The SEC Doesn’t Use its Sense When Dealing with Dollars and Cents


So the SEC wants to take on some of the market distortions caused by decimal (and sub-decimal) pricing.  Well, there are the things that can’t be argued about and the things that can.

Starting with what can’t be argued about: liquidity is not a free good.  In a trading market, it exists because market makers or specialists are willing to offer markets of a certain size and bid-ask spread given the usual price volatility.  Most of the time they  will make money, because there is enough information-less volume trading back and forth, that they can take a few losses when information hits the market, and informed traders temporarily make money against intermediaries until a new equilibrium is reached.

The same is true when things become more uncertain — either bid-ask spreads get wider, or sizes get smaller, or both.  I remember back in 2002 as a corporate bond manager/trader — bonds were trading in “onesies” and “twosies,” though bid-ask yield spreads hadn’t widened much.  (I.e. $1-2 million of face amount would trade at a given bid-ask context… if they got too much interest in one side or the other, the bid-ask spread would move, and fast.

This Tiger grand-cub was flat during Q2 but is ready for the return of volatility

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So when the SEC made its move to change the tick size (minimum bid-ask difference) from fractions of dollars — eighths & sixteenths, to pennies, there was a tendency for the amount offered by intermediaries to decline.

Now if you are a small trader, you don’t care that much about this.  You were able to get your work done, and at thinner bid-ask spreads.  Life is good.

But if you are a large manager of assets, it’s not so easy.  You have a big buy or sell that you have to do, and the market gate is thin.  Give away too much of the size you want to do, and the market runs away from you, costing you money.  You might actually like markets with bigger offerings and wider spreads better.

And so you seek other trading venues out away from the NYSE Euronext (NYSE:NYSE) and NASDAQ OMX Group, Inc. (NASDAQ:NDAQ), and occasionally you find you can get large trades done there when there is another large trader willing to take the opposite side of your trade.

And in the process the other trading venues sometimes create fleeting trading opportunities between them and NYSE Euronext (NYSE:NYSE) or NASDAQ OMX Group, Inc. (NASDAQ:NDAQ), or within them.  That’s high-frequency trading [HFT].  Now,NYSE Euronext (NYSE:NYSE) and NASDAQ OMX Group, Inc. (NASDAQ:NDAQ) profit from this because they sometimes receive payment for order flow.  They seek orders, and are willing to pay a tiny amount to get them, knowing they can make a profit on the other side of the transaction.

Given all of the above, the SEC is now reviewing a proposal to change back to fractions.  My first reaction is this favors the big over the small.  My second reaction is why not regulate/legislate and create one central order book that all orders go through for each security, and publicly display the bids and asks.

My third reaction is why not end payment for order flow.  High frequency trading would end without easy access to the deepest markets.

My penultimate reaction is, why not restructure markets so they transact once a second, or once a minute. It would not impede markets much at all in my opinion.

But my last reaction is, why not charge a teensy fee for every order placed in any venue, whether it executes or not?  It might be as small as a penny on a thousand dollar order.  Or even a penny on a ten-thousand dollar order.  Just enough that there is a disincentive to place a lot of orders where there is little intention of having them fulfilled except at advantage to the order placer.

These are better ideas than moving back to eighths and sixteenths once again — leave that alone, the existing market structure favors small traders, and that is not all bad.  Many large traders disguise themselves as small traders, and get trades done more cheaply than if they were trading in fractions.

Every trading system has its weaknesses — the challenge is to create the system that is the best for the most.  In that case, a good system will:

  • Have a central order book, or,
  • End payment for order flow, or,
  • Change markets to an auction format, or,
  • Add a fee that eliminates most non-completed high-frequency trades.

Personally, I like simplicity.  One central order book and no alternative venues, but allowing for a wide amount of order types that accommodate large orders and small orders.

So don’t go back to fractions.  They weren’t the solution to the current problem.  Better to restrict the market structure so that placing an order costs something.  Being able to place an order is a good, so there should be some cost, whether it executes or not.

What I propose here is more minimalist than other proposals, and would solve most problems from high frequency trading.  Add a small fee to each order — what could be easier?

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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