More Flash Crashes

Had another flash crash yesterday in SPY, one of the most liquid markets in the entire cash equity industry. Fortunately, the rest of the applecart wasn’t tipped over.

For the past several years going back to articles in Pajamasmedia.com and Americanthinker.com, I have written that something is amiss in our markets. This blog has devoted many posts to the problem.  There is a gap. It is turning into a crevasse.

If you don’t believe me because you think I have a particular axe to grind, or am biased toward one segment of the industry, I understand. READ THIS. Tom Peterffy was an innovator back in the late 1990′s at Interactive Brokers.  When I was on the CME board, I spoke with representatives from IB a lot.  CME started the evolution in 1987 with GLOBEX, and nothing really happened in the US futures industry until 1997 with the introduction of the emini S+P futures contract.  Interactive Brokers began to sell that contract to its customers.  It also used electronic order delivery to open outcry pits, trying to speed orders to markets. IB bought a market making firm, Timber Hill to better compete. They were innovative.

Here are some snippets of what Mr. Peterffy wrote:

“The root of the problem, as always, is short-sighted greed on the part of the brokers. Transparent commissions are not enough for them. They want to take more from their customers but without the customers seeing exactly what it is that they are paying. This is done by what is called internalization, which is easiest to illustrate with OTC products. The banks simply take the opposite side of the customers’ orders at prices that leave the banks with undisclosed but huge profits.

It should be shocking, but it probably is not, that according to the Rule 606 reports mandated by the U.S. Securities and Exchange Commission, no major online broker, with the sole exception of Interactive Brokers, sent more than 5% of its orders to an organized exchange. More than 95% of their orders go to internalizers!

Beyond the impact for individual customers, let’s look at the impact of internalization on publicly disseminated prices. Such prices do not even exist for OTC products. But what do public prices mean any more on exchanges where customer orders are no longer routed and it is now only market professionals trading with each other

Second, we must address the issue of fragmentation among exchanges themselves. Some amount of competition between exchanges is a good thing. It keeps costs down, technology up to date and services improved. But having too many exchanges creates difficulties for brokers and regulators and undermines the very purpose of an exchange. In order for brokers to provide best execution, they must be connected to all the exchanges or entrust their orders to another who is. Exchange linkage software is becoming more expensive and difficult to build and maintain, as it has to cope with the complexities of figuring out where best to send an order depending upon who the order belongs to and how much each exchange charges or rebates for what product and for what kind of order.

The right number of exchanges for a class of products is difficult to say, but I believe that if there are fewer than three exchanges in a given product space, the entrance of more should be encouraged. But when we get to five or six, some consolidation should be in order. As for dark pools, they should be made to come into the light and become regulated exchanges, or be restricted to very large institutional participants or be eliminated.

This is a very dangerous development because the purpose of our financial markets is to guide the evolution of our economies by allocating capital to industries and companies that we want to grow, and to allow businesses and investors to efficiently manage risk. If the public comes to perceive that the financial markets are a con game and that they are the marks, then companies and entrepreneurs will not get the funds they need to grow our economies, provide jobs and raise living standards.”

We are starting to reach a tipping point. Many will say I am early in calling this, but I am not.

Timber Hill, the market making arm of Interactive Brokers is going to widen spreads in markets that they make. They also are going to eliminate market making in some markets. These markets will now be more expensive to trade, unless other market makers continue to make tight spreads. However, the volume quoted on each side of the bid/ask will be less, and this increases trading costs without any commission increase. No doubt, other big market making operations are doing the math and reaching similar decisions.

Over 70 billion has left the equity marketplace since the flash crash in May. People are voting with their pocketbooks. Seat prices at the CME are down over 50% from their highs. Market makers and traders are leaving the industry. Volume is being concentrated into fewer and fewer hands. Eventually the entire industry will implode on itself.

Implosion won’t simply hurt a bunch of Wall Street bankers. Markets will be totally dislocated. Dislocation will mean that raising equity capital publicly will be impossible. Floating corporate debt, impossible. Only small clubby private markets will remain, and you’ll need the right key card to get in. If you are not an accredited investor, don’t apply. Main Street will feel the pinch every bit as much as Wall Street.

The core problems are payment for order flow, internalization, dark pools, lack of transparency, and a failure to regulate using a principle of risk/reward-bring back the uptick rule.

The most important facet of any market is price. What the big players in the market do today is intentionally obfuscate price dissemination and what the real price of securities are. Would you go into a store and buy anything without looking at the price? Would you ask if you couldn’t see it? In the stock market today, the customer rarely sees the real price.

Clean running financial markets are integral to operating an efficient capitalist society.

Again, high frequency trading(HFT) by itself is not the problem. It’s poor regulation in Washington that is at the root of the problem. It’s very entrenched banking lobbies that write rent seeking regulation to slant the playing field in their favor.

Barney Frank and Chris Dodd did one of the largest disservices to the American public ever when they totally blew a golden opportunity to get financial regulation corrected. That was the moment. It will be extremely tough to recapture. Unless something happens quickly, the financial market place will eventually implode upon itself.

Addendum
If one wants to see this type of implosion in a microcosm, look at CME Group’s Pork Belly contract. Introduced in the Mid 1960′s, the contract was extraordinarily successful. It became a very useful hedging vehicle for managing the risk of bacon production. The contract grew and grew, until some brokers and locals took things into their own hands. The customers figured out after a number of years that they were not being given a fair shake in the bellies. The contract died.

Risk is still being hedged daily in the bacon industry. It is done specifically through private markets that virtually no one can access. The entire meat industry is cryptic enough that it is very difficult to ascertain price in the belly market.  The Pork Belly contract is still listed, although the open interest in the entire contract is less than 100 cars.

The outcome of this is more volatile bacon prices.

In 1958, Congress passed a law banning onion futures. It made the market less transparent. What’s more volatile, onions or oil? Oil has the more transparent market with more players.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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