Cattlemen say markets are broken: Is there a fix?

January 25, 2016 09:54 AM

For consumers, it will mean higher meat prices. If producers and packers have to figure out ways to internalize risk, they will pass it along to consumers. It’s also important because populist fervor in America today wants to jail bankers. America is a capitalist society. Free markets that work are important to our societal survival. Otherwise, socialist and centralized bureaucracies will exert too much control over markets and they will fail continuously.

I am not going to wade into the debate over electronic trading vs open outcry. Open outcry had its peccadilloes too. I want to make some different points about electronic trading.

I am also not indicting the whole HFT community.  Like the old floor, there are good guys and there are a few bad apples. They are just trying to make money like anyone else. They didn’t build the system-they just play in it.

The floor community used to monitor open outcry. There was peer pressure; there was an organized Pit Committee process. Pit Committee people took that job seriously. That process cannot exist with electronic trading and only the exchange can monitor the community.

The other point I want to make is that when electronic trading started, there was an emphasis on one statistic over all others, trades per second. TPS was touted by exchanges to show the robustness of their electronic platform. In the late 1990’s, Eurex and LIFFE were way ahead of CME.  Their TPS was double CME’s.

TPS is a specious statistic. Going faster shouldn’t have been the most powerful force behind electronic markets. It forced all kinds of bad decisions later. The real reason electronic markets were powerful is the open access to order flow that it gave every market participant. Everyone could be on the top step. Speed doesn’t necessarily create efficiency.

I remember that all of us focused on speed at the outset of electronic trading. It came up in the board room. It was talked about on the floor. Equity owners that had a financial stake in the game wanted us to go faster. Traders at the CBOT would tell us they partnered with Eurex because their system was faster.  Traders are hyper competitive people and beating the other exchanges was on our minds. We made a mistake.

Nobel Prize winning Professor Alvin Roth has stated clearly that financial (and futures) markets are too fast.  Read his book on “Who Gets What and Why.”  The faster they go, the more distortion there is in price. Competition is not on price, but on speed. Supply and demand curves adjust on price, not speed. The market is actually less efficient in academic terms the faster it goes. At the same time, the market was inefficient at slow speeds too.

There is an entire business in the electronic trading world that strives to cut latency. This is the time it takes electronic messaging to make a round turn in the pipes. CME and other exchanges have developed a very nice business selling co-location to traders. They have created their own “top step” and sold it to some entities. Using Professor Roth’s theories would end that business.

It would be interesting to see how markets behaved if exchanges slowed them down. Suppose they matched trades at one second intervals. That would cure a lot of the spoofing because anyone that put up a big order would be on the hook. They wouldn’t be able to cancel it before getting hit.

Slowing markets down would also give humans a chance to interact with the market right alongside computers. Instead of competing on speed, which humans are guaranteed to lose, they would compete on price which changes the risk dynamics of trading.

My gut tells me we would see thicker books, and less marginal volatility. Retail investors and hedgers would be able to get into and out of positions. Professional traders would be able to build larger positions again. That would be good for markets, but it would hurt the profitability for one segment of the industry. It would probably hurt the share price of exchanges too. But, they’d be doing what they are supposed to be doing; providing a level playing field for people to manage risk and raise capital.

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About the Author

Jeffrey Carter is an angel investor and independent trader. From 1988-2011 he was an independent floor trader at the CME.  He served on the CME Board of Directors.