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No,MichaelLewis,theUSEquitiesMarketIs NotRigged
WhileFlashBoysmaycapturethecomplexexecutionframeworkof theUSequitiesmarket,MichaelLewisdoesnotportraythefullstory. Themarketmaynotbeperfect,butitsnotrigged.
ByLarryTabb,founderandCEO,TABBGroup http://tabbforum.com/opinions/nomichaellewistheusequitiesmarketisnot rigged WhileMichaelLewissnewbook,FlashBoys,isanamusingreadanddoestalk abouttheverycomplexexecutionframeworkoftheUSequitiesmarket,hehas notportrayedthefullstoryoftheUSequitiesmarket,leavingmuchonthe cuttingroomfloor. FlashBoysportraysanoverlycomplexmarkethellbentonspeedandtraders willingtoselltheirgrandmotherforamillisecond.TheopportunityMr.Lewis paintscomesattheexpenseofunwittinginvestorswhoarebeingtaken advantageofbyhighfrequencytradersinconjunctionwithcolludingbrokersand exchanges.Hetalksaboutlatencyarbitragebetweenconsolidateddatafeesand directfeeds,aswellasdistancesbetweenexchanges,darkpoolsandcablelines. Whilemostofthephysicalinfrastructureisadequatelydescribed,itspurpose, howitisbeingusedanditsimpactaredramaticallymisstated. MarketFragmentation Whileourmarketsarefragmented,thereissignificantbenefittohavinga fragmentedmarket:competition.Whileeconomictheoryrepresentsthatthe mostefficientmarketisonewhereallordersinteractandcompeteinacentral limitorderbook,thistheoryfallsdownwhenitrunsheadlongintoamarket devoidofcompetition.Thiswasshownwhenmarketmakerswerecaught colludingin1998onNASDAQandontheNYSEin2003.Inbothoftheseinstances, marketmakersandspecialistsweretakenawayinhandcuffs.

115 Broadway 12 Floor New York, NY 10006 T: 646 722-7800 F: 508 519-0519 www.tabbgroup.com 7 Benjamin Drive Westborough, MA 01581 T: 508 836-2031 The TABB Group, Europe LTD 60 Cannon Street, Suite 120 London EC4N 6NP T: +44 (0) 203 207 9027

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OutofbothofthesescandalscameSECrulestofacilitatecompetitionnotjust betweenorders,butbetweenmarkets.TheSECenabledthedevelopmentofthree majornonexchangetypematchingmechanisms:internalizationwherebrokers couldinternallymatchbuyersandsellers;ECNs(electroniccommunications networks)alternativecentrallimitorderbooks(lessregulated,quasiexchanges); anddarkpools,opaquebrokerownedmatchingvenuesthatworklikeexchanges butdonotdisplaylimitorders(hence,dark).DuringthistimetheSECdeveloped theOrderHandlingRules,RegulationATS,andRegulationNMS,whichcodified howordersneededtobetreatedinthisfragmentedmarketstructure. Today,whilefragmented,equityexecutionismuchlessexpensive,faster (generallysubmillisecondcomparedtomorethan10secondsin2005),andmore open.Retailbrokeragefeesaregenerallyunder$10atrade,andinstitutionscan payunder1pennyashare(closerto.8centspershare)forelectronicexecution. Inaddition,averageeffectivespreadsaredown,andinvestorsaremuchmorein controloftheirexecutionsthaneverbefore. Thedevelopmentofmultipleexecutionvenueshaschangedtheeconomicsof trading.Ifwelookbackonequitytradingevenasrecentasadecadeago,the brokersandexchangeswerestandaloneprofitablepowerhouses.Today,equity exchangesarenotinthesamefinancialshape.Derivativeexchangesaredriving exchangegrowth,andequityexchangesneedtobeleanandmeantosurvive. Brokersarenotprosperingeither,astradersandexperiencedsalespeopleare beingswappedformachinesandlessexperiencedsalessupport.ETFs,self empoweringtechnologyandinvestorpressurehavereducedthecostofexecution andhavecausedbrokerstoreducetheirstaffs. Sowhereisallofthisvaluegoing?Tohighfrequencytraders?Wedontseethem doingmuchbetterthantheexchangesorbrokers.Thepressuretoinvestin expensivetechnologyandinfrastructure,colocationandconnectionstomany moremarkets,aswellasimprovementsinvendorbasedsolutions,havecauseda hittotheirrevenues.TABBGroupestimatesthatUSequityHFTrevenueshave declinedfromapproximately$7.2billionin2009toabout$1.3billionin2014. Lookingatrecentpublicdata,theprofitabilityofHFTfirmsintheUSequities markethasdeclined,justasthenumberofplayershasdecreased. Iftheexchanges,brokersandHFTsarenotreapingtherewards,thenwhereisthis leakagegoing?Thismoneyisgoingbacktoinvestorsintheformofbetterand cheaperexecutions,asfewifanyinstitutionalinvestorswehaveinterviewed andwehaveinterviewedthousandshaveeverexpressedthattheirequity
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implementationcostshaveincreased,meaningtradingjustbecomescheaper andcheaper.Thatcostcomesfromsomewhere:marketmakers,speculators, brokersandexchanges. RiskandReward Everyonehatesspeculators.Thatisagiven.Theyareviewedasparasitessucking thealphaoutofinvestorsbrilliantideas.Whileintermediariesdostepinthe middleofinvestorstradingstrategies,speculators/intermediariesdoserveatrue purpose:Theyfacilitatepricediscoverymeaningtheyprovidequotes.Thatisa veryimportant(ifnotthemostimportant)functionofamarket:determiningthe price.Amarketwithoutpricediscoverybecomesanexpensiveandilliquidmarket. Whilemostmajorinvestorsknowtheintrinsicvalueofanassettheyarewillingto trade,thequotingprocessnotonlycrystalizesthepriceforalltosee,itprovides tradablequotesforeventhelargestinvestors. Tofullyunderstandthis,thinkofastore.Astorethatdoesntdisplayoradvertise itspricesdoesntgetmuchbusiness.Thinkofwalkingintoastorefilledwith merchandisewithnaryapricetobeseen.Foreachproduct,youneedtoaska salesperson,whomayormaynotgiveyouanaccurateprice.Whileastorecan advertisethatitwillbeatallcompetitorsprices,ifitdoesntdisplayaprice,itputs theonusonbuyerstofindthebestprice,bringproofintothestoreandhaggle withthestorekeepertobookadeal. Thesameistruewithdisplayedmarkets.Amarketwithoutapricingmechanism isntmuchofamarket. Thepeoplewhoprovidethesepricesaremarketmakers,speculators,orwhat mostpeoplecallHFT.Theseactorsquoteproductbidsandoffersacrossawide spectrumofmarkets(exchanges,ECNs,anddarkpools).Collectively,itistheir businessmodeltotrytoprovidethemostaggressivepricetheycanprovidetobuy orsellastock.Thesefirmsalsogeneratetheirrevenuesfromtwosources:the spreadbetweenwhichtheycanbuyandsellstock,andanyincentivesthat exchanges,ECNs,ordarkpoolsmaygivethemtoquoteintheirmarkets. Whiletradingvenuesmayprovideincentivestoquote(generallyupto$.00029 pershare),theydonotshareinliquidityproviderstradingprofitsorlosses.This meansthatanytradinghousethatimproperlygaugessupplyanddemandhasto beartheentirecostofanylossesitself.

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Letmerephrasethis:Tohavetightmarkets,manyfirms(mostlyHFT)needto competetosetthebestmarketprice.Thesefirmsarecompetingtocapturethe spread(forliquidstocks,thisis1centpershare)plusanyincentive,minusany tradingcost.Ifthesefirmsmiscalculatesupplyanddemand,asKnightdidone fatefulmorning,theywillnotonlyhaveabadtradingday,theycouldgobust. Sohowdothesefirmsmanagerisk? Quotesequatetorisk.Anytimeatrader(assetmanager,retailinvestor,market makerorHFT)putsaquoteintothemarket,itisanoptionforthemarkettotrade. ThequoterprovidestheoptionIwouldliketobuy100sharesofIBMat$190a share.JustbecauseabuyerwantstoacquireIBMat$190doesntmeanthat someoneisouttherewillingtosellIBMat$190;however,ifsomeoneis,unless thequotercancelstheorder,thepersonquotingiscommittedtotrade.Whilea longerterminvestormayhaveatimehorizonforthetradeofdays,weeks, monthsoryears,generallyamarketmaker,speculator,and/orHFTislookingata horizonofsecondstominutes.Ifmywholebusinessmodelispredicatedoff quotingtoearnaspread,thenIneedtounderstandallofthemarketinfluences thatcouldmakeIBMgoupordownduringmyinvestmenttimehorizon(seconds tominutes). Sowhatmakesastockgoupordownintheshortterm?Certainlythereare companyfundamentalssuchassales,earningsormanagementchanges;but typicallythatinformationdoesntchangesecondtosecond.Therealsoisresearch, news,information,andotherdatathatgetsreleasedbyanalysts,media,orpeople simplyexpressingtheiropinionsonline.Lastly,andmostimportant,inthevery shortterm,supplyanddemandimpactspricethemosthowmanypeoplewant tobuyvs.selland,moreimportant,howmuch? Theproblemwithquotingespeciallyformarketmakers,speculators,and/or HFTsisthatthequotercannoteasilygaugethequantitythelongerterm buyer/sellerwantstotrade.Ifthequantityissmall,theproblemisslight;ifthe quantityislarge,thentheinvestorsordercouldsignificantlyaltersupply,demand andprice,forcingtheshorttermtradertolosemoney.Andremember,the quotingpartyiscommitted,whiletheaggressingpartyisnot.Theaggressormay wanttobuy100shares,oritcouldbelookingforamillion. Sohowdoesthequotermanagerisk? Therearedifferentwaysformarketmakerstomanagerisk.First,theyneedtobe quick.Ifmarketmakersareslowtoreact,theywillbetakenadvantageof.Ifthe
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priceofIBMshouldreallybe$191insteadof$190,theneitherthemarketmakers orderwonttrade(ifitisoutofthemoney),orworse,itwilltrade disadvantageouslyandtheliquidityproviderwilltakealoss.Andifthatquoteis for10,000shares,thelosscouldbesignificant. Second,theyneedtobeconnected.Marketmakersneedtobeconnectedto marketswhereliquidityeitherresidesorwillreside.Ifspeculatorsarenot connectedtomarkets,itbecomeshardertotrade.Theymaybeabletogo throughathirdpartytogettoanunconnectedmarket;however,iftimeis important,connectingviaathirdpartywillbelatencyprone. Third,theyneedtobeconnectedtoproxyproducts.Proxyproductsareproducts thatmaytradesomewhatliketheproductthatyouaretrading.Theseproducts couldbefutures,ETFs,FX,bonds,newsorotherindicativeentitiesthatmayhint thatthemarketisabouttomove.Traditionally,futuresmovebeforecash.Ifthe S&P500futurestartsmoving,itwillindicatethatthecashequitiesmaysoon follow. Last,theymustfullyunderstandallofthenuancesofeachmarkettheytrade.This means:howtoconnect,theirprotocols,pricing,ordertypes,marketdata structures,andalloftheinformationsurroundinghowthatmarketoperates. Withoutthisinformation,thespeculatormayfindthatitsconnectiontimelags,its ordertypeusageisntappropriate,oritisjustbeingoutsmartedbysomeone moreversedinmarketmicrostructure. Whydoquotesfadewhenalargerorderentersthemarket? Wehearfrequentlythatonanaggregatebasisthereissignificantdisplayed volume,butwhenapproached,itdisappears.Thereasonwhythisoccursis twofold:first,sincethereare13exchangesandmorethan40darkpools,liquidity providersandinvestoralgorithmsspreadordersacrossexchangesandoften oversizethem,toensurethatnomatterwhichvenueyouarriveatthereisthe abilitytogetexecuted.Sothatlargeaggregatedvolumereallydoesntexist.Itis beingrepresentedmultipletimes.Second,ifalargeorderdoesarriveinthe marketandoutstripssupply,thenthepriceshouldadjustgiventheincreasein demand. Whilenoonereallylikesit,todaysyieldpricingmodelsdothesamething.When buyingaticketonaflightorbookingahotelroom,thepricedisplayedtodayis neverthepricedisplayedtomorrow.Andgivencookietechnology,travelsites and,increasingly,otherInternetpricingenginesaredeterminingyourlocation,
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previoustransactions,andobtaininginformationfromothersitestodotheirbest toextracteverymarginaldollarfromyourwalletthatyouarewillingtopay.That said,ifyoudontwanttogo,dontbytheticket. Ifyoutalkwiththeairlinesandhotels,theysaythatonbalancethesepricing enginesbenefitbothtravelersandtheairlines/hotelsbyenablingpatientbuyers topaylessandmoreurgentbuyerstopaymore.Liquidityprovidersinmarketsare usingtheexactsamestrategiestodotheexactsamefunctiongaugesupplyand demandanddeterminethevalueoftheirriskcapital. Buthowdoesthishappen? HFTexistsbecauseourmarketsaresystematic.Therearewaystoconnect,ways ordersareexecuted,andwaysdatacanbemodeled.Our53orsolitanddark marketsoperateinspecificandconsistentways.Theyareindifferentplaces, connectedviajitterfreedarkfiberconnectionswherelatencycanbemeasuredby thenanosecond.Andordersmovethroughthisinfrastructureincertainways. Ordersmovefrominvestorstobrokers,tobrokeralgorithms,todarkpools,to exchanges.Placinglimitordersacrossthesemarketsgivesliquidityproviders(not necessarilyHFTs)theabilitytocreateaTsunamiearlywarningsystem. Ifatraderplaceslimitordersinall53orsomarkets,asoneorderishitandthen another,thetradercouldbegintodevelopapatternofwhereliquiditywas comingfrom,whereitwasgoingto,howmuchwasbeingtaken,andhow aggressivethemarketwasbeingpushed.Giventhisinformation,amarket marker/liquidityproviderwouldbegintodevelopasenseofhowaggressiveand pricesensitivethetraderwas.Themarketmakercanthenraiseorlowertheprice, dependingupondemand.This,however,iseasiersaidthandone. Canthemarketbemanipulated? Marketscanbepushed,butnotforlong.Withsomanyalgorithmsinthemarket calculatingfairmarketvalue,machinescandetermine,bythemicrosecond,the priceofalmosteveryfinancialasset.Thatsaid,themoreliquidtheproduct,the harderitistomanipulate.Highlyliquidproductsaremuchhardertopushthan lessliquidproducts,justbecausetheyarehighlyliquid.Themorepeopletrading anassetandthemoredivergenttheview,themoretraderstherearepushingthat assetintoanequilibriumprice.Conversely,thelessliquidtheproduct,theeasier itistomovetheprice,especiallyifthebidandofferarethin.However,theless liquidaproduct,thelesssupplyanddemand,sodetermininganaccurateclearing
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priceisalsoharder.Sowhetheryoucallthatpricediscoveryormanipulationis hardtosaywithauthority. Whilemarketscanbepushed,doesitmeantheyarerigged? No.Notatall.Liquidityhasaprice.Havingafirmcommitcapitaltobuyandsellat amomentsnoticecostsmoney.Thatmoneycomesfromthebidofferspreadand anyrebateamarketvenuedecidestopay.Whilethereisanintermediary,the intermediarydoesntdecidetheprice.Amarketmakerholdingaproductfor secondsorminutescanonlyhavealimitedimpactonprice.Whenfirmsare buyinginsecondone(pushingthepriceatouchhigher),andsubsequentlyselling afewsecondsorminuteslater,theactofsellingwillgenerallybringthepriceback toarounditsoriginalvalue.Onlyinvestorswithlongerholdingperiodsandgreater amountsofcapitalcaninfluenceamarketforasustainedperiod.Speculatorsand HFTstendtohavelimitedcapitalandturnitoverfrequently.Itislargerinvestors andhedgefundsthatbuyanddonotsellthatcanpushthepriceforany significantperiod.However,thistypeoftradingisalignedwithrealownership, andhenceshouldhavealongerterminfluenceonprice. Whilelargerinvestorstradinginfluenceslongertermpriceswings,itisthebuy sidetraderthatisresponsibleformanagingtheimpactoftheinvestors executions.Institutionalinvestorstypicallyemploybuysidetraderstomanage theirtrading.Itisuptothebuysidetradertodeterminethetradingstrategythat alignswiththeportfoliomanagersinvestmentthesis.Buysidetradersare professionalswhohaveafiduciaryobligationtotradetheirclientsassetswith care. Whentradersengagewiththemarket,theyarefocusedonexecutionqualityand worryaboutinteractingwithbadactors.Institutionalinvestorsunderstandhow muchtheyarewillingtopayandhowactivetheywanttobeinthemarket.If speculatorswantedtointercedeandsignificantlymarketupliquidity,investors wouldvanishandthepricewouldsettlebackdown,untilpatientinvestorswould reenterthemarket. Thatiswhatamarketdoes.Itascertainssupplyanddemandandforces participantstopaythemosttheyarewillingtopay.Whenyourunoutofpatience (ifyouandnototherswerepushingthemarket),reversiontakesplace,pricesback downandinvestorscancomebackintothemarketagain. Thisisthecostofliquiditythecostoftrading.
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Cantradingbedonesmarter?Yes.Canitbedonebetter?Certainly.Isthemarket rigged?Absolutelynot. Sowhatifthemarketmarkers/speculatorsandliquidityprovidersallgobust? Whilemanywouldliketoseespeculatorsgobust,marketmakers,speculatorsand HFTsdoprovideaservice.Theypriceproduct.Sincemarketmarkersquoteand quotesarecommitmentstotrade,withoutmarketmakerstherewouldbefewer quotes,lesscompetitiontobeatthetopofthebook,andalessaggressivepricing mechanismforinvestors.Whileinvestorsmayfundtheprofitsofspeculators, withoutvigorouscompetitiontobetopofthebook,spreadswouldwiden,and investorswouldactuallypaymore. Thatsaid,speculatorscantbeallowedtocaptureallofthealphaeither.While speculatorsneedtomakeenoughtosurvive,theyshouldntstripallofthe profitabilityoutofinvestorsideaseither. Thejobofprotectinginvestorsalphamanytimesrestswiththebuysidetrader andthebroker.Thebrokersjob(beithumanorelectronic)istoshopanorderas efficientlyaspossibleandcaptureasmuchoftheeconomicinterestofthetrade fortheinvestoraspossible.IfaninvestorfeltthatIBMwasgoingtomovefrom $190to$200,theinvestorwouldntbehappyifthebroker,insteadofobtaining themarketpriceof$190,paidup$10andboughtthestockfor$200.Ifthat occurred,allofthealphaonthattradingideawouldbelost.Ifthisoccurred frequently,investorswouldgetfrustratedandeventuallyleavethemarket. ProtectingClientOrders Itisthebrokersjobtoprotecttheclientorder.Thewaybrokersprotectclient ordersinafragmentedmarketisthroughsmarttrading.Now,thereisntoneway toexecuteanorder;someordersneedtobetradedaggressively,somepassively, someinblocks,andsomewithcapital.Whilestrategieschangewitheachtrade andeachname,therearecertaintacticsbrokershavedevelopedtohelpinvestors gettheirbestprice.Whileordersadecadeagoweremostlytradedbyhand,in todaysmarket,mostordersaretradedbyalgorithm. Algorithmsaredevelopedtomodelthedifferentwaysthatinvestorswanttheir ordersexecuted,suchasatthecurrentprice(implementationshortfall),averaged VWAPorTWAP(volumeortimeweightedaverageprice),whenliquidityarrives, orinstealthmode.Algorithmsgenerallyhavetwomajorparts:thescheduler,and theorderrouter.Theschedulerwilltakealargerorder(parent)anddeterminethe
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mostappropriatewaytosegmenttheorder(breakitintosmallerpieces,orchild orders)andwhentosendittomarket.Therouterthentakesthechildordersand routesthemtotheappropriatetradingvenue.Thiscouldbeadarkpool,anECN, oranexchange.Eachofthesevenueshasaprobabilityofexecutionassociated withit,andeachhasaseriesofcosts. ExecutionCost Executioncostsarenotjustspreadsandexecutionfees.Someoftheleast impactfultradingcostsareexplicitcostssuchasspreadsandexecutionfees.Other executioncostsincludemarketimpact(whatinfluencedidyourorderhaveonthe market?),adverseselection(wasyourlimitorderplacedcorrectly?),and opportunitycost(wasyourorderplacedatthewrongvenue?). Howparentordersaresegmentedandwherechildordersareroutedhave everythingtodowithhoweffectiveyourtradingstrategyis. Oncethechildorderiscreated,gettingthatordertomarketbecomescritical. Shoulditbeamarketoralimitorder,orsomespecialordertype?Shoulditbe exposedordark?Howmanydarkpoolsshouldbecheckedbeforetheorderis routedtoalitvenue?Shoulditbesenttoapingnetwork(anelectroniccapital commitmentfacility)?Whichexchangeshoulditberoutedto?Shouldthe exchangeroutetheordertoanothermarket,ifthereisabetterpriceelsewhere? Thisprocesscanchangedependinguponthestock,timeofday,supplyand demand,andahostofotherissues.Thisisnotaneasyproblemtosolve. Measurement Justbecausethisproblemisnteasy,however,doesntmeanitshouldnotbe solved.Thebrokersthatdevelopbuysidetradingalgorithmstakethisjob seriously.Thereisntonefirmthathasevertoldmethatitgoesoutofitswayto giveitsclientsapoorexecution.Mostbrokershaveavastarrayoffolksthat analyzeexecutioncostsorprovideTransactionCostAnalysis(TCA)services.This servicetriestoanalyzetheimplicitcostoftradingbyanalyzingeachexecution. BesidesbrokerTCAservices,mostbuysidefirmsanalyzetheirowntrading performance,andthereareanumberoffirmsthatprovideTCAservicesacross brokerssuchasMarkit,Bloomberg,ITG,AbelNoser,ElkinsMcSherry,SGLevinson andothers.Arethesefirmsperfect?Probablynot.Buttheinvestorsspendheavily toanalyzetheirtrading,theirbrokers,theiralgorithms,andtheirimpactonthe market.
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Takeaways Now,isthereasinglebestwaytoexecuteanorder?Arebrokersperfect?Are thereconflictsinthepricingstructureoftradesthatmaypushbrokerstotrade offexchangeintheirowndarkpoolversusatalitexchange?Absolutely.Thatsaid, investors,brokers,andthirdpartymeasurementfirmsaretryingtohelpbetter analyzetheproblems,helpinvestorsshiftflowtowardbetterperformingbrokers andalgorithms,andhelptradersbetterunderstandwherethereisleakage. Wehavenotyetreachedexecutionnirvana. TowardaBetterSolution Brokersalgosarenotperfect.Notradingmachine,beitsiliconorhuman,is perfect.Theidea,however,istocreateamoreperfectandmoreefficientmarket. Thatiswhatcompetitionandfreedomareabout.IfIEXhasabetteridea,great putupcapital,createanewmarket,andseeifitworks.Ifitdoes,itwillgain share;ifnot,itwillgobust. ShouldtheSECrestrictmarkets?Ihadsaidyes.Ihadfeltthatthereweretoo manyexchanges,toomanydarkpools,andtoomanyinternalizes.However,ifthe SECwouldhaveplacedalimitonmatchingvenues,wouldnewmarketssuchas IEXorTripleshothavebeendeveloped?Wouldtheyhavehadenoughfundingto buyanATSlicense?Whoknows?Butonethingisforcertain:Theabilitytobring newideastomarketisahallmarkofourmarkets.IftheSEClimitedlicenses,then newplatformswouldhaveahardertimecomingtofruition. Themostimportantaspectofourmarketsisourtransparency.Eachorderis tracked,eachorderisarchived,andeachtradeisprinted.Thekeytomakingour marketsbetterisbeingabletoanalyzethatinformationtomakeinformation basedjudgmentsthataccuratelyrepresentthetruthforeachinvestor,each brokerandeachmarket.Oncethisinformationisinthehandsofinvestors,they canvalueitastheylike.Iftheycareaboutexecutionquality,thenobtain,analyze andmeasurebrokerandvenueexecutionqualityandshiftyourtradingflow accordingly.Ifleakageislessimportantthanotherservicesyourbrokerprovides whetheronlineaccess,custodialservices,research,orcorporateaccessthen understandthetruecostofthoseservicesandmakeavaluejudgment accordingly. Themarketsarenotrigged.Theyarejustintermediatedandpossiblynot effectivelybrokered.Information,analysisandchoiceareourmostpowerful
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weapons.Analyzeyourtradingdata.Ifyourmanagers,brokers,and/ortrading venuesarenotdoingtheirjobs,leverageyourchoice,sendthemamessage,and firethem! Letsusethepowerofchoiceappropriately.

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