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Weekend Reading Re: Knight Capital and HFT

Posted by Larry Doyle on August 4, 2012 7:09 AM |

Investors are constantly confronting the question whether it is safe to go in the water, that is, to commit capital and make an investment.

With so much concern already surrounding the structure of and practices within our equity exchanges, there was serious fuel added to these fires with the malfunction and accompanying meltdown at Knight Capital this week.

This story and situation deserve serious attention. To that end, when I want to know what goes on within the equity markets, I immediately go to the most reliable source. Who is that? Our resident Sense on Cents’ Hall of Famers Joe Saluzzi and Sal Arnuk at Themis Trading. What do these ‘men in the arena’ have to say about the Knight Capital debacle and the structure of the equity markets overall?  

First off we need to state that we are saddened, and we take no pleasure in seeing events like yesterday’s unfold. Thousands of really good people at Knight, NYSE, NASDAQ, Goldman, and countless other industry firms – including ours, have been/are/will be adversely harmed by these continued market structure and trading glitches that demonstrate a broken market.

All of us within the industry and outside of it are harmed. A black eye on NASDAQ or BATS or Knight is a black eye for all of us. We all prosper when investors are confident and eagerly participating in the investment function, and we are hurt by the inverse. Technological glitches will always be a certainty, but a structure that can handle them better is what is desperately needed and what we all strive for.

Read the entire story of how Thomas Goes Off the Rails.

Additionally, what do Joe and Sal and others believe must occur to address a real shortcoming within the structure of the equity exchanges?

Under the leadership of Chairman Arthur Levitt, the SEC implemented the Order Handling Rules, Reg ATS, eliminated Rule 390, implemented decimalization and allowed the stock exchanges to demutualize.  After Mr. Levitt left office in 2001, the SEC continued their push with more regulations.

In February 2004, they proposed Reg NMS that was fully implemented in 2007.  After a decade long push of new regulations, we have ended up with a fragmented web of market centers held together by a very weak structure.  This weakness was very apparent when the Knight software bug ripped through the market for 45 minutes.

For his part, Mr. Levitt, now an advisor to Goldman Sachs and GETCO, shockingly owned up yesterday on Bloomberg radio when he said:

 The irony of all this is that the change in order handling rules that were instituted under my watch at the commission has resulted in the proliferation of markets, technologies and automation that brought about the flash crash and yesterdays events.  I think public confidence is severely shaken by things of this kind.”

You read that right.  Mr. Levitt said that the rules he helped implement have created the current market structure which brought about the flash crash and the Knight algo issue.

So, what do we do now?  We have one simple suggestion that we think can fix many of the current problems in today’s market structure and it won’t require Congressional approval:

Eliminate the maker/taker model

The maker/taker model is the system in which brokers route orders not necessarily to the equity exchanges showing the best prices but to exchanges which might pay the broker the largest rebate (payments for order flow). This practice is rife with conflicts of interest.

Read all of what Joe and Sal have to say on this topic in Dear SEC, It’s Time to Abolish the Maker Taker Model.

If you are sufficiently intrigued by the highly questionable practices ongoing within our equity exchanges, there is one more must read commentary. Thanks to the widely read Zero Hedge for providing a link to a fascinating insider’s look to the world of high frequency trading.

While the attached interview between the Casey Report and HFT expert Garrett from CalibratedConfidence will not reveal much unknown new to those who have been following the high frequency trading topic ever since ZH made it a mainstream issue in April of 2009, it will serve as a great foundation for all those new to the topic who are looking for an honest, unbiased introduction to what is otherwise a nebulous and complicated matter. We urge everyone who is even remotely interested in market structure, broken markets and the future of trading to read the observations presented below.

Interview with a High-Frequency Trader

That interview is a fascinating read.

After absorbing much of what is presented in these reviews, I think you will concur that our equity exchanges are broken and truly little more than shark-infested waters. Little wonder why equity volumes are down so precipitously over the last few years.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.



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