Time to Rethink a Broken Market

Yves here. Readers are likely to assume that the “broken market” of the headline is US housing related, say the private mortgage securitization market, but the subject is what once was the gold standard of trading markets, equities.

Index Universe has cited a study by the Tabb Group that finds that investor confidence in stock markets is even lower than in the period immediately following the flash crash of 2010. Back then, 53% of respondents had high or very high confidence in the markets, and only 15% weak or very weak confidence. As of its August 2012 survey, the number with positive views and negative views were equal, at 34%. This interview with Chris Sparrow, an expert on high frequency trading, describes why he thinks the market is now fundamentally flawed and what can be done to reform it.

By Paul Amery, editor of Index Universe. Cross posted from Index Universe

IndexUniverse.eu: Chris, what’s wrong with the current structure of equity markets?

Sparrow: The current market structure is fundamentally unfair, since different participants have unequal temporal access to information.

To put it simply, if other people can see that your order has been filled before you can, or that there’s been an update to a price quote before you are able to see it, you’ll lose confidence in the market.

This comes down to how price signals are propagated. Currently, no two participants receive price and quote information simultaneously. If you want to ensure fairness in the markets you need to level the playing field for everyone.

If we can fix this then we should be able to restore some confidence to the markets and trading volumes, which have declined dramatically in recent years, should recover.

IndexUniverse.eu: Is the fragmentation of equity market trading between different venues a concern?

Sparrow: I’m not concerned with fragmentation per se, as competition between trading venues is good. What’s missing is synchronisation and coordination.

Let’s take the air travel system as an analogy. Airlines want to minimise fuel use and so all have an incentive to land their planes first. If you allow that, you’re going to have lots of crashes. Regulators impose structure via an air traffic control system, reducing the systemic risk.

Such coordination simply doesn’t exist in the equity markets today and regulators tend to take a passive role, watching what happens and taking action after the event if something goes wrong.

I’m not for overregulation and in my opinion introducing competition between trading venues, which happened in the US under Regulation NMS in 2005 and in Europe following the introduction of MiFID in 2007, was a good thing, as I’ve said. But there have been some unintended consequences of these reforms that now need to be dealt with.

IndexUniverse.eu: Should exchanges be forced to go back to some kind of utility status from their current for-profit model?

Sparrow: I don’t think that’s necessary. I think the for-profit exchange model can continue to exist, but subject to a requirement for synchronisation.

Here’s another example. Let’s say I buy a solar panel and want to contribute electricity back to the grid. If I want to do that I have to supply the electricity at 60 Hz. I can’t unilaterally decide that I want to give the electricity back at 45 Hz.

There’s an infrastructure requirement that should be based on a policy of coordination. If I want to build an ATS (automated trading system) and plug it into the rest of the market grid I should have to do so in a standardised way. Otherwise the system will generate a huge amount of quote “noise” and introduce exploitable latencies that act to inhibit fair trading.

IndexUniverse.eu: What led you to identify the current trading system as a problem?

Sparrow: I’ve done a lot of work in transaction cost analysis (TCA). I was looking at a particular order and for purposes of comparison wanted a proxy for the Canadian equity market. For this I used the iShares S&P/TSX 60 ETF (TSE: XIU).

It turned out that there were a million quote updates in this ETF during a single trading day of 23,400 seconds. Why do we need so many updates? They impose significant storage requirements on everyone, take up significant network bandwidth and arguably do not contribute significantly to price discovery.

All the trading data that’s being produced is an externality on the whole market. We all have to buy bigger hard drives, bigger servers and network switches just to process the data, even though there’s little extra benefit in doing so.

IndexUniverse.eu: So what do you propose as an alternative?

Sparrow: My suggestion is the following. At a single point in time, which we call T0, you open up the order book and allow participants to enter orders, without anyone being allowed to see them. You and I can enter orders up to a second point in time, called T1, at any venue we choose, but we can’t see or react to each other’s activity.

At T1 (plus, in practice, a small delay to ensure the order entry session is closed) the trading venues try to match as many buy and sell orders as possible and to establish a single, market-wide clearing price. At that point all trades get printed and the residual state of the book, consisting of unmatched orders, gets published, as would the location of the unmatched orders. In other words, competition between trading venues could continue.

And by ensuring that matching orders get cleared, we do away with some of the problems that exist under the current system of continuous trading. For example, in the current structure it’s very easy for there to be “locked” markets, where the bid price at one trading venue equals the offer price at another venue, or “crossed” markets, where the bid at one venue exceeds the offer at another. These situations could be eliminated through co-ordination of the matching process.

IndexUniverse.eu: Who would coordinate the times at which this clearing process takes place, and how often would it occur?

Sparrow: I would suggest that regulators set the time standard to which exchanges and other trading systems must conform. And I think that the market clearing price could be set every second. Since the market would tick from clearing price to clearing price every second, from a larger time perspective trading would appear almost continuous, and that’s why I call this model the continuous call market.

IndexUniverse.eu: If the clearing price changes each second, how long does it take within each second for the price to be established and disseminated?

Sparrow: I think that this can happen within a couple of hundred milliseconds—that is, a fifth of a second—at most. In Canada, the geographic latencies between different data centres are in the order of single digit milliseconds.

IndexUniverse.eu: Would the system you’re proposing get rid of all abusive types of high-frequency trading?

Sparrow: No, not all. I think this system would get rid of the worst form of abuse—latency arbitrage—where individual participants can pay extra to exchanges to get a “first look” at price quotes. But you’d still have activities like “spoofing”, often called layering. The idea is to level the playing field with respect to the dissemination of information.

IndexUniverse.eu: What does “spoofing” mean?

Sparrow: Spoofing means that if I’m trying to buy a stock I enter a whole lot of offers I don’t really want to execute into the order book to make it look as though there’s selling pressure. This activity is designed to make other market participants nervous and to “cross the spread” and hit my bid for the stock.

IndexUniverse.eu: But that kind of thing could happen when traders were all physically located on an exchange floor and transacted face to face.

Sparrow: Exactly. You’re not going to get rid of all nefarious behaviour. But what I’d hope to do is remove is what I term “technological adverse selection”—where participants can pay up to be in a privileged position by comparison with everyone else. If you’re an HFT and I’m a traditional buy-side investor you can see and react to the market more quickly than I can and you have an advantage. Let’s remove that advantage.

Is the market about “the guy with the best technology wins”, or “here’s a mechanism to allow the transfer of capital”? I think it’s the latter and people should compete on a level playing field and to win based upon how smart they are, not because they’ve won the technological arms race.

Chris Sparrow’s proposal for reforms to market structure is outlined in more detail here

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      HFT = frontrunning

      Shorter article

      Foe old guys, we’ve seen market confidence in ’50-60′
      still a long way to fall…..

  1. Clive

    Suspect too that this is the reason for the decline of equities as a proportion of investor’s funds under management — at least with, say, bonds there’s a more prescriptive framework (including contract law) to give a better idea of what you’re actually getting, what you’re entitled to in what circumstance.

    Unfortunately there’s still enough retail muppets out there who believe that equities today are like the equities of 20~30 years ago…

  2. psychohistorian

    I would assert that as long as the solution is time driven instead of event driven it will continue to be gamed for profit.

    I agree with the sentiments but challenge folks in that arena to put forth an event driven solution.

  3. Hayek's Heelbiter

    Why wasn’t a Tobin tax considered? Or a way to impose a feel on orders that are never meant to be fulfilled? Just curious.

  4. Chromex

    What I did not see here is that anyone who knows how to read a balance sheet and can analyze the underlying values of the claimed “assets” can clearly see that the market remains highly overvalued. Absolutely insane growth which has not manifested in a sustainable way has been priced in for the next century. This is the reason for my lack of confidence. I am not confident that high frequency trading abuses, while deplorable, are very responsible for this lunacy , where both bad and good news is treated as an excuse to leap into equities because the fed’s feudal ZIRP has quashed the alternatives and because everyone has budgeted asset appreciation into their lifestyles ( if I can’t get interest on my cds or bonds , they think, I must go into equities- oh look the market’s going up). Don’t think this can end well.

  5. s jay

    You really think this gedanken experiment is going to result in a better market than the one determined by competition among the self-interested participants in the market space? HFT is a cutthroat business, and that very competition insures that only those that create real value can survive. It’s certainly inconvenient that information arising from millions of agents worldwide impinge on the market continuously, but modern technology has allowed this situation to be handled ever more efficiently. Throttling technology due to perceived but dimly understood bogeymen is not a prescription for enhancing the trading experience. (Sorry, I don’t find the millions of ETF quotes disquieting at all, it’s only evidence that the price I’m paying when I buy or sell the ETF is incredibly accurate, and I didn’t have to pay much for that. Hooray! Declaring that something is an externality, and that’s it’s costly, without describing the benefits created by the “externality”, is not very illuminating or believable). Different participants have different access to data because the processing of that data is enormously expensive, so we pay third parties to do it for us, it’s cheaper. It’s one of the best bargains going.

  6. F. Beard

    but the subject is what once was the gold standard of trading markets … Yves Smith [emphasis added]

    Et tu, Yves? Does not gold have enough mystique without propagating the “gold standard” meme?

    I suggest the following instead: “the gold fiat standard” of this or that. Or “the gold standard [sic].” That should rile the gold standard folks and perhaps make them think.

  7. polistra

    Can’t fix it. Just let it fail.

    Sane people are already avoiding the stock market. New institutions (crowdfunding, Kickstart, etc) are developing to replace it. These new institutions perform the job that a stock market WAS SUPPOSED TO PERFORM.

    As long as suckers continue to put new money into the old corrupt institution, it can stay alive. With no new money, it will die quickly.

  8. MacCruiskeen

    “This comes down to how price signals are propagated. Currently, no two participants receive price and quote information simultaneously.”

    Einstein’s theory of general relativity demonstrated that observers in different references frames would never receive price and quote information simultaneously. So this is in accord with Einstein’s predictions. Heisenberg went further and said that price and quote couldn’t both be known precisely at any given moment. Bohr, of course, believed that price and quote were not determined until actually measured. We will put aside, for the moment, Everett’s Many-Price theory that price and quotes are never determined, but all possibilities exist. This is clearly absurd.

  9. Warren Celli

    This article is simply another — “Oh poor me the current market structure is fundamentally unfair!” — Vanilla Greed lament.

    Vanilla Greed for Profit Evilism turns cry baby after having its clocks cleaned by Pernicious Greed for Destruction Xtrevilism.

    Boo hoo! Oh how sad! The big bullies, who claim they are playing fair, are beating up the little bullies, who claimed that they were playing fair in the past. The little bullies now weep and moan, “Oh please everyone, help us put the fart of Pernicious Greed for Destruction back in the rectum of deception, it is destroying our fine fragrance of Vanilla Greed for Profit.”

    It is ‘time to rethink a broken morality’ that gave birth to the parasitic markets that were unfair in the first place. It is time — well past time — to ponder the real meaning of ‘do unto others what you would have them do unto you’.

    Deception is the strongest political force on the planet.

  10. Chris Cook

    In my view the optimal market structure is a mix of bilateral/P2P/OTC and multilateral auction along the lines Chris Sparrow outlines.

    The London Metal Exchange and the London precious metals markets evolved organically into this structure because it was ‘what worked’.

    But markets – particularly the equity markets – are broken in more than one way.

    The presence of ‘passive’ risk averse investors (ie ETFs, ETPs and structured products) in the market – who are intent on avoiding loss, rather than speculatively making transaction profit – has literally killed the price formation of all of the markets which they have financialised, and which have become correlated as a result.

    The outcome is zombie markets awaiting final termination when the bubbles collapse – which they will, and sooner rather than later.

    1. Susan the other

      Your article about how peculiar oil trading has become was interesting. Is the oil market so not-a-market that simply by controlling the development and distribution of oil it has become price controlled? So how much of HFT is hedging? Most of it? What a nemesis. How long have we seen this coming?

  11. Another Gordon

    Many years ago – sometime in the 1980s from memory – the New Scientist’s brilliant Daedalus column of mad ideas proposed that there was an opportunity for share trading to exploit the very rapid fluctuations in sentiment that were far too fleeting to be traded.

    It was, of course, completely ridiculous – oh wait …

  12. Hugh

    Something wrong with this posting, the text of the post disappears off the screen (and then there’s that thing with the bold). The equities markets are a complete con from one end to the other. It isn’t just high frequency trading, spoofing, or latency arbitrage. There is something seriously wrong when the average time a stock is held is around 20 seconds.

    And there is information asymmetry in the form of insider information, the planting of market rumors, the dark pools.

    Finally, there is the valuation of the stocks themselves. Does anyone seriously think that Apple is worth $618 billion or Facebook $39 billion? Are they really worth even a tenth that much? And when I say “really” I don’t just mean bricks and mortar or profits but value to our society?

    Or just look at the level of the markets themselves and then relate that to the sinking economies of the US and Europe, and maybe Japan, and the slowing economy of China. Look at all their negatives, what hasn’t been fixed, who’s being looted. How can the DOW be trading at over 13,000 in such economic waters? A realistic valuation of the markets would be probably half of what they are currently trading at.

    In this kind of environment, you are either a shark or a harbor seal, a card sharp or the patsy. Some investors have tumbled to this fact and gotten out or reduced their exposures. Some haven’t. These are the bagholders. Many of them are pension funds. The funds need the pumped up, but temporary, profits of the markets to cover their underfunding, and to justify the paychecks and bonuses of their managers. When the sh*t hits the fan, the managers will be gone. Unfortunately, so will be most of the funds.

    1. F. Beard

      We should make sure everyone has a generous pension (provided by the monetary sovereign) and essentially tell workers that private pensions are a form of gambling.

      That means, in the US, that SS benefits should be increased on a means tested basis and also that the Payroll Tax should be repealed. That would allow workers to use that money to gamble in the Stock Market if they wish and if they lose they can fall back on SS.

      1. Susan the other

        It makes sense to me that we guarantee a living benefit for those over 65 or disabled and that on the other end of the age scale we guarantee a good education for our next generation who will soon be the very people who make the economy work. And everybody in between will also have a guarantee – that of a job. I’m probably a little too ready to guarantee things than you are – but this still leaves plenty of room for free enterprise. About 40 years.

        1. F. Beard

          I’d do the education with vouchers. I went to High School in the late 60’s and only 1/2 of my teachers were good. Have things gotten any better? I doubt it.

          And everybody in between will also have a guarantee – that of a job. StO

          Nope. Instead we should have land reform to get people back onto family farms and a BasicIncomeGaurantee so they would never starve there in case of a bad crop. With those two things, the private sector and a legitimate public sector should provide adequate jobs.

  13. Susan the other

    Sparrow says, “The question is: Does the guy with the best technology win or should there be a mechanism to allow the transfer of capital?” I’m assuming he is asking only if there should be a pause button while your high-frequency-trade is being “verified” or stg. But if these are all big hedge trades, pausing them a few moments won’t improve the market will it?

  14. LeonovaBalletRusse

    “But profit-hungry capitalism doesn’t die; it morphs into its zombie-like, undead phase. Growth-less capitalism turns catabolic. The word catabolism is used in biology to refer to the condition whereby a living thing feeds on itself. Thus, CATABOLIC CAPITALISM is a self-cannibalizing system whose insatiable hunger for profit can only be fed by consuming the society that sustains it.[1]”
    [caps mine]

    Better COIN than even Bitcoin! READ the rest at:

    “It’s the SYSTEM, stupid.” (Anon.)

    1. LeonovaBalletRusse

      But note: real property does NOT “vaporize.” Assume all mega-wealth stolen:

      CLAW BACK all real “fixed” property whether naked or improved from .01%DNA, CLAW BACK all property held/secreted in bank accounts/trusts/financial instruments/etc., and establish Global 90% “Death Tax” on ALL inheritance, abolishing “trusts” used for stealing/hoarding .01%DNA wealth. Abolish the “right of primogeniture” world-wide, so that 10% inheritance equitably divided among all “legitimate” and “illegitimate” progeny. CLAW BACK wealth that absolute despots have looted from their subjects through centuries and place into the public treasury for redistribution.

      Bring Michael Hudson, who comprehends Private Lebensraum schemes through the ages. BUST the TRUSTS.

  15. briansays

    based on limited personal experience i got out of wall street after changing jobs in 2000 at 50 except for new 401k money and parked my money and was lucky to avoid the dot com/con bubble and subsequent subprime bubble

    had i not i could easily been like my former co-workers who lost typically ten percent or so of their 401k for each bubble

    we are not talking about sophisticated investors these are people relying on a menu of options and degrees of risk provided by an employer

    in large part as a result i retired at 57

    my conclusion is people will sell you shit or crap and lie about if they need to for a living or at best a large number are just incompetant

  16. monday1929

    Someone is allowing the very basis of Capitalism to be destroyed. Who would do that?
    A system with roots going back before English Common Law is being gutted.

    Property Rights and The Rule of law.
    The Property recordation and transfer mechanism.
    The Constitution.
    The Bill of Rights.
    The Geneva Convention.
    The Capital Formation mechanism.

    Who would do this and WHY?

    1. LeonovaBalletRusse

      Always and ever, it’s about .01%DNA DYNASTIC power/control for Extraction of Wealth/Resources/Lebensraum With Impunity In Perpetuity.

      Guillotinage awaits.

      1. different clue

        Oh? Does it? Blackwater/Xe/Whatever it calls itself now would say different. So would Triple Canopy, Dyncorp, etc. So would all the various levels of police and enforcement departments with their Portable Raytheon OvenRays, their sound-torture L-Rad machines, etc.

        Lowerclass people might better focus on mutual co-survivalism and economic resistance and rebellion and sustained economic sabotooge. Some dreamy dreams of guillotinage fantasies furnish fun, to be sure; so long as they do not divert excessive time and energy away from building survivalism. For now, we must find or build our Caves of Yennan.

    2. psychohistorian

      If you are the global inherited rich, you are doing it as part of your ongoing control of “Western Democracies”.

      The Shock Doctrine events you are seeing in the EU and US are meant to drive down global wages, destroy government organized social safety nets, and “reduce population pressure” in the face of resource limits.

      Our world is not run by the best and brightest, it is run by the global families that have managed their inheritances into social control.

  17. kevinearick

    Alberta Oil Sands / Competition for Idiots

    It’s just paper folks; it’s just paper. Without labor, capital vanishes, middle class first. Capital always “thinks” that it can extort labor with paper, paid to the middle class, until it learns, the hard way, once the distillation process is complete, that it cannot. Whoever is left standing installs the bridge, if their pieces fit together in the necessary ac wave to complete the circuit, with the necessary negative feedback loop. Those that have been preparing will do well, because they will not get run over by the stampeding herd.

    It’s about productivity, relative to nature, and, contrary to empire false assumption, nature is measuring you. Tithing is not about money; it’s about community. When you look at the 10% of actual community production, and place it back into the feedback loop, to guide the local economy, by ensuring that its metabolism is sustained and the necessary surplus for trade is grown, you will see the problems immediately, that are otherwise hidden by the false assumption of money and the empire propaganda machine sustaining it from the womb, which returns a surplus to non-performing capital, the gravity that now contains and is crushing the global economy.

    Take a look at the finances of Alberta, relative to the finances of Canada, and then take a look at the proposed solution, North Dakota, in the US. It’s ugly, an implied contract price of $95 barrel. Obama or Romney, Bernanke or someone else, 6 of one, half dozen of the other…sooner or later has become later.

    The only people cultists hate more than each other is everyone else. Who you know, who you …is not an economy. The real economy is not collapsing; the empire is. Nature will be here long after these a-h- s are dead and buried.

    If I have surplus, give it to you, and measure my return over time…the “evil” empire is not your enemy; the enemy is the hall of mirrors between you and your self, which exists of your own free will. Hard to believe…pioneers actually walked 2000 miles to Oregon, and their descendants can’t bring themselves to walk to the grocery store, or hire a stranger, the will of which they are entirely dependent upon, to complete the work required. You just can’t find labor anymore, surprise, surprise.

    If a community will not accept you and your spouse at the inn, continue until you find a community that will. There is never a lack of gravity for the necessary transformation, on earth or anywhere else.

    Spin that wheel again…watch how everyone bets, set the odds, and wonder why the dc computer crashes.

  18. ebear

    HFT is just a smokescreen. I see no mention of leverage, counter-party risk, the VAR model, TBTF, phantom shares, co-mingling accounts, or any of a host of more serious problems plaguing the markets.

    I could sling a dozen paragraphs on this subject, but it isn’t my blog, so I’ll just make one observation:

    Under the “I’m nobody special” rubric, I observe that my actions in relation to the market more often than not reflect the general mood. So what am I doing right now? After 25 years of investing/trading, I’m shutting down. In the past, it was more effective to distribute risk over various assets according to the standard formula. That’s not true anymore and I don’t see it changing anytime soon. So, since there’s no way to avoid it, I’m taking my capital and investing it in a private business where I can more effectively manage the risk.

    I’ll just add that the market today has more myths attached to it than ancient Greece, but while the Greeks used myths to illustrate basic truths, today’s market uses them to hide the truth, and as smart as I am, I no longer have the patience to try and separate myth from reality, and thus I elect to create my own.

    So to the market I say, “so long and thanks for all the fish.” And to anyone considering that trade today, I say to them “the only way to win is to not play the game.”

    And yes, I took out more than I put in, but that’s what Boomers do, right?

    1. different clue

      Only the affluent and rich Boomers do that. The poor and near-poor working class Boomers spend their worklives ever since 1983 paying double for Social Security . . . . the money needed to fund benefits for current recievers and also the money needed to prefund those selfsame Boomers when they reach SS-age. And now we see Catfood Obama conspiring with the Republicans to make sure that our prepaid SS money which was stolen from us for Bush’s upper class tax cuts reMAINS stolen from us through the mechanism of SS-benefits cuts or cancellations to us the prepayers when we get old.

      So . . . that’s what Boomers do? Speak for yourself, Richie Rich.

      1. Lambert Strether

        Thank you. Exactly.

        NOTE That strategic hate management of boomers and elders generally is an important component of the 1%’s plan to gut social insurance programs like Social Security and Medicare. The vilification of Clint Eastwood should be put in this context.

      2. ebear

        Richie Rich, eh? LOL! You Americans. When you’re not consumed by greed you’re consumed by envy. At least the people I gamed were adults who had their eyes open. Social security? Feh. The people you hope to game haven’t even been born yet. How pathetic is that?

  19. Paul Jurczak

    “I think that the market clearing price could be set every second” – that HFT habit must be very hard to drop! How about every hour or every day? If you really worry about “different participants have unequal temporal access to information”, one second time quantum still excludes most individual investors, who interact with markets through keyboard/screen or paper/phone, and arguably contributes no additional societal value compared to a longer tick.

    1. liberal

      Yeah, exactly. The idea that there’s something socially useful about trading every second is ludicrous.

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