Out of both of these scandals came SEC rules to facilitate competition – not just between orders, but between markets. The SEC enabled the development of three major non-exchange-type matching mechanisms: internalization – where brokers could internally match buyers and sellers; ECNs’ (electronic communications networks’) alternative central limit order books (less-regulated, quasi-exchanges); and dark pools, opaque broker-owned matching venues that work like exchanges but do not display limit orders (hence, “dark”). During this time the SEC developed the Order Handling Rules, Regulation ATS, and Regulation NMS, which codified how orders needed to be treated in this fragmented market structure.

Today, while fragmented, equity execution is much less expensive, faster (generally sub-millisecond compared to more than 10 seconds in 2005), and more open. Retail brokerage fees are generally under $10 a trade, and institutions can pay under 1 penny a share (closer to .8 cents per share) for electronic execution. In addition, average effective spreads are down, and investors are much more in control of their executions than ever before.

The development of multiple execution venues has changed the economics of trading. If we look back on equity trading even as recent as a decade ago, the brokers and exchanges were standalone profitable powerhouses. Today, equity exchanges are not in the same financial shape. Derivative exchanges are driving exchange growth, and equity exchanges need to be lean and mean to survive. Brokers are not prospering either, as traders and experienced sales people are being swapped for machines and less experienced sales support. ETFs, self-empowering technology and investor pressure have reduced the cost of execution and have caused brokers to reduce their staffs.

So where is all of this value going? To high-frequency traders? We don’t see them doing much better than the exchanges or brokers. The pressure to invest in expensive technology and infrastructure, colocation and connections to many more markets, as well as improvements in vendor-based solutions, have caused a hit to their revenues. TABB Group estimates that US equity HFT revenues have declined from approximately $7.2 billion in 2009 to about $1.3 billion in 2014. Looking at recent public data, the profitability of HFT firms in the US equities market has declined, just as the number of players has decreased.

If the exchanges, brokers and HFTs are not reaping the rewards, then where is this leakage going? This money is going back to investors in the form of better and cheaper executions, as few if any institutional investors we have interviewed – and we have interviewed thousands – have ever expressed that their equity implementation costs have increased, meaning … trading just becomes cheaper and cheaper. That cost comes from somewhere: market makers, speculators, brokers and exchanges.

Risk and Reward

Everyone hates speculators. That is a given. They are viewed as parasites sucking the alpha out of investors’ brilliant ideas. While intermediaries do step in the middle of investors’ trading strategies, speculators/intermediaries do serve a true purpose: They facilitate price discovery – meaning they provide quotes. That is a very important (if not the most important) function of a market: determining the price. A market without price discovery becomes an expensive and illiquid market. While most major investors know the intrinsic value of an asset they are willing to trade, the quoting process not only crystalizes the price for all to see, it provides tradable quotes for even the largest investors.

To fully understand this, think of a store. A store that doesn’t display or advertise its prices doesn’t get much business. Think of walking into a store filled with merchandise with nary a price to be seen. For each product, you need to ask a salesperson, who may or may not give you an accurate price. While a store can advertise that it will beat all competitors’ prices, if it doesn’t display a price, it puts the onus on buyers to find the best price, bring proof into the store and haggle with the storekeeper to book a deal.

The same is true with displayed markets. A market without a pricing mechanism isn’t much of a market.

The people who provide these prices are market makers, speculators, or what most people call HFT. These actors quote product bids and offers across a wide spectrum of markets (exchanges, ECNs, and dark pools). Collectively, it is their business model to try to provide the most aggressive price they can provide to buy or sell a stock. These firms also generate their revenues from two sources: the spread between which they can buy and sell stock, and any incentives that exchanges, ECNs, or dark pools may give them to quote in their markets.

While trading venues may provide incentives to quote (generally up to $.00029 per share), venues do not share in liquidity providers’ trading profits or losses. This means that any trading house that improperly gauges supply and demand has to bear the entire cost of any losses itself.

Let me rephrase this: To have tight markets, many firms (mostly HFT) need to compete to set the best market price. These firms are competing to capture the spread (for liquid stocks, this is 1 cent per share) plus any incentive, minus any trading cost. If these firms miscalculate supply and demand, as Knight did one fateful morning, they will not only have a bad trading day, they could go bust.

So how do these firms manage risk?

Quotes equate to risk. Any time a trader (asset manager, retail investor, market maker or HFT) puts a quote into the market, it is an option for the market to trade. The quoter provides the option – I would like to buy 100 shares of IBM at $190 a share. Just because a buyer wants to acquire IBM at $190 doesn’t mean that someone is out there willing to sell IBM at $190; however, if someone is, unless the quoter cancels the order, the person quoting is committed to trade. While a longer-term investor may have a time horizon for the trade of days, weeks, months or years, generally a market maker, speculator, and/or HFT is looking at a horizon of seconds to minutes. If my whole business model is predicated off quoting to earn a spread, then I need to understand all of the market influences that could make IBM go up or down during my investment time horizon (seconds to minutes).

So what makes a stock go up or down in the short term? Certainly there are company fundamentals such as sales, earnings or management changes; but typically that information doesn’t change second to second. There also is research, news, information, and other data that gets released by analysts, media, or people simply expressing their opinions online. Lastly, and most important, in the very short term, supply and demand impacts price the most – how many people want to buy vs. sell and, more important, how much?

The problem with quoting – especially for market makers, speculators, and/or HFTs – is that the quoter cannot easily gauge the quantity the longer-term buyer/seller wants to trade. If the quantity is small, the problem is slight; if the quantity is large, then the investor’s order could significantly alter supply, demand and price, forcing the short-term trader to lose money. And remember, the quoting party is committed, while the aggressing party is not. The aggressor may want to buy 100 shares, or it could be looking for a million.

So how does the quoter manage risk?

There are different ways for market makers to manage risk. First, they need to be quick. If market makers are slow to react, they will be taken advantage of. If the price of IBM should really be $191 instead of $190, then either the market maker’s order won’t trade (if it is out of the money), or worse, it will trade disadvantageously and the liquidity provider will take a loss. And if that quote is for 10,000 shares, the loss could be significant.

Second, they need to be connected. Market makers need to be connected to markets where liquidity either resides or will reside. If speculators are not connected to markets, it becomes harder to trade. They may be able to go through a third party to get to an unconnected market; however, if time is important, connecting via a third party will be latency-prone.

Third, they need to be connected to proxy products. Proxy products are products that may trade somewhat like the product that you are trading. These products could be futures, ETFs, FX, bonds, news or other indicative entities that may hint that the market is about to move. Traditionally, futures move before cash. If the S&P 500 future starts moving, it will indicate that the cash equities may soon follow.

Last, they must fully understand all of the nuances of each market they trade. This means: how to connect, their protocols, pricing, order types, market data structures, and all of the information surrounding how that market operates. Without this information, the speculator may find that its connection time lags, its order type usage isn’t appropriate, or it is just being outsmarted by someone more versed in market microstructure.

[Related: “Take the Time to Understand the Complexities of the Markets”]

Why do quotes fade when a larger order enters the market?

We hear frequently that on an aggregate basis there is significant displayed volume, but when approached, it disappears. The reason why this occurs is twofold: first, since there are 13 exchanges and more than 40 dark pools, liquidity providers and investor algorithms spread orders across exchanges and often oversize them, to ensure that no matter which venue you arrive at there is the ability to get executed. So that large aggregated volume really doesn’t exist. It is being represented multiple times. Second, if a large order does arrive in the market and outstrips supply, then the price should adjust given the increase in demand.

While no one really likes it, today’s yield pricing models do the same thing. When buying a ticket on a flight or booking a hotel room, the price displayed today is never the price displayed tomorrow. And given cookie technology, travel sites and, increasingly, other Internet pricing engines are determining your location, previous transactions, and obtaining information from other sites to do their best to extract every marginal dollar from your wallet that you are willing to pay. That said, if you don’t want to go, don’t by the ticket.

If you talk with the airlines and hotels, they say that “on balance” these pricing engines benefit both travelers and the airlines/hotels by enabling patient buyers to pay less and more urgent buyers to pay more. Liquidity providers in markets are using the exact same strategies to do the exact same function – gauge supply and demand and determine the value of their risk capital.

But how does this happen?

HFT exists because our markets are systematic. There are ways to connect, ways orders are executed, and ways data can be modeled. Our 53 or so lit and dark markets operate in specific and consistent ways. They are in different places, connected via jitter-free dark fiber connections where latency can be measured by the nanosecond. And orders move through this infrastructure in certain ways.

Orders move from investors to brokers, to broker algorithms, to dark pools, to exchanges. Placing limit orders across these markets gives liquidity providers (not necessarily HFTs) the ability to create a Tsunami early warning system.

If a trader places limit orders in all 53 or so markets, as one order is hit and then another, the trader could begin to develop a pattern of where liquidity was coming from, where it was going to, how much was being taken, and how aggressive the market was being pushed. Given this information, a market marker/liquidity provider would begin to develop a sense of how aggressive and price sensitive the trader was. The market maker can then raise or lower the price, depending upon demand. This, however, is easier said than done.

Can the market be manipulated?

Markets can be pushed, but not for long. With so many algorithms in the market calculating fair market value, machines can determine, by the microsecond, the price of almost every financial asset. That said, the more liquid the product, the harder it is to manipulate. Highly liquid products are much harder to push than less liquid products, just because they are highly liquid. The more people trading an asset and the more divergent the view, the more traders there are pushing that asset into an equilibrium price. Conversely, the less liquid the product, the easier it is to move the price, especially if the bid and offer are thin. However, the less liquid a product, the less supply and demand, so determining an accurate clearing price is also harder. So whether you call that price discovery or manipulation is hard to say with authority.

While markets can be pushed, does it mean they are rigged?

No. Not at all. Liquidity has a price. Having a firm commit capital to buy and sell at a moment’s notice costs money. That money comes from the bid-offer spread and any rebate a market venue decides to pay. While there is an intermediary, the intermediary doesn’t decide the price. A market maker holding a product for seconds or minutes can only have a limited impact on price. When firms are buying in second one (pushing the price a touch higher), and subsequently selling a few seconds or minutes later, the act of selling will generally bring the price back to around its original value. Only investors with longer holding periods and greater amounts of capital can influence a market for a sustained period. Speculators and HFTs tend to have limited capital and turn it over frequently. It is larger investors and hedge funds that buy and do not sell that can push the price for any significant period. However, this type of trading is aligned with real ownership, and hence should have a longer-term influence on price.

While larger investors’ trading influences longer-term price swings, it is the buy-side trader that is responsible for managing the impact of the investors’ executions. Institutional investors typically employ buy-side traders to manage their trading. It is up to the buy-side trader to determine the trading strategy that aligns with the portfolio manager’s investment thesis. Buy-side traders are professionals who have a fiduciary obligation to trade their clients’ assets with care.

When traders engage with the market, they are focused on execution quality and worry about interacting with bad actors. Institutional investors understand how much they are willing to pay and how active they want to be in the market. If speculators wanted to intercede and significantly market up liquidity, investors would vanish and the price would settle back down, until patient investors would reenter the market.

That is what a market does. It ascertains supply and demand and forces participants to pay the most they are willing to pay. When you run out of patience (if you and not others were pushing the market), reversion takes place, prices back down and investors can come back into the market again.

This is the cost of liquidity – the cost of trading.

Can trading be done smarter? Yes. Can it be done better? Certainly. Is the market rigged? Absolutely not.

So what if the market markers/speculators and liquidity providers all go bust?

While many would like to see speculators go bust, market makers, speculators and HFTs do provide a service. They price product. Since market markers quote and quotes are commitments to trade, without market makers there would be fewer quotes, less competition to be at the top of the book, and a less aggressive pricing mechanism for investors. While investors may fund the profits of speculators, without vigorous competition to be top of the book, spreads would widen, and investors would actually pay more.

That said, speculators can’t be allowed to capture all of the alpha either. While speculators need to make enough to survive, they shouldn’t strip all of the profitability out of investors’ ideas either.

The job of protecting investors’ alpha many times rests with the buy-side trader and the broker. The broker’s job (be it human or electronic) is to shop an order as efficiently as possible and capture as much of the economic interest of the trade for the investor as possible. If an investor felt that IBM was going to move from $190 to $200, the investor wouldn’t be happy if the broker, instead of obtaining the market price of $190, paid up $10 and bought the stock for $200. If that occurred, all of the alpha on that trading idea would be lost. If this occurred frequently, investors would get frustrated and eventually leave the market.

Protecting Client Orders

It is the broker’s job to protect the client order. The way brokers protect client orders in a fragmented market is through smart trading. Now, there isn’t one way to execute an order; some orders need to be traded aggressively, some passively, some in blocks, and some with capital. While strategies change with each trade and each name, there are certain tactics brokers have developed to help investors get their best price. While orders a decade ago were mostly traded by hand, in todays’ market, most orders are traded by algorithm.

Algorithms are developed to model the different ways that investors want their orders executed, such as at the current price (implementation shortfall), averaged VWAP or TWAP (volume- or time-weighted average price), when liquidity arrives, or in stealth mode. Algorithms generally have two major parts: the scheduler, and the order router. The scheduler will take a larger order (parent) and determine the most appropriate way to segment the order (break it into smaller pieces, or child orders) and when to send it to market. The router then takes the child orders and routes them to the appropriate trading venue. This could be a dark pool, an ECN, or an exchange. Each of these venues has a probability of execution associated with it, and each has a series of costs.

Execution Cost

Execution costs are not just spreads and execution fees. Some of the least-impactful trading costs are explicit costs such as spreads and execution fees. Other execution costs include market impact (what influence did your order have on the market?), adverse selection (was your limit order placed correctly?), and opportunity cost (was your order placed at the wrong venue?).

How parent orders are segmented and where child orders are routed have everything to do with how effective your trading strategy is.

Once the child order is created, getting that order to market becomes critical. Should it be a market or a limit order, or some special order type? Should it be exposed or dark? How many dark pools should be checked before the order is routed to a lit venue? Should it be sent to a ping network (an electronic capital commitment facility)? Which exchange should it be routed to? Should the exchange route the order to another market, if there is a better price elsewhere?

This process can change depending upon the stock, time of day, supply and demand, and a host of other issues. This is not an easy problem to solve.

Measurement

Just because this problem isn’t easy, however, doesn’t mean it should not be solved. The brokers that develop buy-side trading algorithms take this job seriously. There isn’t one firm that has ever told me that it goes out of its way to give its clients a poor execution. Most brokers have a vast array of folks that analyze execution costs or provide Transaction Cost Analysis (TCA) services. This service tries to analyze the implicit cost of trading by analyzing each execution.

Besides broker TCA services, most buy-side firms analyze their own trading performance, and there are a number of firms that provide TCA services across brokers such as Markit, Bloomberg, ITG, Abel Noser, Elkins McSherry, SG Levinson and others. Are these firms perfect? Probably not. But the investors spend heavily to analyze their trading, their brokers, their algorithms, and their impact on the market.

Takeaways

Now, is there a single best way to execute an order? Are brokers perfect? Are there conflicts in the pricing structure of trades that may push brokers to trade off-exchange in their own dark pool versus at a lit exchange? Absolutely. That said, investors, brokers, and third-party measurement firms are trying to help better analyze the problems, help investors shift flow toward better performing brokers and algorithms, and help traders better understand where there is leakage.

We have not yet reached execution nirvana.

Toward a Better Solution

Brokers’ algos are not perfect. No trading machine, be it silicon or human, is perfect. The idea, however, is to create a more perfect and more efficient market. That is what competition and freedom are about. If IEX has a better idea, great – put up capital, create a new market, and see if it works. If it does, it will gain share; if not, it will go bust.

Should the SEC restrict markets? I had said “yes.” I had felt that there were too many exchanges, too many dark pools, and too many internalizes. However, if the SEC would have placed a limit on matching venues, would new markets such as IEX or Tripleshot have been developed? Would they have had enough funding to buy an ATS license? Who knows? But one thing is for certain: The ability to bring new ideas to market is a hallmark of our markets. If the SEC limited licenses, then new platforms would have a harder time coming to fruition.

The most important aspect of our markets is our transparency. Each order is tracked, each order is archived, and each trade is printed. The key to making our markets better is being able to analyze that information – to make information-based judgments that accurately represent the truth for each investor, each broker and each market. Once this information is in the hands of investors, they can value it as they like. If they care about execution quality, then obtain, analyze and measure broker and venue execution quality and shift your trading flow accordingly. If leakage is less important than other services your broker provides – whether online access, custodial services, research, or corporate access – then understand the true cost of those services and make a value judgment accordingly.

The markets are not rigged. They are just intermediated and possibly not effectively brokered. Information, analysis and choice are our most powerful weapons. Analyze your trading data. If your managers, brokers, and/or trading venues are not doing their jobs, leverage your choice, send them a message, and fire them!

Let’s use the power of choice appropriately.