Zero Hedge 
June 12, 2010
As part of the SEC’s process to fix the broken market, it is currently soliciting public feedback on a variety of issues. Why it is doing so, we don’t know – after all anything that does not conform to the SEC’s preconception of what the most lucrative market to the SEC’s recent batch of clients (see earlier news about an SEC director going to HFT specialist Getco) is, just ends up in the shredder anyway. At this point to believe that the SEC will do anything remotely in the interest of investors instead of millisecond speculators, is naive beyond compare. Nonetheless, while combing through some of the recent public responses on the topic of market structure, we came across the following presentation by $34 billion Southeastern Asset Management (SAM), titled “Comment & Analysis on Equity Market Structure” which must be brought to the attention of all those who have the temerity to defend HFT as an altruistic source of liquidity provisioning. SAM’s 4 points are simple, and laid out very easily so that even the mildly retarded public, pardon, GETCO servants at the SEC can understand it: “1) The intent of the Securities Exchange Act of 1934 as provided for in its preamble is being twisted and abused for the benefit of gamblers and to the detriment of investors. 2) The markets are not “fair and honest”, 3) Securities prices are presently “susceptible to manipulation and control, and the dissemination of such prices gives rise to excessive speculation, resulting in sudden and unreasonable fluctuations in the prices of securities. 4) The preceding three issues are fixable by the SEC.” Let’s dig in.
Before we get into the meat of the complaint, one of SAM’s primary concerns, is that the US stock market has become the functional equivalent of China: trading intellectual property is routinely abused, stolen and used against its very creator.
- The US equity markets are meant to facilitate investors’ allocation of capital to businesses, thus expanding production and improving the quality of life in America.
- The markets have strayed from this social purpose, and presently resemble casinos more than orderly markets. As a result, the economy is hindered, fewer jobs are created, and reasonable returns for true investors (not traders) are compromised.
- The property rights of creators of intellectual capital are being systematically and openly ignored by the exchanges and certain market participants. The order originator’s hard work, ingenuity, and prospective returns are being taken and sold by those who did not create it.
- Whereas trading was once a means with which to match long-term buyers and sellers of businesses, trading has now become an end in and of itself.
And while these are rather philosophical concepts which will stump the SEC for years, and even then Mary Schapiro’s lack of brain trust will still say evidence is inconclusive and the IP theft, as established, will continue indefinitely, SAM’s disclosure about the true nature of HFT should be read by everyone, especially by the industry increasingly more conflicted defenders (why else would a firm like Getco go out and hire a pathologically “confused” person from the SEC if not for the fringe benefits of regulatory capture):
The traditional defense that HFT provides “liquidity” was completely disproven on May 6. Yet for those who still believe this naive argument, here is a more extended analysis.
Some undisputed facts for the novices in the HFT arena, such as the SEC:
As to what SAM requests of the SEC in order to take the first proper steps of correcting the busted market, here is the summary:
Forbid and prosecute the theft of trading decisions, which represent the actionable cumulative
value of a manager’s intellectual property by stating that:
- The creator of trading information is the owner of such information.
- Brokers have a fiduciary obligation to protect such information of their clients.
- Exchanges cannot repurpose such information for their own benefit without the express consent of the information’s originator.
- Exchanges and brokers must furnish the information that is released regarding an order to the order’s originator.
- Investors may opt to relinquish this intellectual property right, but, the default would be in favor of protecting information. No market participants can discriminate based on another party’s elections.
Mandate that all investors receive the same market data at the same time by:
- Amending Regulation NMS Rule 603 to prohibit “single exchange data feed[s]” and require an exchange or national securities association to provide any quotation or last sale data for an NMS stock to any investor only as part of a consolidated display of all quotation data and all last sale data from all markets.
- Banning an exchange or national securities association from providing “Order 10” or any other identifying market data that allows participants to determine whether specific quotes or executions are linked.
Mandate that any order on an exchange or national securities association have a minimum duration of 1 second prior to any cancelations/ amendments taking effect. Alternatively, institute 1 second duration auctions during which all exchange transactions must occur.
Eliminate maker/ taker pricing rebates by:
Expanding the ban on excessive access fees in Regulation NMS Rule 610 to ban a trading center from offering rebates as they provide perverse incentives when order routing.
In light of the events of May 6, SAM provides the following very useful cheat sheet for the SEC on what Fat Tail events are, and what the proper questions to ask of those who derelicted their duties to preserve and orderly market structure:
In statistics, fat tails (kurtosis) describe how often “outlier” events occur. The cliche “a once-in-a-lifetime catastrophe seems to occur every other week,” is a commonplace reference to fat tails – extraordinary, unexpected events occurring more often than predicted.
Fat tails are important in the financial markets as investors and regulators calibrate systems and expectations for the steady, normal state. When the abnormal occurs, most participants are caught off guard and find themselves in peril.
After most fat tail events, a review of the contributing factors results in culpable parties explaining how their models could not have predicted what actually did happen.
- 1987 Black Monday, portfolio insurance
- 2007 Subprime Mortgage Crisis, exceptional default rates
- May 6, 2010, DJIA temporarily falls nearly 1000 points, what was high-frequency trading’s role?
Questions for market regulators, legislators, and participants:
- Is the current market structure robust and resilient? Or,
- Do market regulators permit too many “tricks” amongst market participants?
- At the macro level, in a normal environment, do these “tricks” go unnoticed? But,
- In a fat tail event, will these “tricks” effect catastrophic outcomes?
- Are we wholly confident that the odds we place on extraordinary events – market shocks – are correct?
- Are market participants being consistently and effectively regulated, and are those strategic, tactical, and systemic risks being understood?
Yet most interestingly is the direct attack at exchanges who provide enough information to those willing to pay millions of dollars for what in any other practice would be considered an unfair advantage. SAM provides an overview of just the kind of unfair advantage HFT’s get when paying for preferential treatment by exchanges. Armed with the following information even computers with half a blown CPU will be able to legally front-run the entire market and make a killing. And people wonder why Goldman never loses money any more…
In the regard, we were very happy to learn that SAM has sent a letter to our old, opaque friends at the NYSE, which has recently been losing gobs of revenue to dark venues and as such has taken the war against dark pools into the open, even as it itself allegedly engages in precisely the type of IP theft defined above. To wit:
We hope that now that SAM’s response has received far more public scrutiny, the SEC will no longer hide behind the “we didn’t see it, so it doesn’t exist excuse” – the invesros of America are disgusted with how the SEC has allowed what was once an efficient market to degenrate into a manipulated, broken and inefficient casino, which only generates benefits for a select few, and in which “trading has now become an end in and of itself” but is only profitable for those who, through kickbacks, are part of the “captured” regulatory club that knows the SEC will never touch them for endless market frontrunning and manipulation.
In conclusion it is almost with shame that one has to be reminded about the very charter of the Securities Exchange Act of 1934, which described the requirement for regulation, and which was the very bedrock of what was once supposed to be an agency serving the public, and instead is now as worthless as US Treasuries will be in a few years:
For the reasons hereinafter enumerated, transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets are affected with a national public interest which makes it necessary to provide for regulation and control of such transactions and of practices and matters related thereto, including transactions by officers, directors, and principal security holders, to require appropriate reports to remove impediments to and perfect the mechanisms of a national market system for securities and a national system for the clearance and settlement of securities transactions and the safeguarding of securities and funds related thereto, and to impose requirements necessary to make such regulation and control reasonably complete and effective, in order to protect interstate commerce, the national credit, the Federal taxing power, to protect and make more effective the national banking system and Federal Reserve System, and to insure the maintenance of fair and honest markets in such transactions:
Frequently the prices of securities on such exchanges and markets are susceptible to manipulation and control, and the dissemination of such prices gives rise to excessive speculation, resulting in sudden and unreasonable fluctuations in the prices of securities which (a) cause alternately unreasonable expansion and unreasonable contraction of the volume of credit available for trade, transportation, and industry in interstate commerce, (b) hinder the proper appraisal of the value of securities and thus prevent a fair calculation of taxes owing to the United States and to the several States by owners, buyers, and sellers of securities, and (c) prevent the fair valuation of collateral for bank loans and/or obstruct the effective operation of the national banking system and Federal Reserve System.
Appendix: in order to demonstrate conclusively the false liquidity argument, SAM provides this additional Addendum which explains why “counter to the argument that investors save money by paying smaller spreads, true investors actually lose money because they are front-run” and also how retail investors keep getting consistently ripped off: “Retail investors once displayed the smallest public bids and offers. Unfortunately, retail investors have not changed their tactics to account for HFT rovers and are now displaying larger orders relative to other market participants on average.”