Sense on Cents

Why are investors increasingly less comfortable putting capital to work in the market? Why are investors increasingly less confident in the very structure of the marketplace itself?  The simple fact is the supposed technological advancements embedded in high frequency trading have come with very real costs for long-term investors. The biggest advocate for investors in addressing these real costs has been Themis Trading’s Joe Saluzzi. I interviewed Joe twice over the last year and have referenced his work often. I commend Joe for often being the lone wolf within the industry crying out on these critically important issues.

Well, Joe now has company in the form of a very, very, very large wolf. Who might that be? None other than JP Morgan. Thanks very much to a regular reader of Sense on Cents for pointing out a story, JP Morgan’s Views On The Five Best Things About the Flash Crash, that ran yesterday at the fabulous site Zero Hedge.

This story highlights a JP Morgan research piece which exposes the shortcomings of high frequency trading and the real costs for long-term investors.

The research piece embraces a principle prized by long-term investors, but typically anathema to the Wall Street technological giants. JP Morgan’s Private banking CIO writes:

There’s a postmodern temptation to define all forms of innovation as progress, but there are big differences between the two. One example: while some forms of genetic engineering are possible, they may also be very undesirable. The downside to some innovation only becomes apparent over time (overuse of antibiotics which may lead to the survival of more virulent strains of bacteria; species transplantation that cause disastrous side-effects for local populations). Some derivatives activity (e.g., CDO-cubed) ended up being innovations with strongly negative aftershocks. You do not have to be a Luddite to raise questions about undesired consequences of innovation, particularly when financial services are involved.The debate is not about reversing innovation in electronic trading, but making adjustments along the way.

Why do we care about all of this? As fiduciaries for several hundred billion dollars in client assets, we are very focused on issues that either raise or detract from market confidence, stability, volatility and perceptions of fairness.

Sense on Cents also very much cares about these same tenets. JP Morgan’s piece highlights basic high frequency trading issues which were largely exposed in the Flash Crash on May 6th. These issues include the difference in volume versus liquidity, cancelled orders, and higher trading costs versus lower commissions. I am compelled to specifically highlight:

With the advent of HFTs, cancelled orders have soared. Today’s ratio of 30 cancelled orders for each one executed means that 97% are cancelled. To curb abusive practices, some market participants recommend applying a fee to HFTs for an excessive number of cancelled orders.The increase in cancelled orders is one reason we do not agree that increased order depth on S&P 500 stocks at the NBBO is a clear indication of greater liquidity, as some market research alleges. Quotes pulled within a nano-second of being posted, and which are part of an algorithmic order detection exercise, don’t seem like liquidity in the traditional sense. Ameritrade’s representative on the recent SEC Roundtable referred to this as “opportunistic liquidity”.

The research piece concludes:

Over the last decade, trading automation coincided with substantial improvements for equity investors. Information is available more readily, and transactions costs have come down on individual trades. High frequency trading is here to stay, and parts of the industry contribute to greater efficiencies. But the HFT industry may have gotten ahead of anyone’s ability to understand and monitor its capabilities and consequences. The combination of a singular quest for lower execution costs and advanced technology may have resulted in a more fragmented marketplace in which liquidity is temporal, and in less incentive to display limit orders or contribute capital to market-making. The Flash Crash provides a basis for regulators and market participants to consider these consequences in more detail than they have so far, and make adjustments. As shown below, confidence in the market has been dented by the latest events, and there’s work to be done to restore it.

In its request to improve market structure and sort these issues out, the SEC had this to say:

“Where the interests of long-term investors and short-term professional traders diverge, the Commission repeatedly has emphasized that its duty is to uphold the interests of long-term investors”.

On that, we agree 100%.

Michael Cembalest
Chief Investment Officer
J.P. Morgan Private Banking

Thanks again to the reader who brought this story to my attention. Hats off to Zero Hedge for highlighting it. Major props to JP Morgan for genuinely addressing these issues and pursuing truth, transparency, and integrity in the process.

For those who would like to review the entire JP Morgan piece, here you go:

7-13-10 – EOTM – 5 Best Things About the Flash Crash

LD

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This entry was posted on Thursday, July 15th, 2010 at 1:24 PM and is filed under General, JP Morgan. 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.