US Market Structure, the SEC, and Shepard Tones




I am the driver at the wheel of the horror
Marching circles at the gate
Mine eyes have seen the fury
So flattered by fate

Born Alone – Wilco


No, the above is image is not a Nanex chart of the NBBO in a stock (it is sad testament to our market structure, however, that your first impression would identify it as such). It is an image of a Shepard Tone – an auditory illusion of a tone continually descending in pitch, which ultimately is not getting any lower. The Chicago-originated music group, WILCO, uses the effect in the song, Born Alone, and the tone and some of the lyrics bring analogy to our current market structure. You see, our market structure is one which has so many built-in seemingly small issues that appear small (especially to regulators) until you look at them in totality, where together they represent quite a big mess.

While we frequently are exposed to sound bites in which the SEC is proclaiming to examine market structure flaws (such as order types, dark pools, and exchange rebates), we witness full well that nothing ever seems to come from those sound bites. When we yet again hear that Market Structure Issues Are on the SEC’s Front Burner, we are now conditioned to ignore such proclamations, and we instead focus on what SEC officials tell insider industry groups in their speeches.

Fast forward please to a market structure speech given by Director Berman at a SIFMA conference just days ago, titled Transformational Technologies, Market Structure, and the SEC. In this speech, Berman makes clear the SEC really feels about our current market structure and high speed trading – it is beneficial and data doesn’t support otherwise. Some points from his speech:

–          A large seller in the futures market caused excessive downward pressure on futures prices which then cascaded over to the equity markets. An independent academic study confirms this – the SEC was right. [Actually we featured that very same paper in a note to you a few months back, and it actually makes the opposite point the Berman asserts it makes!]

–          Mini flash crashes are outliers – and demonstrate laziness and sloppiness by humans and their fat fingers.

–          There is no real need to slow down the markets; why should people just assume that there is a problem if trading takes place faster than a blink of an eye?

–          Flickering quotes are no problem – quotes flicker mostly because a new guy joins the bid, and a different one withdraws their bid.

–          Knight’s blow up was not caused by high frequency trading, but by technical issues involving Knight’s routing.

–          The SEC now has Manoj Narang’s MIDAS system. It allows the SEC to examine many issues with high speed data – excluding off exchange trading.


We, and others, disagree with much of Berman’s speech. He insists that only through data on individual issues in the markets can the agency even begin to judge fairness in the marketplace. His speech demonstrates that the SEC is caught in myopic viewpoints, and is intent on defending a system of games that it created itself. Berman is missing the forest for the trees. Only by looking at the totality of all the issues taken together can the SEC get an accurate understanding of the flaws in our market structure.


Flash orders, proprietary data feed leakage, inappropriate dark pool leakage, maker-taker rebate arbitrage, automated HFT quote manipulation, latency arbitrage, cherry-picking paid-for retail order flow, as well as unfair and abusive order types in exchanges and dark pools all combine to create a market structure that caters to high speed traders at the expense of investors.


Mr. Berman and the SEC would benefit greatly by sitting on buyside trading desks, “at the wheel of the horror” to quote WILCO. If the SEC did that they could see firsthand what so many of you see every day. The SEC would see how automated traders step in front of investors, manipulate quotes trying to trick buyside traders into paying wrong prices – prices that are increasingly divorced from true prices that reflect real supply and demand. The SEC would see how the foundation of liquidity in our markets is still increasingly moving like a Shepard Tone away from true price discovery. It is increasingly becoming illusory.