Liquidity Quality In A Changing Market

My focus on various topics in the realm of program trading and market liquidity has engendered quite a few vitriolic responses, some of which have argued bitterly that Zero Hedge is on the wrong path in describing the somewhat vampiric qualities of liquidity extraction by recent artificial constructs, most notably those undertaken by the NYSE. I present to our readers an original paper by two BNY ConvergEx managing directors from 2007 which should provide some additional datapoints in the great debate on whether or not liquidity benefits at all from the recent domination of computers in the "open" market, and touches on other such highly contested issues as dark pool and dark liquidity value and execution.

I want to bring our readers' attention particularly to Exhibit 4 which indicates that from a liquidity standpoint, intra-day prop trading is the worst (Goldman Sachs domination anyone?) followed by black box algo and automated market making.

In essence these observations dovetail with the findings in a recent guest post by Joe Saluzzi.

I would also like to bring attention to the finding on page 27, according to which intra-day prop trading and black box trading is low quality because both compete with long and intermediate term traders for the best price. "From the portfolio manager’s and trader’s perspective, these are sources of low-quality liquidity that can be viewed as competition for buying or selling a stock at the best price." Maybe in this more theoretical light, it is useful to again readdress the very pertinent complaint that the NASDAQ launched against the NYSE SLP program which has as of yet still generated no response either by the exchange or by the Securities and Exchange Commission.

BNY Beyond Execution 2007 Fall

Hat tip Richard

Sphere: Related Content

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Rogue Algorithms And Other Mutually Assured Destruction Program Trading Alternatives

Submitted By Joe Saluzzi Of Themis Trading

Why Institutional Investors Should Be Concerned About High Frequency Traders

By Sal L. Arnuk and Joseph Saluzzi

A Themis Trading LLC Mini White Paper

It is now generally understood that high frequency traders (HFTs) are dominating the equity market, generating as much as 70% of the volume.

HFTs are computerized trading programs that make money two ways, in general. They offer bids in such a way so as to make tiny amounts of money from per share liquidity rebates provided by the exchanges. Or they make tiny per share long or short profits. While this might sound like small change, HFTs collectively execute billions of shares a day, making it an extremely profitable business.

Why should institutional or retail investors care? After all, aren’t HFTs adding liquidity? That’s what they and the exchanges, who court their business, say.

There’s a lot to worry about.

1. HFTs provide low quality liquidity.

In the old days, when NYSE specialists or NASDAQ market makers added liquidity, they were required to maintain a fair and orderly market, and to post a quote that was part of the National Best Bid and Offer a minimum percentage of time. HFTs have no such requirements. They have no minimum shares to provide nor do they have a minimum quote time. And they could turn off their liquidity at any time. When an HFT computer spots a real order, the HFT is not likely to go against it and take the other side. The institution is then faced with a very tough stock to trade.

2. HFT volume can generate false trading signals.

This can cause other investors to buy at a higher price, or sell at a lower price, than they would otherwise. A spike in HFT volume can cause an institutional algorithm order based on a percentage of volume to be too aggressive. A spike can attract momentum investors, further exaggerating price moves. Seeing such a spike, options traders can start to build positions, which, in turn, can attract risk arbitrage traders who believe there’s potential news that could affect the stock.

3. HFT computer servers are faster than other trading systems.

Because most HFT servers are co-located at exchanges, they can beat out institutional or retail orders, causing them to pay more or sell for less than they should have for a stock.

Then there are the “what if” problems that could be created by HFTs.

1. What if a regulation like the uptick rule were enacted?

Volumes could implode and stocks that appeared highly liquid could become extremely difficult to trade with wide spreads and no depth in the quote.

2. What if a “rogue” algorithm entered the market?

Many HFTs are hedge funds that enter their orders into the market through a “sponsored access” arrangement with a broker. Many of these arrangements do not have any pre-trade risk controls since these clients demand the fastest speed. Due to the fully electronic nature of the equity markets today, one keypunch error could wreak havoc. Nothing would be able to stop a market destroying order once the button was pressed.

Gives new meaning to the term “mutually assured destruction?” Sphere: Related Content

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Guest Post: Manipulation?

Authored by Joe Saluzzi of Themis Trading

We have talked extensively on our blog and in our white papers about the power of high frequency trading and program trading. We have noted that these trading strategies can move the market quickly during the trading day. We have always suspected that there have been certain major players that can dominate this space. Now comes the case of the stolen proprietary trading code from Goldman Sachs.

http://www.bloomberg.com/apps/news?pid=20601087&sid=axYw_ykTBokE

Most interesting in this Bloomberg article is the following statement by Assisitant U.S, Attorney Joseph Facciponti:

“The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways,” Facciponti said.

Is this an admission by Goldman Sachs that there is the possibility of manipulation in the market? Does anyone think that this is the only program in the world that can “manipulate” markets? With all the programmers in the world, we can only imagine how many more manipulative programs are out there. Now here is the best part according to the assistant U.S. Attorney:

The proprietary code lets the firm do “sophisticated, high- speed and high-volume trades on various stock and commodities markets,” prosecutors said in court papers. The trades generate “many millions of dollars” each year.

Markets are a zero sum game - somebody wins and somebody loses. Where do you think these “many millions of dollars” are coming from? They are coming from you - the average retail investor and the large institutional investor. These programs are taking advantage of real order flow and are siphoning off small profits throughout the day that belong in the pockets of the retail investor and the traditional money manager. [TD: highlight mine]

So, who is out there to protect you from these “machines” and their army of programmers? One would think the SEC has your back. But what did they have to say about high frequency trading. According to an article in the WSJ (http://online.wsj.com/article/BT-CO-20090618-707189.html )

The Securities and Exchange Commission believes institutional money managers are “sophisticated” enough to trade against the machines without further regulation.

“We don’t want to curtail liquidity,” said Gene Gohlke, associate director for the SEC. Gohlke said it’s up to the managers themselves to make sure other traders aren’t manipulating their models.

This story is just at the beginning stages and we here at Themis Trading intend to keep a careful watch on it. Sphere: Related Content

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