Barrons: A Fairer Stock Market for All, By Jacqueline Doherty, 26 October 2009

IN THE PAST 10 YEARS, TECHNOLOGICAL innovation has radically transformed how and where stocks are traded. Regulation, however, has failed to keep pace, leading Wall Street to exploit its newfound liberty in the pursuit of fatter profits and to engage in certain practices that may be hurting smaller investors.

Now the watchdogs are waking up. Securities and Exchange Commission Chairman Mary Schapiro announced potential rule changes Wednesday that could curtail certain trading practices in so-called dark pools, or off-exchange trading platforms, that have sprung up — in part to help traders shroud their identities, and in part to hide transactions from competitors. The SEC’s proposals, including forcing some dark pools to make bids and offers public if their trades represent more than 0.25% of the daily volume in a given stock, follow its recommendation last month to ban “flash orders.” Those enable someone who hasn’t displayed a quote publicly to see orders a fraction of a second before the public can trade on such information.

It’s a safe bet Schapiro won’t stop here — nor should she. Spurred by critics such as Democratic Sen. Edward Kaufman of Delaware, who argues that the drive for more liquid markets “is trumping transparency and fairness,” the SEC has begun what its chief calls an “in-depth review of multiple market-structure issues.” In coming months the agency is likely to investigate whether computerized high-frequency trading confers unfair advantages on trading companies with superior technologies, particularly those able to situate, or co-locate, their servers at the major stock exchanges, enabling them to capture and process information ahead of other market players.

The SEC also is likely to examine and possibly restrict direct market access, which enables some investors, such as high-frequency traders, or HFTs, to pay for the use of broker/dealers’ identification to trade directly with exchanges in a way that bypasses the risk analysis and oversight that dealers provide. The inability of such a piggybacker to settle its trades potentially could put the entire system at risk.

Schapiro hasn’t signaled publicly her intention to study the growing practice among exchanges of offering rebates in return for orders, but this, too, would seem to warrant a closer look. In addition to the obvious questions such “pay for play” arrangements raise, some market participants say that capturing rebates, not buying and selling shares at the best available prices, has become the raison d’être of some HFTs.

Here is a closer look at several market practices that could face regulatory scrutiny — and at potential changes in each arena that could make today’s brave new world fairer for all investors.

THE STOCK MARKET’S MOVE in 2001 to price shares in decimals, not sixteenths, set the stage for today’s market structures, in which computers, not the New York Stock Exchange, play the starring role. By shrinking the difference between the best bid and offer on liquid stocks to a penny a share, decimalization hurt the profitability of the Big Board’s market makers. Many left the business, while others grew more risk averse and reduced the size of their trades. By the end of last year, the average trade had fallen to 250 shares, from more than 1,400 in 1997.

In 2005 the SEC enacted Regulation NMS, which linked all exchanges and market makers, allowing traders to see the best quotes available and trade in the market that offered the best price. This forced the NYSE to move to digital systems.

High-frequency trading, conducted by computers that place trades in less than a second, millions of times a day, flourished amid these changes; it now accounts for 70% of daily U.S. trading volume, according to TABB Group. Its explosive growth has led to greater volume and liquidity, and significantly lower trading costs. But technological superiority also may benefit the market’s biggest traders at the expense of other investors.

Institutional investors typically rely on the consolidated tape to provide the most recent quotes on shares. The tape gets information from all the stock exchanges, sorts it and “prints” the latest quotes within five milliseconds. It then transmits this information to data providers such as Reuters and Bloomberg. In their quest for speed, some HFTs now pay to place their servers at the exchanges to capture information milliseconds ahead of competitors.

Critics are crying foul. “It’s not a fair playing field if you need a massive infrastructure to have the same access to order flow,” says Ross McLellan, an executive at State Street Global Markets.

Others fear HFTs, with their superior speed and ability to gather information, are driving stock prices to the detriment of “legitimate” buyers. Bob Gasser, CEO of Investment Technology Group, which advises institutions on how well their trades are executed and operates a dark pool, offers a theoretical example: An investor hoping to buy 100,000 shares of a stock tests the waters by making two purchases of 500 shares each. An HFT, which has sussed out interest in the stock, steps in and accumulates shares at a slightly higher price. When the original buyer — your mutual fund, perhaps — re-enters the market, the HFT sells its shares at a profit, pocketing the difference between its purchase and sale price.

Technology inequality is a thorny issue in all spheres, not only trading. If the exchanges stopped selling co-location services, others would build server farms next door to the NYSE or Nasdaq. To combat the HFTs’ potential ability to trade ahead of other market players, the SEC ought to consider forcing the Consolidated Tape Association, keeper of the tape, to increase the speed with which it disseminates information to all traders. “CTA will continue to look at reducing the amount of time it takes to process messages from the exchanges,” says an association official.

Even so, HFTs are likely to continue to enjoy an advantage — albeit a smaller one. In return for that opportunity, some market participants think the SEC should require them to make better-than-posted markets a certain percentage of the time during the trading day. After all, that’s what market makers did in days of old, notes an executive at a broker/dealer.

TO ESCAPE DETECTION by HFTs, institutional investors have been flocking to dark pools. Thirty dark pools, the largest run by Credit Suisse and Goldman Sachs, now account for almost 10% of total equity trading in the U.S. They enable institutions to submit bids and offers that aren’t posted publicly, and that are crossed only if a matching order exists or buyer and seller agree to trade at the midpoint.

Only three dark pools — Pipeline Trading, Liquidnet and ITG Posit — trade “institutional-sized” blocks of 6,000 to 50,000 shares, according to Rosenblatt Securities. Most of the rest trade in blocks of 300 to 400 shares. This suggests they have opened themselves to HFTs, which also trade in small increments to minimize risk. Despite concerns that HFTs may be profiting by deliberately moving prices, Richard Gates, a portfolio manager at TFS Market Neutral Fund, thinks they’re welcome because they create the trading volume dark pools need to survive.

Unlike the New York Stock Exchange, whose share of U.S. trading volume has plummeted to 27% in recent years, dark pools don’t have to provide market surveillance. Thus, some fear they are attractive to potential manipulators.

“When activity is fragmented among multiple venues, it’s harder to police,” says Joseph Mecane, an executive vice president at NYSE Euronext, parent of the NYSE. What’s needed, he says, is a central regulator with access to data from all stock-trading venues — dark pools, electronic-communication networks and exchanges — with all parties shouldering the cost.

Yet cost is one attraction of dark pools to the brokerages that run them. By putting orders through their dark pools, these firms avoid exchange fees and get paid by both sides when they are able to match bids and offers, says Seth Merrin, founder and CEO of Liquidnet.

As more trading leaves the regulated exchanges, some fear the price-discovery role they have played will be damaged, and the efficiency of the capital markets harmed. The increase in trading volume executed through dark pools raises “the potential for dark pools to detract from the quality of public price-discovery mechanisms,” Schapiro said in a recent speech.

While the SEC’s latest proposals aim to expose some dark pools to more light, more action may be needed. If adopted, these proposals probably would stop dark pools from sharing indications of interest, or IOIs, the equivalent of bids and offers, with anyone. Regulators fear nonpublic postings of such information could lead to the creation of a two-tiered market that hurts those with access only to public best bids and offers.

Eleven dark pools use IOIs, according to one analyst. Pools run by Goldman and Credit Suisse don’t. The SEC’s move to require dark pools to publicize bids and offers above 0.25% of the daily volume in a given stock — the threshold currently stands at 5% — applies only to those sharing indications of interest. The agency also wants to compel dark pools to identify themselves when reporting trades to the tape.

Some exchange officials had expected the SEC to recommend lowering the threshold for publicizing bids and offers to 2% of daily volume for all dark pools. That likely would have driven more trading to the exchanges, but so far, it’s wishful thinking.

ONE WAY DARK POOLS and exchanges have competed for business is by making trading cheaper. Lower costs are especially attractive to high-frequency traders, who cross millions of trades a day.

Some dark pools, stock exchanges and other trading platforms are offering rebates to broker/dealers or others willing to post bids and offers. They charge those who take the other sides of the trades. Under such “maker/taker” pricing, rebates often can range from 10 cents per 100 shares to 30 cents, depending on the platform.

Rebates were supposed to incentivize traders and investors to post liquidity, thereby improving markets. But some fear dealers are going to venues that offer the biggest rebates, not those that give clients the best execution. “For some high-frequency traders, rebate trading is their business,” says David Easthope, a senior analyst at Celent, a financial-services-industry consultant. “The rebates have a huge influence on where the orders go.”

So far, the SEC has given no indication it is concerned about maker/taker pricing. But other payment-for-order-flow schemes have been curbed by regulators in the past. An SEC spokesman declined to comment.

BROKER/DEALERS VYING for business from high-frequency traders also have adopted some potentially dangerous practices. While HFTs such as Getco have registered as broker/dealers, gaining direct access to exchanges, other traders have gained such access through their dealers. HFTs seeking faster execution co-locate their servers at the stock exchanges and use the dealers’ identification to trade directly with the exchanges, an arrangement known as naked sponsored access.

Unlike their dealers, high-frequency traders enjoying naked sponsored access aren’t subject to capital requirements, or to SEC audits, says Larry Tabb, founder of market-research firm TABB Group. They can also sidestep the oversight and risk-management analysis that dealers provide before trades occur, and enjoy pricing discounts received by the dealer for high trading volume.

The lack of pre-trade analysis and risk-management could lead to severe problems. If, for example, a trading customer doesn’t have the funds to settle a trade, or its computers malfunction, sending unintended trades to the exchanges, the dealer must make good on the transactions. Some dealers themselves might lack the capital necessary to step in on a client’s behalf.

“Goldman Sachs believes that naked sponsored access introduces the potential for significant systemic risks due to the lack of appropriate pre/intra/post trade controls,” the firm recently wrote in a report provided to legislators. Goldman doesn’t allow its customers naked access.

Wedbush Securities is one of the largest dealers that does. The firm says all trades go through clients’ risk-management systems, which Wedbush inspects before giving them access. Wedbush tests those systems and does post-trade analysis to ensure clients’ risk-management systems have worked, says Jeff Bell, head of clearing and technology at the firm. So far, clients have managed risk well.

The SEC’s attempts to wrestle with the fallout of modernization are belated. But any effort to improve transparency and level the playing field is bound to benefit investors.

Overview Of Goldman Sachs Electronic Trading: Part 1

By Tyler Durden

Created 10/04/2009 – 21:04

Zero Hedge is starting a multi-part overview of Goldman Sachs’ Electronic Trading client-focused product suite, to demonstrate just how extensively embedded in modern market architecture are Goldman’s various DMA and “liquidity” facilitation schemes, and the depths of dark pool domination via Goldman’s global order router, and other specific topical offerings.

Our first focus is on Goldman’s DMA/liquidity/order router integrated suite, represented by REDIPlus and Sigma, as well as Goldman’s privileged access dark pool, SIGMA X.

A first and key observation is that Goldman’s Direct Market Access program accounts for over a whopping 1 billion shares daily, as disclosed to clients by Goldman itself. When one considers that the NYSE’s trading volume has recently been in the 1-1.5 billion shares per day range [1] (a number that has been consistenly dropping over the past decade, and explains the NYSE’s animosity toward other new exchanges such as Direct Edge, which however shot themselves in the foot by procuring clients thru the adoption of such shady practices as Flash Orders), and one can see how Goldman is becoming a dominant force in the market landscape, and why all other market participants are sweating profusely. This is true now more than ever, now that the Fed and the U.S. government have indicated that no matter what happens, Goldman Sachs will never be allowed to fail, no matter how great of a risk it takes. If in the meantime, it is allowed to gain an exclusive monopoly in any one aspect of the market, so be it.

Goldman increasing domination via DMA routing also explains its careful treading when it comes to DMA discussions with the regulators: any major change (which also includes any hits to Goldman’s well-greased machine that would result as a function of a ban on Naked Short Selling, and subsequent attempts by Goldman’s well placed lobby efforts to prevent such a ban [2]) would likely result in a need to dramatically overhaul its product offering which so far has been so efficient and attractive to new clients, it is on par to challenge the NYSE in share volume. For some very prophetic words of caution on how dangerous DMA could be if it were to go haywire, and slip out of control, we refer readers to the following discourse by Lime Brokerage principals [3]. And, as one can expect, the debate here is about so much more than pre-trade or post-trade monitoring.

Orders routed through Goldman’s router for the most part end up on various semi-dark exchanges, ECNs and crossing networks.

As Goldman itself discloses, the Objective/Strategy of its SIGMA Smart Order Router, consists of the following:

• SIGMA is the Goldman Sachs smart router
• SIGMA breaks up an order into smaller pieces with the objective of maximizing liquidity at the most favorable price
• Accesses every ECN and public destination under Reg NMS
• GSAT algorithms leverage the SIGMA smart router for all child orders
• 15-20% of SIGMA volume is executed within SIGMA X

A graphical representation of the order routing distribution can be seen below:

[4]

And here is the simplified explanation of the three primary tracks in the diagram above, direct from Goldman Sachs:

1. Algorithmic Orders systematically post liquidity to SIGMA X and other ATSs. Additionally, child orders are routed via the SIGMA router, accessing SIGMA X and other non-displayed liquidity before ultimately reaching the public markets.
2. SIGMA Smart-Routed Orders are DMA orders that pass through SIGMA X, benefitting from potential price improvement due to enhanced liquidity.
3. SIGMA X Posted Orders sit passively on the SIGMA X order book, where they can interact with pass-through DMA/algorithmic flow and other posted orders. Orders posted to SIGMA X receive full price improvement when interacting with opposite-side marketable flow.

In summary: Goldman keeps procuring more and more clients who use REDI, Sigma, etc., for the sole reason that Goldman now provides a practically alternative “exchange” to virtually every other full/major access venue. Obtaining “privileged access” to SIGMA X provides Goldman PB counterparties with what is quickly becoming the best populated and highest “inventoried” dark venue in the world. And the kicker: few if any know who trades what on SIGMA X. A major threat to technicians: open exchange volume is increasingly representative of exactly nothing, as all the real action occurs in the gray, and mostly dark, arenas (and of course, in OTC CDS). Which is why as the administration is transfixed on the DJIA, even that is becoming increasingly disjointed with whatever is left of the true market. And as Zero Hedge has been pointing out, the economy has long since stopped being represented by the stock market. It is only fitting that the market is only no longer representative of “itself” – compliments of Goldman Sachs.

In future posts of this series, we review Sonar, Sonar Dark, benchmark matching via OptimIS, PortX, VWAP, TWAP, dynamic participation, reactive participation, price and liquidity seeking, and other topics where Goldman has stealthily become the primary market force.