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Part 2: New order ... or new virus?

Byline: Nick Onnembo

COLUMN: Guest Column

Editor's note: This is the second of a two-part column on automatic trading. This issue looks at the programs and concerns of the issue. Part one, which ran in the Oct. 9 issue, looked at the history.

What's not to like? From a narrow perspective, the robot traders seem to be enjoying an unfair physical advantage over other investors. One eyebrow-raising reality is that a big chunk of high-frequency profits derive from jumping into markets before small investors can. In the high-frequency world, the 20 milliseconds it can take quotes to travel from Chicago to NASDAQ's market site in New Jersey is an unacceptable lag. So interminable, in fact, that it gave rise to the entire strategy known as latency arbitrage. The need for speed, in turn, has led to a rush for real estate as close to securities exchanges as possible. In Chicago, 6 square feet of space in the data center where the big exchanges also house their computers goes for $2,000 a month. It's not unusual for trading firms to spend 100 times that to house their servers. Now, even the tradition-bound NYSE plans to open a 400,000-square-foot tech center in New Jersey and is taking orders for server stalls.

Does this institutionalize an unlevel playing field? It does and it doesn't. Small-fry investors are cut out of the business of making 0.1 cent markups. But this isn't what the fellow buying 1,000 shares of Exxon-Mobil should be worried about. For him, the risk is that he pays 5 cents a share too much, only to see the quote fall back a nickel a few seconds later, perhaps because brokers in the middle could see what he was doing, but he couldn't see what they were doing.

For years, regulators have tried to make trading fair by putting bids and offers out in the open. When I first entered the business 23 years ago, the American Stock Exchange (AMEX) talked of a "composite limit order book" that would make it harder for middlemen to pocket undeserved spreads. That idea didn't fly, but variations of it lived on in all sorts of rules designed to force transparency on the market. The trouble with such rules is that they can't force anyone to really show his hand. A new regulation can mandate that a 10,000-share order be put on the tape within a certain number of seconds, but it can't mandate that the hedge fund trader placing it reveals his intentions for his other 90,000 shares.

No surprise that today's order books are filled with feints and parries, made and withdrawn in a blink of the electronic eye - 1,000-share bids and offers that are stalking horses for million-share moves. Unfair to the little guys? Not necessarily. Their salvation comes from volume. If enough shares move every second, it is less likely that they will be gouged out of a nickel spread.

Another controversial offshoot of high-frequency trading is sponsored access, which already accounts for 15 percent of NASDAQ activity. In the old world, traders were required to send every order to a registered broker-dealer, who passed it along to an exchange or executed it themselves. With sponsored access, traders send orders directly to exchanges. This has raised concerns that a lack of oversight could lead to the sort of disaster that overtook derivatives during the recent financial crisis. Some high-frequency traders are sending out 1,000 orders a second. In the span of the two minutes it typically takes to rectify a trading system glitch, a careless trader could pump out 120,000 faulty orders. On a $20 stock, that represents a $2.4 billion disaster. Without better controls, the next trading market meltdown can realistically happen in a five-minute time period.

While many market centers have adapted to cater to high-frequency traders, dark pools have adapted to evade them. Dark pools are a place where professional money managers can swap large blocks of stock anonymously. It's the successor to the brokerage work that used to keep block traders busy decades ago, when the NYSE ruled Wall Street but a fair amount of its trading took place upstairs. The goal of dark pools is to avoid tipping off the market, including high-frequency arbitragers, that a big order is in the market and moving prices. Dark pools already handle 61 million shares a day, and many views them as something of a crusader who is enabling mutual funds, pension plans and other investors to trade at the best possible prices. All told, dark pools handle about 8 percent of stock trades and are expected to control 10% by year's end (source: New York Stock Exchange).

The problem with such liquidity pools is that they are in fact "dark," meaning they conceal their orders from public markets. What's more, they piggyback off publicly displayed bids and offers rather than adding to the liquidity pools that determine them. That, in turn, has led to charges that they are depriving investors in both lit and dark markets of the best possible prices, thus the calls for heavy-handed regulation or an outright ban.

Proponents of Big Brotherism should stop hyperventilating. The high-frequency engineers are already on the case, sniffing out when dark pools are trading at the midpoints between public bids and offers and posting their own prices around them (and, in turn, forcing the dark pools to come up with countermeasures to the countermeasures). As this cat-and-mouse game plays out, trading is getting ever faster and spreads ever thinner. This probably isn't the market that securities market overseers envisioned, but it's working just fine.

To sort out different investment strategies, there are many very reputable publications and information sources. But, as always, consult with your financial, tax, or legal adviser to determine the best financial strategy for your situation.

Clinton resident Nick Onnembo is a senior systems executive for a Boston investment firm and holds a master's in business administration in finance
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Publication:Telegram & Gazette (Worcester, MA)
Date:Oct 16, 2009
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