Sense on Cents

Confidence in the markets and the economy is ultimately a function of truth, transparency, and integrity.

The reason global investors have such little confidence currently is due to the very simple fact that both the financial industry and their government counterparts have not promoted practices which embrace these cherished principles.

That is not to say that each and every individual in the financial industry or in government does not try to promote these values. In fact, I believe the overwhelming majority of people on Wall Street and in the global markets do embrace these values, but they are not in a position to speak out when the principles are violated. I love it when I come across people who possess the courage and are unencumbered to speak out for the truth, transparency, and integrity our markets, our country, and our world so badly need. Like who?

No individual on Wall Street today embodies this courage more than Themis Trading’s Joe Saluzzi. I have interviewed Joe twice (August 2, 2009 and just this past May 23rd). He is very special.

Joe recently exposed a practice being implemented on the Nasdaq and BATS exchanges which compromises the interests of investors to the benefit of high frequency traders. European regulators quickly picked up on Joe’s work and made changes on European exchanges. The Financial Times addresses this story today in writing, Trust in Dark Pools Is Dented:

If there was ever a business in need of a new name, it is “dark pools”.

This week, the role of these trading facilities is once again under the microscope after revelations that rapid electronic traders – possibly “high-frequency” traders (HFTs)- sniffed out what was going on in two leading European dark pools and profited from the information they found.

Dark pools – a type of block trading platform – are places where large institutions such as asset managers can place large orders in the hope of finding a match. With rapid-fire trading increasingly slicing orders on public exchanges into ever-smaller sizes, it is getting harder to carry out such orders on exchanges without the asset manager running the risk of moving prices against them.

Asset managers will place such orders with their broker and ask them to ensure that the order is done either as a block or – more commonly – in chunks over the course of a trading day, until the whole order is done.

At all times, the name of the game is not to reveal who you are, or to reveal at what price you want to trade. That is market sensitive information that can be used by rivals, jeopardising your trade, and explains why prices are not made public until matches are found.

Yet last week it emerged that slivers of information had leaked out of two dark pools, one operated by Chi-X and BATS, operators of two of the “multilateral trading facilities” (MTFs) that compete against the London Stock Exchange and other established bourses in Europe.

The information gave enough clues to anyone who was interested about what orders certain large – although unnamed – participants had sitting in those pools. High-frequency traders could then place trades on the public exchanges – on which dark pools often base their bid-offer spreads – in the hope of profiting, trading experts say.

Within a few minutes of the discovery, volumes on Chi-Delta – the Chi-X platform – and on the BATS platform plunged as so-called “buyside” participants called their brokers with instructions to pull their orders, fearful their orders were being exploited.

Trust in market structures has already been badly shaken this month, following the “flash crash” on Wall Street on May 6, when computerised trading exacerbated a huge fall in the Dow Jones Industrial Average index.

But the latest development in dark pools shows trust is in equally short supply in an increasingly important corner of the region’s equity markets. Dark pools, after all, account for 6-7 per cent of all equities trading.

The sudden withdrawal of trades from the two platforms also raises questions over the role of highfrequency trading in dark pools. Hitherto such traders, who seek to profit from minute changes in prices between trading venues, were assumed to operate only on exchanges and MTFs. But some suspect that they may be picking off trades in dark pools without the original poster of the order knowing.

Joe Saluzzi, co-head of equity trading at Themis Trading, a US securities firm, says participants have to ask whether some HFTs are actually “predatory” in dark pools, by taking advantage of information they are not supposed to have.

“People are going to say they thought they were able to trade, cloaked and anonymously, but now I am supporting a multi-million dollar industry called highfrequency trading,” he says.

Themis believes the problem lies in data feeds provided by trading venues. “Information in these feeds allows high-frequency trading firms to track when an investor changes price on his order, how much stock the investor is buying or selling in accumulation, as well as the ascertaining of hidden order flow.”

Chi-Delta and BATS have changed their data feeds so that such so-called “information leakage” has stopped.

Asset managers and others using dark pools can protect themselves against predatory trading by stipulating that their orders can only interact with other orders if those orders are of a certain minimum size.

Kudos to our great American Joe Saluzzi and his colleagues at Themis for exposing this practice. Kudos to those financial regulators in Europe for having the courage to move quickly to eliminate this predatory practice. Lastly, kudos to the Financial Times for publicizing Joe’s work and the changes on the European exchanges.

Where are our financial regulators? Where is Mary ‘Muammar Gaddafi” Schapiro? Where are the executives on our exchanges, especially at the Nasdaq and BATS, to address this practice here in the States? Where is our financial media, starting with The Wall Street Journal, to expose these practices and promote Joe’s work?

Wonder why retail volumes are down enormously? Wonder why investors have little confidence in regulators and exchanges? It’s all about trust.

America needs more men like Joe Saluzzi!!

LD

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This entry was posted on Wednesday, May 26th, 2010 at 12:31 PM and is filed under Equity Markets, General, Joe Saluzzi. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.