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Hyper traders have transformed our markets into a fragmented web of chaos

May 3rd, 2012

By Joe Saluzzi and Sal Arnuk of Themis Trading LLC

This Sunday marks the second anniversary of the May 6th Flash Crash of 2010. As we all trade in this extremely low-volume trading environment, it is fitting that we recap where we stand today.

Listening to the conference call discussing NYSE Euronext’s first quarter financial results, we shook our heads in dismay as NYSE executives described a trading environment where volumes fell to a four and half year low – the lowest levels since Regulation NMS (National Market System) was implemented in late 2007.

NYSE’s Duncan Niederauer described a 44% profit decline from the prior year, due largely to a 25% fall in revenues from transactions. He blamed the decline on an unfriendly environment for high frequency trading firms, in which regulators and folks in the media have condemned high frequency trading (HFC) as a bogeyman, creating a climate of uncertainty for HFT firms, causing their migration to other asset classes and geographies.

His comments on the conference call proved that Duncan Niederauer doesn’t get it. He is mistaking the symptoms for the underlying problem. He thinks volumes have declined because people have not been nice enough to HFT firms. This is, of course, laughable. The truth is HFT volumes are down because investor volumes are down. And investor volumes are down because investors have been steadily awakening to the dangers of drinking from a dangerous watering hole.

Like the animals on the Serengeti which for years were accustomed to drinking long and heartily at the watering hole, investors can now discern the crocodiles lurking beneath the surface. They are easier to spot now, given the drought and diminished water level in the hole, and ordinary investors are deciding that the drink they crave is just not worth the risk.

More than $250 billion in long term equity money has retreated from the markets since May 6th, 2010 – despite a slow but steady improvement in the US economy and a stock market that has nearly doubled since the 2009 lows. Investors have lost confidence.

It’s hard to blame them. They have witnessed a radical transformation of the best capital allocation market system in the world to one where:

– 13 stock exchanges cater to hyper traders who game the system, chasing exchange rebates, and leveraging speed for the purpose of a nanosecond scalping dance.

– More than 40 dark pools together trade over one third of all shares in a murky secret sauce known to the dark pool operators and their “liquidity provider” partners only.

– Exchanges own stakes in dark pools, and HFT firms own stakes in exchanges.

– Internalization practices feed HFT financial modeling of investor orders.

– Exchange data feeds act as a veritable DVR for investor orders and behavior.

– Rogue exchange-traded products break down (TVIX comes to mind), trap unsophisticated investors, and only enrich their issuers, stock exchanges, and the HFT firms that make markets in them.

– “Mini-flash-crashes” still take place across the US equity space, including the high profile IPO of one of the stock exchanges hoping to go public.

– While HFT firms in the last decade have achieved wondrous profitability (double-digit Sharpe ratios), investors at best have clawed back to even.

– Thieves were able to make off with customer-segregated monies at MF Global, with not a single prosecution, nor a hope of redress.

And as they witness all of the above, they see that our regulators have had a challenging time acting as effective policemen in the marketplace. Flash orders are still alive and well, under many different names, despite the SEC’s own proposal to ban them in 2009.

Dark pool regulation, which the SEC also proposed a few years back, has not materialized. Internalizing brokerage/HFT firms, which clearly played a huge role in the market meltdown on May 6th 2010 (and perhaps in the financial crisis in late 2008 and 2009 as well) still practice the same way, but now with additional help from dark pools and exchanges who have all embraced “liquidity provider” programs.

Finally, payment for order flow is alive and well on numerous levels throughout the system – from retail online brokers selling retail orders to HFT market makers, to maker/taker exchange pricing, to free dark pool executions for order flow routed through certain pools first. Exchanges have even had the gall to propose rules to the SEC where issuers would give payments to HFT market makers for their “liquidity provision” in ETFs that contained the issuers’ common stock.

Investors know that the markets are broken. And they want a fresh watering hole that is simple and clean.

Our outrage over the transformation of the best capital markets in the world to this conflicted and fragmented web of chaos is what led us to write our book, Broken Markets.

When it comes out a month from now, we are confident it will find no shortage of critics from within the investment industry. However, we needed to write it – we tried to highlight the troubling issues of our transformed market structure through many other avenues, including trade magazines, financial media, industry conference calls, trade conference panels, as well as with our regulators in person.

We wrote Broken Markets for one reason: to expand the debate surrounding our conflicted equity market structure to more mainstream investors. We want Main Street to understand what our markets have become, so that they can affect the change we need to take place, so that we can one day once again have the best capital markets in the world.

Written by Joe Saluzzi and Sal Arnuk of Themis Trading LLC whose book Broken Markets is published on June 3rd. The original version of the post was published by Themis Trading LLC on May 1st, 2012. Republished with permission

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