Markets Are Broken

Posted by Jeff Carter
on August 1st, 2012

The price action in the stock market this morning was more evidence to long time traders that markets as they are structured today are broken. If you follow Themissal, Dan_Dicker on Stocktwits, you will get some good information as to just how broken they are.

Technological innovation isn’t a detriment to making a good market as long as there is good market structure for that innovation to play in. What we have today is an antique regulatory system, that allows an antique market structure to form around it.

On the private side, exchanges are paid on volume($CME, $NYX, $NDAQ, $ICE). Their economic incentive isn’t to provide a horizontal playing field to participants. Exchanges have are out of touch with much of their customer base, and cater to the high frequency traders that do most of the volume.

But, what if we look at just one facet of technological innovation, examine how it got started and what effect a change would have. At CME Group, they use an allocation algorithm. The allocation algorithm takes a percentage of each buy and sell order and distributes it across the bid or offer. How much you get relates to how much “size” or volume you are putting into the book. HFT systems routinely bid and offer for gigantic quantities and pull the order as soon as it starts getting hit. They are so fast, they can go the other way, scratching the trade or even reversing themselves against the book and move the market the other way. Independent traders call this getting “chopped up”.

The idea behind the allocation algorithm was to benefit the little guy. Supposedly, it gave them a chance to get into and out of the market. Instead, what it’s done is hurt the little guy. They have to give up the edge to get into or out of the market.

What if $CME got rid of the allocation algorithm? Then the entity or individual that made the market would get the trade. Algos would have to jump ahead of orders in the book that were better bids or offers than them. It’s called a FIFO system, or first in first out.

I notice that on every order I put into the book at $CME, if I am the best bid or offer, immediately I am joined by an algo. As soon as I cancel it, their order goes away, or gets decreased in size. If they took the allocation algorithm away, the market would reward risk takers, and decrease rewards for price takers and “joiners”.

Independent Traders will never win the speed battle with algo traders. Never. However, there are things that exchanges and regulators can do structurally to make the playing field more level.

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Thanks for the link Doug Ross.

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