The Liquidity Problem With HFT In Equity Markets

There has been a little more study on high frequency (HFT)  trading in the marketplace.  Nanex continually tweets out data.  Joe Saluzzi and Sal Arnuk have consistently beat the drum on how HFT was hurting markets.

However, so much money was at stake between the banks and exchanges, anyone complaining was considered a crackpot.

This is an important issue to everyone because the free market capitalistic system is the best way to create wealth.  Having a broken market impacts your daily life. Even if you aren’t trading every day, your retirement fund probably is. And it’s getting screwed.  The issue is non-partisan.

Free markets are a core American value and have been with us since the beginning of time.   But, I want to be clear-the problem isn’t HFT and electronic markets exclusively.  It’s more the way the marketplace is structured and the rules in place that have been put there by market insiders.

This week an academic study has come out along with some ensuing articles.  Rick Santelli did a spot on The Santelli Exchange over on CNBC.  PnF has written about the effects of electronic trading on markets starting back in January of 2010-but hasn’t commented in a while.

Meanwhile, some events are happening that I foresaw.

  • Volume on listed exchanges is down.  
  • There are less participants in the market
  • Markets have less liquidity when they need it.
  • Customers are turning to private markets.
  • Independent traders are exiting the marketplace

Some of these developments will be explained by HFT advocates as macro trends in the market due to over regulation, Jon Corzine, and the fact that in other industries- big brawny competitors tossed a lot of Mom and Pops out of business.  “Hey, we have a crappy economy so volume should be down and with interest rates stuck on 0 volume should be down.”, they might say.

They’d be right.  But, they are also wrong.

As one old trader told me, “How is it that when it was pit traded I was right 70% of the time and now I am wrong 100% of the time?”.  It’s statistically improbable.  Old traders know that markets are screwed up.   Zero interest rates ought to lead to exploding stock volume and options volume.

The major problem:  the playing field is totally unlevel.  It’s so slanted against retail customers that they have 0% chance to make money trading.  They can’t beat the electronic traders.  It’s always been stacked against the retail guy, but today the market looks like Mt. Everest to them.  Oh, and they have to climb it without assistance and without any tools.

Instead of crying about it, I propose some simple changes and then lets see what happens.  For market mavens, I am focusing on the SEC side of the marketplace-not the CFTC side.  They are regulated differently.  The marketplaces exist for far different reasons.  They each have individual issues that are hyper related to the business they conduct, and thus require different solutions.

Here is the way to try and fix the broken marketplace.

1.  End dark pools.  Everyone has to transact business in a centralized marketplace. Compete on the bid/ask spread.  Exchanges provide market transparency.  Dark pools conceal it.  Exchanges provide free flow of information to allow participants to make better decisions, dark pools hide information.

2.  End payment for order flow.  This is economically unsound.  If I could have payed for order flow and traded against it, discarding the orders I couldn’t trade risk free against, I’d own a few islands.

3.  Go to .05 spreads.  The Bid/Ask spread will get thicker.  All penny spreads do is invite front running.  They hurt all in prices (when slippage and commission is figured in)

4.  Force market participants to make a choice-be a broker or a trader. No more trading against customer orders on an internalized order desk and flipping them out to the market for a risk free profit.

5.  Steep fines for orders that intentionally screw up markets.  Quote stuffing and the like should be penalized heavily.  If there is a history of it, kick them out of the marketplace.

6.  No more fungibility-back office clearing that day.  No more +3 days to clear.  It’s an electronic marketplace for goodness sake.  Trades ought to be settled in real time.

7.  Block trades reported to the market within 1 minute of trade being consummated.

8.  Offer co-location to everyone who wants it.  Or develop a system where everyone has the same access to the market with regard to speed.

9.  Do not bring back old the specialist system.

Those simple changes would affect the market place greatly.  I can guarantee you banks, HFT firms and  exchanges, along with the SEC would be against them.  Too costly, too hard to do etc.  It’s because through regulation, and market structure they have built in advantages that no one else can access.

If you aren’t on the inside, competing is like trying to win a NASCAR race with a Fiat 500.  You are guaranteed to lose and might get flattened in the process.

My logic stems from this.  Equity markets are there to raise capital for firms, and to provide a way for investors that took risk on the company to monetize their investment.  Once the firm is publicly listed, it’s a pool of capital for them to grow their business-and a place for people to build their wealth. Period.

If firms or individuals want to try buying and selling stocks intraday to make money, no one should care.  But the rules ought to be the same for everyone.  Democratized markets.  The market is not a Republic.

Leveling the playing field for everyone, including market professionals that seek to make a buck by buying and selling forces them to compete on their skill in stock picking and trend following.  It’s not a contest over artificial points like tiered distribution or speed.

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Here is Santelli’s segment:


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