." (Themis Trading)

We are literally talking billions of dollars here. The SEC needs to step in and stop this, and soon. This is a lot more important than the salaries of investment professionals, for which the Obama administration today suggested new rules, which would allow the SEC to oversee salaries at member firms. Seriously? They don't have enough to do already? the paper referenced is here

I don't disagree with any of facts about volume increases or the existance of the liquidity provider incentive payments or the algorithmic trading systems, What i disagree with is the notion that this is harmful. My experience is that markets are tighter and more competitive than ever before. It is easier to get larger sizes done at lower total cost than before. It has not been very long since the minimum bid ask difference was a sixteenth not a hundredth. Plus one had to pay broker fees to get an execution, now one pays very, very little to get an electronic execution.

The quarter cent paid to the liquidity provider is paid by the exchange as means of remaining competitive with other exchanges for volume and tight bid ask quotations. What has been eliminated is several levels of commission that used to be paid to brokers. All of this reduces the frictional cost of trading for the public. These are good things.
The institution with a 20.00 price order doesn't have to pay 20.01 just because it is offered but it certainly is better than the best offer of 20.06 that used to exist. I believe the market is more efficient in terms of cost and liquidity down at this micro level than it has ever been.

Blaming electronic execution systems for the increased volatility of the market when the entire banking system is falling apart seems to reflect the bias of agency brokers whose business is being rendered semi-obsolete. i understand and sympathize with brokers being cut out of the process but all sounds like the complaints by floor traders at the commodity pits when electronic trade began to steal volume from the pit, an it is just as self interested and incorrect.


Lsquared said...

I agree. Whenever you read this stuff, you have to ask "Who is writing this and what are the writer's interests?" Self-interest rules the day.

Drumski said...

I agree as well.....very reminescent of the CBOT brokers of the past decade!

Bill C said...

I have a problem with HFT if it is a game that hurts smaller traders, which was suggested in the NYT article, by allowing these large institutions to see the hidden orders for a fee.

Also, does this really show up at all in the futures markets?