2. Coping with Liquidity Provision

Transaction Cost Analysis

In a follow-up interview, Jonathan Clark said the biggest “tax” on his trade executions was directly related to volatility. His costs rose as volatility went higher. He noted, as an aside, that being on the buy-side, his firm could not play both sides of the market in the same way as the sell-side could play it. Volatility is often widely viewed as an opportunity for sell-side practitioners, such as market makers or liquidity providers.

The speaker explained that stock prices might rise or fall, a situation that is not always a positive sign for a liquidity “demander” on the buy-side, when that participant is buying or selling stocks in the most cost-effective way.

In a follow-up note, the speaker noted, referring to the time period of the conference: “The point is that exchange-traded products are a fast growing segment of the market, and they need the type of liquidity [support] that high-frequency trading (HFT) provides. Traditional buy-side firm may not find HFT liquidity valuable, but the newer, faster growing asset management[ETP-related] businesses do.”

See Fact Sheet on Global Analyst Research Settlements. Securities and Exchange Commission. April 28, 2003. https://​www.​sec.​gov/​news/​speech/​factsheet.​htm

Ibid.

Prior to the Research Settlement, a market maker was effectively incented to be number one in a stock, even if this market maker took a loss as a result. New investment banking deals with lucrative fees could follow if a firm was a dominant market maker in a stock. The “settlement” aimed to eliminate that business model, a model rife with at least the perception of a conflict of interest.

Refers to the platform, Autex, operated by Thomas Financial, for the dissemination of block trading data, and the rankings of firms, via Autex BlockDATA, by the size of their block shares traded.

“We’re” refers to the exchanges collectively.

For more on trading halts in US markets, see backgrounder on Securities and Exchange Commission: https://​www.​sec.​gov/​fast-answers/​answerstradingha​lthtm.​html

Flash Crash of May 6, 2010, lasted about 36 min, erasing 998.5 points in the Dow Jones Industrial Average and then quickly recouped much of the losses as the various indexes rapidly rebounded in this high-speed, electronic trading phenomena.

See Has Wall Street Employed Enough Tech to Protect Against Another Black Monday? Circuit breakers and tech can safeguard against market meltdowns, but cannot completely prevent market crashes. TheStreet examines the technology of the era and the technology of today as part of its Black Monday special report. Chris Nolter. The Street.​com https://​www.​thestreet.​com/​story/​14345945/​1/​rebooting-wall-street-technology-after-black-monday.​html

NASDAQ Frequently Asked Questions: https://​www.​nasdaqtrader.​com/​content/​MarketRegulation​/​LULD_​FAQ.​pdf

Under the rules of the Securities and Exchange Commission, individual exchanges cannot add their own short pauses.

See Liquidity Provider. NASDAQ. http://business.nasdaq.com/list/listing-options/European-Markets/liquidity-provider/index.html.

Referring to the essential ideas on the panel in the incenting of liquidity. In maker taker, an exchange pays a participant a rebate for posting liquidity, charges a fee for taking liquidity.

Referring to the various changes in US market structure around this time period of the conference which reflect the response of the marketplace to an earlier phase, circa 2004. The changes are many and varied and can be traced back many decades. For the purposes of the speaker’s comment, it is worth nothing that in 1997, the Order Handling Rules were introduced by the Securities and Exchange Commission. In 2001, the trading of stocks in the USA switched from fractional to decimal increments. The maker taker model followed in the high-speed trading markets that emerged. As previously noted, in a competitive program to encourage trading on exchanges, maker-taker fees offer a transaction rebate to trading participants who provide liquidity, charging customers who take liquidity.

The metaphor takes the image of a brand product for catching roaches. In the same way, an illiquid stock posted on some trading platforms may have a challenge finding the other side of the trade for an execution.

Liberty Direct was the predecessor company of, and then became Tullet Liberty, and subsequently it was purchased by ICAP.

See The Clock For Market Structure Change Is Ticking. Wall Street & Technology. Ivy Schmerken. http://www.wallstreetandtech.com/trading-technology/the-clock-for-market-structure-change-is-ticking/d/d-id/1318135. Ivy Schmerken. 1/7/2015.

At Lime Brokerage, George Hessler was executive vice president, head of sales, marketing, and strategy.

By the same token, “displayed” data refers to data the market participant can see, the opposite of the non-displayed market data fed directly into trading algorithms.

In 2008, the New York Stock Exchange had abolished specialists on the floor, replacing them with Designated Market Makers. This was preceded by Regulation NMS (National Market System) in 2005, the regulation which spurred the NYSE to become more fully electronic, and fostering the rise of competing ECNs and exchanges. Consequently, the block trading of shares soon became challenging, if not problematic.

See Block traders prefer the human touch. Philip Stafford. Financial Times. September 17, 2014. https://www.ft.com/content/44841008-3cf7-11e4-a2ab-00144feabdc0

A conditional order is a type of order that will be submitted or canceled if set criteria are met, which are defined by the trader/investor entering the order. This allows for a greater customization of the order to meet the specific needs of the investor. Source: Investopedia

Referring to BIDS.

Ibid.

For a comprehensive account of dark pools and there opposite in lit markets, see Dark Pools: Fear of the Dark. Third Way. Lauren Oppenheimer, John Vahey. August 28, 2013. http://www.thirdway.org/report/dark-pools-fear-of-the-dark

As the authors explain: “Dark pools are private, electronic stock trading venues that allow buyers and sellers of a stock to be matched anonymously. In a dark pool, prices are not displayed to investors—stock prices are dark. Dark trading is an alternative to trading on a “lit” exchange, like the New York Stock Exchange (NYSE), where traders benefit from visible prices.”

In equities trading, an IOI is an Indication of Interest, usually disseminated by an electronic signal by a sell-side broker to various other market players, usually the customers of the broker dealer, indicating to them the positions he is currently dealing in and looking for interest in those positions from his clients. An IOI is an indication, and not a commitment.

Actionable IOIs are bids or offers for a stock that are in effect, available for execution.

250,000 share prints would have been the ideal objective in this example. As the speaker explained in a follow-up, the thinking back then is that when you had quarter point spreads in this era, and everything was traded in a “manual” manner, a block trader would prefer to write say one or two price points down rather than a multiple of price points, for a total of two trades so as to complete the full block. That compares with today’s reality of potentially thousands of smaller trades.

There was a “perverse incentive,” Mahoney said, to trade larger stocks in this aforementioned manual environment. “If you were manually trading stocks and had to record and write every trade you executed, you certainly did not want to have to write down a 100-shares order a thousand times over for a large 100,000 share block,” he explained. “Each one of those trades could have come at different price points; each one of those trades could have had a different counterparty. There was a structural impediment that led you to want to trade larger share sizes.” Today, the markets are “fully electronic” which, in effect, eliminates that kind of “bias” to complete a block in larger share sizes.

The Financial Information eXchange (FIX) protocol is an electronic communications protocol launched in 1992 for the real-time exchange of information in securities transactions and markets.

The term “virtual block” was popular at the time of this conference. It refers to the idea of electronically executing a block trade, even a million share order, however challenging, given the need to break up large orders, on a computerized network.

The speaker is talking in broad terms about free-market competition and is defending the idea that the competitive markets should “select” what venues and platforms fail and succeed, a concept that harkens back to the “invisible hand” introduced by Adam Smith in his book, The Wealth of Nations.

See Reg NMS (Regulation National Market System) adopted by the Securities and Exchange Commission in 2005 and introduced 2 years later to further advance the ideals of a national market system. The regulation includes the order protection, or trade-through rule; access rule (fair access) to market data including quotations; and rules on sub-penny trading and on market data.

IEX (also known as the Investors Exchange). The much publicized US-based stock exchange was founded in 2012 and is the subject of Michael Lewis’ bestseller, Flashboys.

For additional information, see Nazli Sila Alan, , John S.​ Mask, Robert A.​ Schwartz, “A Liquidity Program to Stabilize Equity Markets, The Journal of Portfolio Management Winter 2015, 41 (2) 113-125; DOI: https://doi.org/10.3905/jpm.2015.41.2.113 (Reprinted in this book on page __).

In follow-up, Mahoney explained that Jonathon was running a buy-side trading desk at the time of the conference, and so his aim would have been to buy at below fair market price. He had no obligation, so to speak, to ensure the market was priced appropriately. However, he could leverage his knowledge of the market to ensure that he did better in terms of executions for his clients than they could potentially do on their own.

For additional information, see Nazli Sila Alan, Timothy Mahoney, and Robert A. Schwartz, “Combating Turbulence in the Equity Markets: Get the Listed Companies on Board,” The Journal of Portfolio Management Invited Editorial, Summer 2015, 41 (4) 8-11; DOI: https://doi.org/10.3905/jpm.2015.41.4.008. (Reprinted in this book on page __).

Referring to the buy-side generally and more specifically to Jonathan Clark on the buy-side.

Referring to the paper outlined by Professor Nazli Sila Alan.

Flash Crash of May 6, 2010, lasted about 36 min, erasing 998.5 points in the Dow Jones Industrial Average. It then quickly recouped much of the losses as the various indexes rapidly rebounded during this high-speed, electronic trading phenomena.

“The first contemporary global financial crisis unfolded in the autumn of 1987 on a day known infamously as “Black Monday.” A chain reaction of market distress sent global stock exchanges plummeting in a matter of hours. In the USA, the Dow Jones Industrial Average (DJIA) dropped 22.6% in a single trading session, a loss that remains the largest 1-day stock market decline in history. At the time, it also marked the sharpest market downturn in the United States since the Great Depression.” Source: Stock Market Crash of 1987. Federal Reserve History. Donald Bernhardt and Marshall Eckblad, Federal Reserve Bank of Chicago. https://www.federalreservehistory.org/essays/stock_market_crash_of_1987

A stock buyback, also known as a “share repurchase,” involves a company buying back its shares from the marketplace. Think of a buyback as a company investing in itself or using its cash to buy its own shares. Because a company can’t act as its own shareholder, repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. When this happens, the relative ownership stake of each investor increases because there are fewer shares, or claims, on the earnings of the company. Source: Investopedia

Referring to the Supplemental Liquidity proposal.

See footnote 45.

Corporations can buyback their own shares with money borrowed in the credit markets or with their own cash. However, the speaker, in a follow-up, stressed that he was referring to was the fact that, at the time of the conference, companies preferred to issue debt over equity.

See footnote 17.

Current benchmark price is equal to the price of the last order executed, with the initial benchmark being set to the market closing price on the day before the SL program is implemented.

Ibid.

See footnote 34, FIX.

Referring to potential risk in trading. These “tails” mark the highs and lows of the period.

This refers to the ability of market participants to gain advantages in the speed of their trade executions and price-quote data through advanced technology, specifically the “co-location” of their computer servers near stock exchanges’ computers. That lowers so-called latency, a critical factor in high-speed trade executions. The practice is regarded as legal though it has many critics.

Ibid.

Ibid.

Ibid.

Price/time priority refers to how orders are prioritized for execution. In this instance, orders are first ranked according to their price; orders of the same price are then ranked based on when they were entered.

The “old” NASDAQ here refers to the more manual based- trading of stocks by market makers before the advent of advanced technology in NASDAQ trading rooms fostered by regulatory changes.

Refers to the competition among vendors and exchanges to introduce high-speed trading platforms, oftentimes on the basis of speed of execution.

FGPA was developed for military and commercial purposes and later made its way into the business of exchanges. https://en.wikipedia.org/wiki/Field-programmable_gate_array

For further background, and most recent updates as of writing, see Investor Alert. Tick Size Pilot Program. What Investors Need to Know. Securities and Exchange Commission. October 03, 2016. https://​www.​sec.​gov/​oiea/​investor-alerts-bulletins/​ia_​ticksize.​html

Ibid.

Jumpstart Our Business Startups (JOBS) Act https://www.sec.gov/spotlight/jobs-act.shtml. The thinking among many proponents of this law is that wider spreads would trigger more demand for otherwise illiquid stocks among market makers and foster more research coverage of these same stocks of small companies. That in turn would ultimately assist the capital raising process for smaller companies, which many see as the engine of job growth in the USA.

The “parent” order is regarded as the original starting order the trader is aiming to execute. For example, it could be a one million block share order but with only 100,000 shares put to work. So the parent order, in this example, is for one million shares.

For an informed discussion on how the pilot program fared, see Tick-size pilot disappointment has experts searching for alternatives. New ways to add liquidity, boost trading examined. Rick Baert. Pensions&Investments

From the story:

“The tick pilot, which began in October and extends through October 2018, has not resulted in an increase in the number of listed small-company stocks, as was hoped, but it hasn’t hurt small-cap stock performance so far.”

“The pilot securities assigned to the third test group will adhere to both the quoting and trading requirements of the second test group but will also be subject to a ‘Trade-At’ requirement, which generally prevents price matching by trading centers that are not already displaying a quotation at that price, unless an exception applies, including for example, an exception for block size orders and exceptions that mirror those under Rule 611 of Regulation NMS.”

Source:

Investor Alert. Tick Size Pilot Program. What Investors Need to Know. Securities and Exchange Commission. October 03, 2016. https://www.sec.gov/oiea/investor-alerts-bulletins/ia_ticksize.html

The “full-employment” reference by Frank Tabb was a tongue- in-cheek comment on the notion that the Trade-At requirement would drove more liquidity and order flow to the exchanges.

During 2014, “Exchanges have been lobbying US regulator the Securities and Exchange Commission (SEC) to introduce a rule that would force equities transactions onto lit exchanges, unless dark pools or internalising matching engines operated by brokers could prove meaningful price improvement had been achieved.” From The Trade News.

SRO is the acronym for Self-Regulatory Organization.

The Investment Company Institute.

See footnote 37.

The SEC’s Order Handling Rules of 1997 and Beyond: Perspective and Outcomes of the Landmark Regulation RICHARD LINDSEY, JOHN AIDAN BYRNE, AND ROBERT A. SCHWARTZ. The Journal of Portfolio Management. Spring 2016 http://www.iijournals.com/doi/pdfplus/10.3905/jpm.2016.42.3.056

The Dodd–Frank Wall Street Reform and Consumer Protection Act (commonly referred to as Dodd–Frank Act) was signed by President Barack Obama, on July 21, 2010, in response to the financial crisis of 2007–2008. “An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes,” according to the long title of the Act.

Frank Hatheway elaborated, in a follow-up, that on NASDAQ’s European markets operations, trades are matched first to the best price. If multiple orders are at the best price, then the second criteria is whether two orders from the same broker can be matched at the best price. NASDAQ’s US markets do not have this second criteria.

Referring to the Nickel Pilot program.

See footnote 37.

See footnote 17.

Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization-based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions as well as seeking to enhance risk-adjusted returns above cap-weighted indices.

Source: Investopedia

ETPs include exchange-traded funds, ETFs.

The speaker, in a follow-up explained further: “If your choice as a market maker is to trade 100 shares against the uniformed retail flow, or 10,000 shares against an institutional investor, you are trading less money more frequently with less risk by the first way than by the second way. My point is that market making is not a great business enterprise [today], which is why there are not enough market makers in the industry.”

See Dodd-Frank, Basel 111 and the Age of Uncertainty. Sullivan & Cromwell. 2012. https://​www.​sullcrom.​com/​siteFiles/​Publications/​Wiseman-Gladin-Basel-Dodd-Frank-Oct-2012.​pdf

See footnote 37.

Regarding trading nickels without trading inside the spread, Hessler explained in a follow-up, that he was making a case for the second test group in the Nickel Tick pilot program.* His belief is that trading in nickel increments would consolidate liquidity in those stocks better than allowing all price points between the nickels. As a simple example, Hessler offered: “Suppose you owned a stock and wanted to sell it at 20.11. You might decide to wait until a 20.11 bid comes into the market.”

However, he added, “if the stock could only trade at 20.10 or 20.15, you might hit a 20.10 bid, and you would certainly be willing to offer at 20.15. Historically, when stocks traded in 1/4 point increments, there was tremendous additional liquidity at each increment. Very liquid stocks don’t need this kind of liquidity consolidation, but illiquid ones could benefit from it.”

*The pilot securities assigned to the second test group generally will be quoted in $0.05 increments, subject to limited exceptions. In addition, these securities also must trade in $0.05 minimum increments, subject to exceptions, including for executions at the midpoint of the national best bid and offer (NBBO), certain retail investor executions and negotiated trades. Source: Securities and Exchange Commission.

In a follow on “restrictions,” George Hessler further explained that by trading certain illiquid stocks in nickel increments, for example, the market is consolidating liquidity by price points. The same stock trading in pennies could be problematic, say when there is a 23 bid and a 27 offer. The two parties are so far apart on price they never realistically expect to meet. “The less liquid a given stock is, the more helpful these restrictions can be in consolidating the liquidity in the stock,” Hessler noted.

Referring to the nickel tick pilot program.

See footnote, 61 for “third bucket.”

See footnote 37.

The late New York Stock Exchange floor specialist, James (Jimmy) Maguire. He died in August 2017. Maguire, a trading vet, was famous for advocating a return to nickel trading.

See footnote 61.

See https://www.sec.gov/spotlight/regnms/jointnmsexemptionrequest043010.pdf