The SEC is widening an investigation into stock exchanges amid growing concern that their business model gives preference to “sophisticated clients” over ordinary investors, the WSJ reported this week.Here’s what that actually means: Regulators are starting to see exchanges as a source of the problems in our markets — the flash crashes, the flight of the retail investor, the IPO disasters. High frequency trading firms have caught most of the public ire for these issues, but as people like Mark Cuban have argued, the problem runs much deeper than that.
Here’s what he said in an interview about this issue on CNBC last month:
It’s really just the NYSE protecting their own… they’re the root of this problem despite the fact that people don’t want to admit it….they’re a for-profit entity now as opposed to being a non-profit entity in the past and they’re doing what every for-profit entity does — They’re trying increase their sales protecting their best customers and to do this they’re creating all these different kinds of order types. How many order types do you need? Well in the case of the NYSE and other exchanges they create as many as they can to try to get more algorithmic trading to try to enhance more volume and even to pay for that volume…
It’s a pretty aggressive accusation (and that’s all it is for now, an accusation), but Cuban hit what the SEC’s investigation is trying to nail right on the head. It’s all about the order types.
Order types are how trading firms tell stock exchanges what they want to do with their trades.
The SEC wants to find out if some order types are known to be better, faster, and smarter than others. And if bigger, faster, favoured firms are privy to that knowledge while smaller firms are being left to get gobbled up.
After all, on Wall Street, we know that knowledge is power.
The SEC is looking at how order types “get developed, vetted, approved and tested and ultimately how they interact” with other investor orders, said John Polise, who heads OCIE’s (Office of Compliance Inspections) market-oversight unit, in an interview.
The SEC is now going after e-mails and other communications between exchanges and big high frequency trading firms. They’ll be looking for anything that smacks of favoritism and collusion — anything that indicates that the exchanges are giving HFT firms more information than they are investors like mutual funds, for example, or that HFTs are helping to craft order types directly.
As the WSJ points out, the exchanges are willing to admit that HFTs get some preference. However, they also say that anyone with the “right hardware and technical savvy” can have access to these advantages. Plus, HFTs help the market by providing volume and liquidity.
What has always been hard to explain to the general public on this issue, though, is what exactly that knowledge entails and how it’s used to make the market and choppier, more dangerous place to trade. This order type probe is the key to understanding that.
Scott Patterson, one of the WSJ reporters who broke the news of this investigation, also published a book about this over the summer called Dark Pools.
It’s the story of one trader named Haim Bodek, the CEO of a trading firm called Trading Machines. All of the sudden, he discovered that his company’s was once successful algorithms were getting gamed by order types that seemed to be a secret.
He thought he was going to go under.
In early December 2009, Haim Bodek believed he’d finally solved the riddle of the stock-trading problem that was killing Trading Machines. He was attending a party in New York City sponsored by a U.S. exchange. He’d been complaining for months to the exchange about all the bad trades…and he’d finally stopped using the exchange altogether.
At the bar, he cornered an exchange representative and pushed for answers. The rep asked Bodek what order types he’d been using to buy and sell stocks. Order types were how trading firms “talked” to exchanges, the language they used to communicate their intentions. They determined how a buy or sell order interacted with other orders. A “market order” essentially told the exchange to “buy the stock now no matter what!” They were for urgent traders who didn’t care if the market moved in the next few seconds. “Limit orders,” used by most professional traders, specified that an investor wanted to buy or sell a stock within a “limit.” A limit order might tell the exchange to buy Intel for up to $20.50—but no higher. They protected investors from sudden swings. They were the kind of orders Bodek used at Trading Machines. That’s what he told the exchange rep.
The rep smirked and took a sip of his drink. “You can’t use those,” he told Bodek. “Why not?” “You have to use other orders. Those limit orders are going to get run over.”
“But that’s what everyone uses,” Bodek said, incredulous. “That’s what Schwab uses.”
“I know. You shouldn’t.” As the rep started to explain undocumented features about how limit orders were treated inside the exchange, Bodek started to scribble an order on a napkin, detailing how it went into the exchange. “You’re f*cked in that case?” he said, shoving the napkin at the guy. “Yeah.” He scribbled another. “You’re f*cked in that case?” “Yeah.” “Are you telling me you’re f*cked in every case?” “Yeah.” “Why are you telling me this?”
“We want you to turn us back on again,” the rep replied. “You see, you don’t have a bug.”
By “run over” the rep meant that the order type would get pushed back in line during a trade. That means, if a trader has indicated that he to buy Stock A for $41 a share, by the time the transaction is complete the price may have jumped to $41.10.
When you’re dealing with big investors like mutual funds with tons of trading to do, those nickels and dimes add up.
Last year Bodek blew the whistle on these practices, and the story of his campaign made the front page of the WSJ this fall.
That’s no small thing for a man who thought he was about it lose it all.
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