When the book “Flash boys: A Wall Street Revolt” was splashed into our consciousness and CBS’ 60 Minutes interviewed author Michael Lewis, it created a huge controversy. The controversy was based on Lewis’ claim that U.S. equity markets were rigged.
This created a huge backlash from equity markets and seemed somewhat counterintuitive. After all, in the decade since Reg NMS went into effect the cost of trading for retail traders has dropped dramatically. Commissions have decreased and bid/ask spreads have tightened. It wasn’t that long ago that equities were quoted in eighths. The key to that progress was competition. The New York Stock Exchange no longer has a virtual monopoly in equity trading. Ironically, while this competition has led to many of the positive changes in terms of cost, it also has created many of the problems cited in Lewis’ book and is the reason Brad Katsuyama, a former broker at RBC Capital Markets, decided to launch his own exchange, IEX.
Both Katsuyama and Keith Ross, CEO of dark pool PDQ ATS, say there are too many trading venues (see “Building a better market”). The key to liquidity is competition for orders, and with 50 plus trading venues, those orders and the market-makers looking to take the other side are disbursed across those venues. It is not like futures where nearly every market is traded in one location and all the liquidity in the world has to come to that market.
In a sense that is what those two exchanges attempt to do. PDQ tells its markets-makers there is an executable order in a specific stock and asks them to give their best price and compete for it. IEX briefly delays orders into the market and fills out of the market long enough so that high-frequency traders can’t race IEX customer orders to the next venue if the order is not completely filled.
Katsuyama acknowledges that traders have always looked for an edge, and high-frequency traders are simply using the tools of the day to do what traders have always done. But he says that technology can be used to even the playing field.
As someone who has worked on a trading floor, I understand the frustration of having a broker quote a market, then attempt to hit a bid or lift an offer only to be told that that bid or offer is no longer there. It did not happen often in the futures market, and when it did you expected to know why. So if this is something that happened consistently to Katsuyama, his frustration is understandable. But he seemed to have figured out a solution with his trading software, Thor, and now with IEX. Perhaps the democratization of trading technology has turned all traders into scalpers. In our conversation, Katsuyama said he would like to attract resting orders to his exchange, but nearly in the same breath he talked about executing at a mid-price peg. That doesn’t really square with ‘resting orders.’
Scott Skyrm’s piece, “How Power Peg brought down a Knight,” illustrates how complex trading has become and the dangers of rogue algorthms.