Finally Congress is looking at high speed trading and what it is doing to the marketplace. Like most things, this is a messy issue. It’s not necessarily electronic trading that is causing the problems. Mostly the roots of the problems are in the way the markets are regulated by the SEC, and in the way the exchanges administer them.
Congressman and Senators don’t have intimate understanding of these markets. They also have relationships with banks, trading firms, exchanges and individuals so don’t look for any altruistic market based rules or regulations to come out of their committee hearings. But it’s good that there is a public vetting.
Just in the past week we have learned of new order types not available to regular consumers of the market. We have learned favored participants get data feeds that other market players don’t get. This is patently unfair and gives one part of the market an edge they can arbitrage against the rest of the market.
One of the reasons Fama’s Efficient Market Hypothesis works is the assumption that no one has more information than the rest of the marketplace. It’s why we have insider trading laws. But today, some have more information than the rest of the market and they are making outsized returns because of it.
Once I met a guy that uncannily could predict exactly where the Crack spread in energy markets would go. It was truly amazing. He would say, “I think it’s going to move up.”. Gosh darn it, it moved up. He was never wrong. Ever. It turns out, he had inside information on the supply/demand of the energy market and he was not allowed to trade. I never traded on his information because I wasn’t a crude trader and I have a cynical tendency to discount anything I hear from people that aren’t in the market.
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What we have today in the marketplace is a tiered playing field. Insiders get first dibs. In the old days of guys on trading floors, there most certainly was an edge. That’s why you leased or bought a membership to an exchange-to get the edge.
When I was in a pit, I knew I only had to be faster than the other people in my pit. It’s also why there were huge fights over pit position. Sometimes when I was faster it didn’t matter, since another guy was standing closer to the order filler. Lots of times, order fillers would whisper in their pals ear. Those guys always made a lot of money-more than the average trader in the pit. Getting a wink and a nod always helps.
These revelations about data feeds and co-location strike me as similar to the same battles we had on the floor. Except electronic trading was supposed to level that playing field. Instead, exchanges have exploited it as a profit center by charging for special data and charging for co-location; good pit space if you will. The wink and the nod goes to certain firms. But the average Joe is left holding the bag. It’s like trying to mount an 80 yard game winning touchdown drive against All Stars on an uphill field. Besides, the other team hired the refs to officiate-so your team won’t be going anywhere anyway.
We need to get far better regulation. No one in the exchanges or government will ever keep up with the innovations in speed and technology that trading firms are engaged in. So instead of micro regulating and creating economic imbalances, the government needs to set some broad rules. For example, limiting the types of orders that can be entered to Limit, Market, Market if Touched and Stop would change everyone’s strategy and speed would be less important. Keeping things simple with clear lines makes it easy for players in the market and also easy to regulate.
Right now, everyone wants gray areas. Then they can exploit them to their advantage. They can hire fancy attorneys to argue their position. Regulators and exchanges can decide things on a case by case basis, and reward friends while punishing enemies.
It’s very important to note that the fault doesn’t lie just in exchanges. Most of the blame lies in the infernal regulations that the exchanges have to adhere and comply with. Exchanges have made errors, and I disagree with many of their policies. They risk running good marketplaces into the ground which will cause the price of goods and services to rise because intrinsic risks will be left unhedged. But regulators have written the rules of the road in such a way it is impossible to have a fair market today.
The playing field in all markets is not even close to level. As one old trader friend said to me, “How for 30 years could I have been right 70% of the time, and now I am wrong 100% of the time?” It’s because the high speed traders have more information than him.
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