ValueWalk’s Q&A session with Don Ross, the CEO of PDQ Enterprises, parent company of the auction-based CODA Markets ATS. In this interview, Mr. Ross discusses his background and when he started his firm, what his firm does, how his firm makes money, how CODA Markets work, how CODA differs from NASDAQ and OTC, the current state of small-cap markets, HTF and how it impacts liquidity, HFT vs spoofing, and the potential impact of CODA Markets.
Can you tell us about your background?
The first decade of my career was spent growing up with GETCO. GETCO was an electronic trading pioneer, and we grew it from a 10-person start-up in 2001 to one of the world’s largest market-makers by 2012. During my 11+ years, which culminated in me being head of US [actually “North American”] equities, we developed the strategies and systems that would, among other things, dramatically streamline trading and reduce spread costs.
But by the end of my time there, I was feeling dissatisfied. We made massive investments in technology and they delivered profound benefits for retail traders and for large-cap liquidity, but small and mid-cap liquidity – which is the vast majority of listings – was still terrible. I saw this massive failure in market structure – where exchanges did everything they could for electronic trading firms but little for investors and companies needing capital – and knew that the speed race was ultimately futile.
That led me to the CEO role at PDQ, which runs the CODA Markets trading venue.
When did you start your firm and what does it do?
Actually, I joined PDQ well after it got started. Chris Keith, the former NYSE CTO, founded PDQ in 2001, and my father, Keith Ross, took it over from him in 2006. I joined as Head of Strategy in 2015 and became CEO in the fall of 2016 after a period of time guiding PDQ technology development.
PDQ owns CODA Markets, which is an alternative trading system that makes it easy for investors to find liquidity without tipping their hands. Our market structure is built on the power of on-demand auctions (“CODA” is an acronym for “centralized on-demand auctions”) to eliminate information leakage and minimize market impact of your trades.
And auctions aren’t new. In fact, 150 years ago all stocks were traded via auctions, but, as listing and trading volume grew, there was no way to keep up. That’s when the NYSE introduced today’s market structure – “continuous markets.” For the next 140 years or so, it was the best alternative out there. But what we are proving at CODA Markets is that today’s technology can allow us to bring back auctions, which can empower investors to find liquidity without leakage and with minimal market impact.
How does your firm make money on the spread?
We don’t make money “on the spread,” as CODA Markets is an agency-only broker dealer. We are paid based on our ability to get the investor the liquidity they need for each trade.
In short, through their broker or order management system, the investor enters a desired order – symbol, size, direction and price – but CODA only displays the symbol to the market. We then aggregate the market’s replies, and match the trade. If the auction can’t match it, the investor can instead route it to the market for best execution or simply cancel it.
What is the difference between FLARE, Block, and Micro?
PDQ is a technology company which owns a broker-dealer, CODA Markets, that operates an alternative stock trading venue.
The CODA Markets ATS runs on-demand auctions for every trade, and when we find the right liquidity, we match the trades. We currently have two auction types – CODA Micro, a sub-second auction that’s been in operation since 2009, and CODA Block.
In an era of speed, CODA Block is unique in that it uses a 30-second multilateral symbol-only auction to allow traders of every kind – even manned trading desks – to compete against one another in a process of true liquidity discovery. All while protecting order privacy for minimal market impact and leakage.
CODA Flare is our routing option. If we can’t find a match on CODA Markets, CODA Flare will route that trade to other venues using customized strategies and algorithms.
How is CODA different than other markets? NASDAQ, OTC?
We all know there is something wrong about the way the market works for investors today, particularly those buying and selling small and mid-cap stocks.
The culprit is the “continuous limit order book” used by every other exchange and venue, which matches orders immediately upon arrival in the order in which they arrived. Now, for retail trades and large cap stocks, that market structure works amazingly well.
But for less liquid stocks, we are in a crisis, and that’s where CODA is particularly strong.
CODA is the only on-demand auction. We subvert the speed arms race by taking a moment to aggregate liquidity with less risk of leakage and market impact.
Why has IEX failed to make a big dent in market share?
On the surface, it’s surprising, particularly with Michael Lewis and his best-selling book, Flash Boys, banging their drum. But if you just scratch the surface of IEX, the answer is clear. True, like CODA Markets, IEX seeks to remove time as a competitive advantage, but their use of a “speed bump” doesn’t address the fatal flaw of the prevailing market structure. That is, the continuous matching process.
No investor can ever win the speed arms race, so the better approach is to have a market where intelligence – not speed – is what separates the winners and losers. And that market structure is auctions.
What type of transactions do you do? Stocks? Any private?
Auctions would be beneficial in many markets, but today, CODA allows trading on all listed stocks covered by Reg NMS.
Do you deal exclusively with traders or all types of firms?
We have every class of market participant placing orders on CODA Markets, though in most cases they do so through their broker-dealers, or through order management systems like Bloomberg and ITG.
Can you tell us about the current state of small-cap markets?
I’ll let your readers speak to the state of investment opportunities, but I can speak to the state of liquidity. It’s a total disaster. One hedge fund CIO said that trying to find liquidity in small caps is like sticking your hand in a fan to see if it’s moving. You may be lucky enough to find enough liquidity, but the process will leave you bloodied.
What is HFT and how does it impact liquidity?
High frequency trading firms use massive investments in hardware and software to send and update orders at a high rate of speed – faster than a human could ever process. Because “natural” investors can never match their speed, HFT firms that spot activity on one market are able to move their prices on others, creating the idea of front-running. While Lewis’s Flash Boys makes them a malevolent force, the fact is HFT has been and continues to be a massive net positive for today’s markets. These firms have removed a huge amount of their cost out of the process by narrowing spreads.
So we wish no ill will to HFT with CODA. We just wanted to create a venue where investors were no longer at a speed disadvantage. One where their intelligence and market acumen was enough to win.
Is HFT different than spoofing?
Yes, they are different. Spoofing is a fraudulent act of submitting “non-bona fide” orders, i.e., orders that do not reflect a true interest to buy and sell, and it doesn’t require being an HFT firm. In fact, it used to happen in the trading pits before technology took over. So yes, while it is possible for an HFT firm to participate in this sort of activity, it would be illegal and is far from a standard practice.
For long term investors why would they care about HFT or liquidity if they plan to hold for years
For small- and mid-cap stocks, liquidity is so bad there’s no way to accurately measure the quality of execution. As your portfolio grows, and you have to make moves into and out of positions, not getting an immediate fill is a big problem. The “smart” algos your broker uses are detectable by the top firms, and can allow them to get in front of you before you can complete your trade (again, this is nothing criminal, it’s just a symptom of continuous markets).
And if that doesn’t make it clear enough, ask yourself these questions:
- Do I like to pay more for something than I should?
- Do I like it if my broker fails to manage my orders in a way that optimizes my returns?
- Do I like putting time and money into an investment decision and then have the market move so much against me that I miss my opportunity?
And last, if you’re accepting execution that could be better than it is, are you falling short of your fiduciary responsibility?
What would be the biggest impact on trading if CODA makes it big time?
We see two potential impacts.
First, CODA Markets can be a source of free liquidity, whereas there is a hidden liquidity cost to today’s markets. In short, the price you see quoted by an HFT firm on an exchange represents more than just their valuation of the stock. Also part of the quoted price is what is in effect a hidden premium that HFT firms “charge” in exchange for offering up a firm and visible quote that anyone can execute against. Because CODA has no public quoting, this additional cost goes away.
And with some simple back-of-the-envelope calculations, one can see trillions of dollars in economic value resulting from better pricing and more capital availability. This number sounds ridiculous but it’s totally true.
The second benefit should be near and dear to your readers. Because we remove time as a competitive advantage, CODA rewards intelligence over brute speed. Value investors will be able to improve returns.
Would this have any impact on non US markets?
Nothing about CODA’s market structure is particular to US markets, so we could be the market structure for equities – or pretty much any other asset class – in any other market around the world.
Does the SEC play any role here? What are their current views on HFT?
Ultimately, the SEC faces the same problem as any investor or trading firm, and that is the inherent limitations of continuous markets.
To the SEC’s credit, they continually look for new ways to create a better experience, but we would like to see an SEC that applies policies that spur new market structures that can deliver a better experience for investors, which is first and foremost, bringing them improved liquidity.
The SEC is very understaffed and dealing with serious issues like outright fraud, why should liquidity or HFT related questions be a priority?
The beauty of a pro-innovation agenda is that it doesn’t require the SEC to do extra work. It’s about creating an environment where firms like PDQ are pushing the industry forward with market structures that address the most pressing needs of investors. It would also avoid many of the unintended negative consequences of well-intended regulations.
The order protection rule is a great example.
On the surface, it sounds great, as it ensures that you get the price you were quoted. But what if executing at a particular size is a bigger priority to you than a particular price? What if you’re willing to accept a “worse” price if that’s what it takes to get your trade done instantly without leakage?
Obviously we found a way to create a market in which our auctions can execute outside of the quoted spread, but getting there took a much greater investment in time and resources than it should have. Investors know best what they care about – price alone or the ability to execute large trades with minimal impact – but regulations can get in the way.
Has FINRA or the CFTC weighed in on any of these issues?
FINRA’s mandate is to monitor the behavior of its membership, not the broader issues of market structure. However, they could do more to encourage broker-dealer members to look at and test new innovations that create a better experience for their customers. I’d argue that it’s a fiduciary responsibility to always be trying to find better execution.
If you could pass one liquidity related piece of legislation what would it be?
We’re believers in free markets, so instead of more legislation we’d like to see less of it. Certainly we always need to protect investors, but too often well-intended rules actually hurt many of those they’re meant to help, like the order protection rule I discussed earlier.
When the SEC gave us Reg NMS,which includes the order protection rule, they were putting a cast on a broken leg. Yes, it fixed the immediate problem. But the cast remains and it’s limiting movement, namely in the form of market innovation. Regulations that would allow exceptions to Reg NMS in general, or the order protection rule more specifically, so long as some other benefit – namely liquidity – was provided, would maintain important protections but open the door to something better.
As an investor, you should be challenging their broker about how they handle your trades and evaluate their success. Ask for reports on execution quality, see how they monitor the market impact of your trades, understand the algorithms they use, and explore how gameable those algorithms are by HFT firms. Ask if they treat small and mid-cap executions differently than large-cap, or if theirs is a one-size-fits-all approach (hint: It better not be).
There’s a better future out there, and we are thrilled about our role in moving investors to it.