Trading for Peanuts: the Illusion of Transparent Markets

stockmarket

Yet investors worry that, in many cases, competition has brought down the visible price of trading by adding hidden costs. Two anxieties stand out. One is the worry that the current set-up of the markets allows high-speed traders to anticipate big orders and “front-run” them, moving prices in an unfavourable direction before an order can be executed. The other is the question of how robust the system is, with regulators still unable fully to explain events like the “flash crash” of 2010, when the Dow Jones Industrial Average plunged by 9% in minutes before rebounding.

Start with fears of front-running. Many institutional investors complain that ultra-fast traders spot big orders entering the market, and race ahead of them to adjust their prices accordingly. Attempts to hide from the speedsters can go awry. In January Credit Suisse and Barclays, two big banks, agreed to pay $154m in fines for misleading clients about the workings of their “dark pools”, where offers to sell and bids to buy are not published. In theory, that protects investors from front-running; in practice, several of the firms running such venues had concealed the central role that high-frequency traders played on them. (Credit Suisse didn’t admit or deny wrongdoing in the settlement.)

There is another, less-often-told side to the story. Speed is necessary to knit together a dispersed set of exchanges, so that investors are immediately routed towards the best price available and so that their orders are the first to get filled. And plenty of high-frequency traders are market-makers; it is their job to adjust prices in response to new information. Nonetheless, the idea that markets are rigged is widespread, not least thanks to the publication of “Flash Boys”, a book by Michael Lewis on the evils of high-speed trading.

One proferred solution is to level the field by slowing things down deliberately. IEX, whose founder is the hero of Mr Lewis’s book, is a trading platform that has applied to the SEC to become an exchange. It uses miles of coiled cable to create a “speed bump” that delays trades to the advantage of institutional investors. The SEC has received more than 400 letters in support of its application, but there is a vigorous debate about whether IEX’s system complies with the requirements of Regulation National Market System (Reg NMS). Some think that the better solution would be to get rid of Rule 611, which in effect requires orders to be sent to the exchange showing the best price, even though such quotes can sometimes be unobtainable in practice. The SEC will vote on IEX’s application by March 21st.

Share Trading, Complicate, then Prevaricate, Economist, Feb. 27, 2016

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