By Duncan Smith, Director of Client Portfolio Strategy
Stories of computers running amok seem to be occurring with increasing frequency. The most recent involved Knight Capital, a firm that acts as market maker for about 10% of the stocks listed on the New York Stock Exchange (NYSE). Erroneous trades resulted in a loss of $270 million, an error that is now threatening future existence of the firm.
Stock exchanges everywhere trumpet that they provide a “level playing field” for all participants, but is this really possible when some trades seek executions measured in micro-seconds while others seek only to acquire (or dispose of) positions based only on long-term goals for a portfolio? This piece examines elements of “institutional” trading. High net worth (HNW) investors are not themselves institutions, but the mutual funds and investment managers with whom they invest do fall into that category.
It is important we recognize that no amount of vigilance nor any expanded regulation can assure we will not experience computer glitches in the future. The better we understand how trades take place, the more comfortable we become in our ability to build sensible, long-term portfolios. Computers are not evil; they (usually) do what their masters, the programmers, tell them to do.
Our trading lesson will need some context and history. From the earliest days of stock exchanges, market making was a service provided by designated traders on the floors of exchanges. These traders assured buyers and sellers that orders were filled in a timely manner. The market making function continues to this day. Market makers are charged with working against pressure – they buy for their “book” if sell orders are dominant and sell those positions when buyers return. Because market makers have their own capital at risk, they adjust bids and offers; thus making incremental gains from completed trades. We can all recall pictures of the NYSE trading floor before computers replaced people. There were Specialists who had control of the trading for a particular stock, floor traders who would work orders for the wire houses or trade for their own account, and broker dealer representatives, all wearing different color jackets and using finger signals to communicate their desires. When things got heated and orders poured in, it wasn’t necessarily the biggest or loudest broker or trader who prevailed; specialists had to follow specific rules when accepting orders. These floor traders and their colorful mannerisms are mostly gone now.
Many traders have been replaced by server-based systems and trading algorithms. Regulatory changes, such as decimalization of share prices in 2000 and the establishment of a national market system in 2007, helped spur the exchanges toward greater integration and automation. Order sizes shrank, and the speed of order execution increased. Trading strategies that depended upon speed of execution for their advantage eventually evolved into a phenomenon now known as high-frequency trading.
Since the connecting of markets, as required by Regulation NMSin 2007, the number of trades that could be characterized as high-frequency grew at a phenomenal rate. They now represent a majority of trades executed on the major exchanges. Although distinct from formally designated market making activity, high-frequency trading is a major part of overall exchange trading volume, and its proponents argue that it’s an important source of liquidity.
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Let’s take a coffee break from the trading tour to ask a question: “If high-frequency traders get excited over a tenth of a point, maybe two-tenths, why should the long-term investor care?” The answer is pretty simple, these micro-spreads in pricing are not important. Now, back to the tour…
As practices and structures changed, problems emerged. Flash crashes showed how trading and share prices could come rapidly unhinged from company fundamentals. The “quality” of bids and offers displayed declined, as many offers were placed only to be canceled within fractions of a second. Questions emerged as to the quality of price discovery occurring in markets where most of the trades are made as a product of liquidity-responsive strategies. So-called “dark pools,” which are electronic networks that cross trades at reference prices expressed on exchanges, have become safe harbors for institutional investors. The dark pool gets its name because details of these cross trades are unavailable to the public. This also means “natural” investors, those who care about long-term fundamentals of a security, aren’t trading as much on the exchanges as they once did. It also calls into question the degree to which short-term share price fluctuations will accurately reflect the outlook or health of a firm.
It is important to keep in mind many of the problems cited above are not new, and were present in the previous market structure. In principle, high-frequency traders are not much different from physical floor traders, specialists and market makers of old. Floor traders primarily managed ebbs and floods of liquidity, worrying about share fundamentals only to the extent that they might trigger changes in trading flow. The proper ratio of speculators to natural investors in any traded asset has been a question of the ages. What is different now is that the speculators are much faster and their electronic methods are less detectable to most investors.
In addition, the NYSE has incorporated many changes to accommodate expansion of stock ownership and increases in daily trading volume. Along the way, some problems have occurred. Events occasionally have triggered the exchange to close for a few days, a few hours or a few minutes, either due to “computer” problems or to allow emotions to subside as the market anticipates a large influx of orders. A four-month closure followed the Declaration of War in 1914, and a five-day closure in 1933 was enacted to coincide with FDR’s Bank Holiday. In contrast, the NYSE remained open until its normal closing time on Monday, October 19, 1987, a day of extremely heavy trading and near historic declines, but closed early (2pm) during several days thereafter to address higher volume.
In today’s environment of real-time communication, high-frequency trading and electronically linked national markets are relatively new artifacts of global capital markets. Clearly, today’s rules and practices governing markets and trading are not optimal. However, it would be unwarranted to conclude that it is time to stay out of the capital markets altogether. The many positive aspects of electronically linked national markets are rarely accorded headlines. On balance, Threshold believes features such as global transparency, low transaction costs and around-the-clock trading have lowered risk and increased profit potential for long-term investors.
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1- Regulation NMS (National Market System is administered by the Securities Exchange Commission in an effort to modernize and strengthen the national market system for equity securities.
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Tags: trading, stock exchange, high net worth, nyse