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Saturday, August 29, 2009

MORE "FLASH" TRADING   Even Chris Hynes won't have an answer for this! Thanks to reader Mark Spahn.

Posted by Donald L. Luskin at 7:16 PM | link  

Friday, August 28, 2009

HYNES ANSWERS THE CRITICS ON "FLASH" TRADING   My co-author of yesterday's Wall Street Journal op-ed weighs in with some great points:
As a co-author of the original article, I want to thank all the commenters for their interest and willingness to take time to debate this issue. Many of you have raised points which get right to the heart of the issue. In my own career, I have been a sell-side (brokerage) trader in both derivatives and equities, head trader of the what is now the world’s largest asset manager, co-creator of the POSIT alternative trading system, portfolio manager, and retail investor. As I read the comments, I observed a few themes that I’d like to address: the fairness of unequal information in free markets, trading profits , and the nature of front-running. I’d like to address these issues.

First, the fairness of unequal information in free markets.

Warren Buffett made great deals recently with Goldman, Dow and others. These deals were not offered to the public at large. The sellers made a decision to selectively disclose their trading intentions, and Buffett benefited due to his reputation, ability to make a quick decision, and hoard of cash.

In 2007 there were 75 million American homes occupied by owner, with a median value of $191,000, for a total value of around $15 trillion. Today’s stock market capitalization is around $11 trillion in the US, so it’s safe to say that housing is a bigger asset class than stocks for the average American. If you are buying a condo in a building, you may have no idea of the last sale for the same model you want for a couple of months from the time the deal was struck. There are huge commissions and fees compared to stock trading. The seller may be seeing multiple bids on a property, while a buyer might only be aware of his own bid. The high transaction costs make it difficult for intermediaries to make a market in homes. If you need cash, you can sell stock in 10 seconds and have the money in 3 days. If you own a house it may take you 10 months or more.

Wal-Mart knows how to source in China and other places, and has created an extremely efficient distribution system. Its low pricing has put a lot of competitors out of business—competitors who don’t have that knowledge of overseas sourcing or can’t match the distribution costs.

Free markets don’t require equality of information. They require an absence of coercion, and protection against fraud. Free markets allow people and firms to develop expertise which create competitive advantages. Users of free markets who don’t care to develop expertise can still benefit from them. Wal-Mart customers, with no sourcing skills of their own, benefit from Wal-Mart’s efficiencies in the form of lower prices.

Twenty years ago, retail stock traders had to call in orders and wait 20 minutes or more for reports. They might miss markets due to the lag between their broker getting an order and the order getting to the post. They could not have their bid or offer shown on NASDAQ. Spreads were a minimum of an eighth of a point, and often more. Today they can go to the web, enter an order and get an execution in seconds. The spread on large cap stocks is as little as a penny. They did not have to develop any expertise to obtain these benefits. They arose, “trickled down” if you will, out of the forces of competition created by free markets. TD Ameritrade uses flash trading to improve executions for its retail clients. The clients may have never heard of flash trading, but they are reaping the benefits of selective disclosure. I’m sure TD Ameritrade will stop the practice if its data show the practice is hurting their clients. By the way, stock trading commission rates are down about 90% or more in the past 4 decades.

Some commenters felt that exchanges must treat everyone equally. In my experience, this has never been true. Customer orders often received favored treatment relative to firm or specialist orders. Program traders have been subject to different rules than other traders as so-called “circuit breakers” restricted their trading when the market made large price movements. Automated Trading Systems arose to create market segments that appealed to customers with certain types of order handling requirements. These were free markets, subject to the rules of the ATS, which itself was subject to overriding governmental anti-fraud rules.

We need these electronic markets because there is simply too much volume for humans, unassisted by machines to handle. Yet traders have found the need to replicate core trading functions, such as selective disclosure, in the electronic environment.

What about Profits?

Senator Schumer stated the possibility of $21 billion in profits being made by high-frequency traders. The implication is that profits are bad. Wal-Mart will make $15 billion this year. Yet consumers shop there because they save money. Seems like Wal-Mart’s been reinvesting profits to increase its competitive advantages. Without profits, they could not invest for improvement in their operations. High-frequency traders made money because they improved the American system of trading as it transitioned from a virtual monopoly to a competitive environment that produced the benefits described above. Have we forgotten the profits the specialists used to make? I suppose the buggy whip makers objected to the obscene profits of the automakers. Once again, a segment of the American economy is transformed by a new industry that makes greater profits than the one it replaced, while providing even bigger benefits to consumers.

Finally, let’s address front-running. When Goldman approached Buffett, they probably felt certain that he wouldn’t use the information against them. It is not front-running to respond to a flash order with a trade. The flasher is being helped, and the responding trader has every right to use the publicly available information of current bid/asked and size to inform his trade. But let’s get real here. After all, doesn’t every single-stock trade involve some sort of front-running, in the sense that the buyer thinks he knows something that makes him want to buy now because the stock is going up, and the seller has the opposite view? In his recent book on the collapse of Lehman, author Larry McDonald talks about the time he and a colleague went to the bar across the street from New Century Financial’s headquarters, met some of the salespeople, and went back to New York and opened a huge short position. They had information most people didn’t have, and acted upon it. Someone getting flashed a 1,000 share order, just a fraction of a stock’s daily value, has no idea whether the other side of the trade has knowledge like McDonald had or not, or whether it’s the opening salvo of a one million share institutional order. Front-running is just not an issue in the typical flash trading scenario, as there’s just not enough certainty as to the future direction of the stock price as to meet the high standard for front-running.

Posted by Donald L. Luskin at 11:37 AM | link  

Thursday, August 27, 2009

FROM OUR TEXAS CORRESPONDENT   Thanks, Richard Ridgeway!

Posted by Donald L. Luskin at 10:43 AM | link  

Wednesday, August 26, 2009

IN DEFENSE OF "FLASH" TRADING   My op-ed, with Chris Hynes, in this morning's Wall Street Journal:
For the past several weeks, New York Sen. Chuck Schumer has attempted to intimidate the Securities and Exchange Commission into banning so-called flash trading. Eliminating this technique would be a dangerous mistake that would squash competition and automation in equity trading. Flash trading exemplifies the virtues of two decades of innovation that have improved executions for both individual and institutional investors.

What is flash trading? As pioneered by the electronic communications network Direct Edge, it is simply a way for one customer to query other customers to see if they will take the other side of a trade.

Let's say that among all the exchanges, the highest bid for stock XYZ is 10, and the lowest offer is 10.5. Bob enters a flash order to buy 500 shares in between, at 10.25. This order exists in Direct Edge's system for mere milliseconds, but in that time the high-speed computers of other participants might decide to sell Bob the 500 shares he wants to buy. So Bob gets a price better than the best offer, and the seller gets a price better than the best bid. If a trade can't be executed, then Bob can try other markets.

In this example, because the flash trade comes in between the best bid and the best offer, it does not contribute to market volatility. Buyer and seller have entered into a trade in which they both feel they have achieved the best possible deal, or they wouldn't have traded. And the flash order created an opportunity for new liquidity to enter the market.

Flash trading is like offering to sell your house to your neighbor before you officially put it into the real estate listings. For that matter, it's just like what upstairs traders did in the pre-computer era: shopping an order before sending it to the exchange floor. We had no problem with this process, so why would we ban flash trading, which simply makes it more formal and produces an audit trail that the upstairs traders didn't?

Yet according to Mr. Schumer, in flash trading "a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions." The truth is that there's no particular privilege involved. Any broker can enter flash orders or respond to them, even when executing on behalf of ordinary individual investors.

Chris Nagy, managing director of routing for TD Ameritrade, a leading retail broker, has said that his company sees flash trading "working so well that we've increased our utilization of it." It's hard to see how anyone is deprived of a fair price, since a flash trade cannot, by SEC rules, trade through pre-existing orders—that is, it cannot be executed below the best bid or above the best offer.

Mr. Schumer also claims that seeing flash orders allows traders to "act on that early information to trade ahead of the pending orders." Yes, a flash order does reveal information. But so does any order. If flash orders entailed a heightened risk of being front run, as Mr. Schumer claims, no one would ever enter into them.

The real issue here is that innovators like Direct Edge are able to use new systems like flash trading to challenge entrenched institutions like the New York Stock Exchange by attracting their own new pools of liquidity. Innovators profit most when trading is internalized within their new pools, drawing market share away from incumbents. The incumbents typically seek self-protective regulation, characterizing the creation of new pools as "fragmentation" of the equity markets.

In fact, trading innovations do not create fragmentation. They expand the market, drawing in entirely new liquidity that wouldn't have otherwise existed.

Since introducing flash trading in 2006, Direct Edge's market share has soared to 12% from 2%. No wonder, then, that Duncan Niederauer, chief executive officer of NYSE Euronext, said in June that "we're spending a lot of time in Washington." And no wonder that Mr. Schumer has suddenly developed an interest in the microstructure of equity markets.

Competition is what makes America's equity trading system the envy of the world. Let's not throttle it by demonizing the innovations that improve it.

Mr. Hynes is the chief executive officer of Hynes Capital. Mr. Luskin is the chief investment officer of Trend Macrolytics LLC. They are the co-creators of Investment Technology Group's POSIT, the first alternative trading system.

Posted by Donald L. Luskin at 9:40 PM | link  

JOKE OF THE DAY 2   I promise... It's not about Teddy. This one is about health care costs (attention Teddy, wherever you are...).

Posted by Donald L. Luskin at 9:49 AM | link  


Posted by Donald L. Luskin at 8:47 AM | link  

Tuesday, August 25, 2009

SOMETHING TELLS ME...   ...that Paul Krugman won't be getting his health care at the Veterans Administration, despite his ringing endorsement of it in a column a couple weeks ago.
By the way, our own Veterans Health Administration, which is run somewhat like the British health service, also manages to combine quality care with low costs.
You see, news stories like this one just keep coming up...
CHARLESTON, W.Va. - At least 1,200 veterans across the country have been mistakenly told by the Veterans Administration that they suffer from a fatal neurological disease.

One of the leaders of a Gulf War veterans group says panicked veterans from Alabama, Florida, Kansas, North Carolina, West Virginia and Wyoming have contacted the group about the error.

Denise Nichols, the vice president of the National Gulf War Resource Center, says the VA is blaming a coding error for the mistake.

Thanks to reader Robert Wilson.

Posted by Donald L. Luskin at 10:50 PM | link  

NOW IT GETS PERSONAL   Now it's not just the Left calling for a boycott of Whole Foods -- they want CEO John Mackey's head, for daring to criticize Obamacare in a Wall Street Journal op-ed. Some pressure group that has given itself the name "CtW Investment Group" (I suspect from their website they "invest" in nothing but union-funded lobbying), is putting pressure on Whole Foods independent director John B. Elstrott to fire Mackey, saying in a letter, "The board must now recognize that managing reputational risk is central to building shareholder value at Whole Foods and act accordingly." Yeah -- and building a great global company from scratch is central to building shareholder value, too.

Update... "The Zoogler" writes,

From their website:
The CtW Investment Group is not named fiduciary for any pension or other fund or plan, nor does it render investment advice. The CtW Investment Group does not exercise or seek to exercise any discretionary authority or discretionary control regarding management of any plan, disposition of any plan assets, proxy voting decisions, appointment of plan trustees, or any other aspect of plan management or administration. Although CtW Investment Group strategies and initiatives are thoroughly reviewed for compliance with applicable laws and regulations, the law requires trustees and other fiduciaries to conduct their own review and make independent decisions before implementing or adopting any of these strategies or initiatives.
Nice guys, huh?
Update 2... Reader William Heasley strikes back!
Personally, never have shopped at Whole Foods. Just never have been to their stores.

Its now my favorite store. Going shopping there tomorrow. First thing will be to find store manager and tell him exactly why I am there and why I will coming back.

Posted by Donald L. Luskin at 9:31 AM | link  

Sunday, August 23, 2009

THE MYSTERIOUS EAST   Our monetary affairs correspondent "Irrational Exuberance" found this gem from Bloomberg at Infectious Greed:
A Chinese government estimate that inflation may be 2 percent for 2009 is puzzling economists after prices fell for six of the past seven months.

The Ministry of Commerce made the estimate in a statement on its Web site yesterday, citing rising demand and gains in commodity prices.

“It’s just impossible,” Wang Qian, a Hong Kong-based economist at JPMorgan Chase & Co., said today. Inflation would have to jump to more than 6 percent for the rest of the year to bring the average to that level, said Wang, who forecasts a 0.5 percent decline in prices for 2009.

Posted by Donald L. Luskin at 11:05 PM | link