On Wall Street, Everybody Gets Paid
“Trust me, it’s hard to get paid trading for a penny spread.”
Andy Kessler is an author (Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score, Eat People, and Wall Street Meat: My Narrow Escape from the Stock Market Grinder). He is also an ex-Wall Street analyst (Paine Webber, Morgan Stanley, Unterberg Harris), former hedge fund manager (Velocity Capital), Bell Labs chip designer, and to top it off – he grew up in New Jersey. This pedigree makes me wish I had followed him on Twitter a long time ago, and it is also responsible for my giving extra weight to his Sunday WSJ Op-ed: High Frequency Trading Needs One Quick Fix. Please read it!
He begins the piece by reminding you all that there is a Senate Permanent Subcommittee on Investigations Hearing tomorrow that will examine Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Stock Markets. This senate panel will hear from the following witnesses:
– IEX’s Brad Katsuyama
– Notre Dame’s Professor Robert Battalio (NYSE vs BATS-DirectEdge horse-race paper)
– NYSE’s Thomas Farley
– BATS’ Joe Ratterman
– Vanguard’s Joe Brennan
– TD Ameritrade’s Steven Quirk.
Kessler believes that these investigation-panels are challenged, because ‘none of them understands the old Wall Street adage: “On Wall Street, everybody gets paid.”’
Kessler recalls an anecdote where he questioned a NYSE Specialist at a cocktail party about front-running orders on the NYSE, who responded to him, “You big investment banking guys shouldn’t worry about it, we need to get paid too.”
He then notes that in today’s environment, “it’s hard to get paid trading for a penny spread.” So how have markets adjusted?
Electronic trading was considered more efficient and even more honest. So in 2005 the SEC’s Regulation National Market System or Reg NMS began encouraging it. At the same time, Wall Street firms stopped putting up their own capital or liquidity to facilitate trades because they couldn’t get paid enough to bother. Over time they created their own electronic trading venues known as dark pools, to try to match customer buy and sell orders, but with little success until they let high-frequency trading into the pool.
Typical of most regulations, Reg NMS has had many unintended consequences. The main culprit has been NMS Rule 611, known as the Order Protection Rule. Due to expensive lobbying by existing exchanges, the rule requires trades to take place at the “best price.” Sounds fair, but these two words sparked, as exposed in Michael Lewis’s “Flash Boys,” a massive spend on servers and fiber lines by high-frequency trading firms.
High-frequency trading firms would post the “best price” for every stock and then when hit with a trade, knowing there was a buyer in the market, take advantage of the fragmentation of exchanges and dark pools and latency (high-frequency traders can get to an exchange faster than you) to buy up shares from other HFTs or from Wall Street dark pools, and then nudge the price up and sell those shares.
Kessler recaps the above three paragraphs in one amazing sentence:
In other words, in an era with no spreads or commissions for trading stocks, high-frequency trading is just a complex system to move the price of a stock in order to get paid. As dark pools discovered, no pay, no trade.
And he believes the system needs fixing, and all the regulators need to do is Change Reg NMS Rule 611 to read ‘best execution’ instead of ‘best price.’
Kessler also gives a powerful and sage reason why everybody should care about market structure:
Should we even care? I always felt that trading is just plumbing. Real value is added elsewhere on Wall Street. The risk is not that the markets are unfair, but that markets don’t function and things start to back up.
Markets are always about access to capital—feed the stars and starve the dogs. It is well-functioning markets, more than management or government, that yell stop and eventually whack the stock price of bad ideas like eToys, Enron and mortgage generation. [Regulators] risk damaging truly functioning markets if they don’t get the rules right so that someone can get paid by trading.
In the aftermath of Lewis’ Flash Boys, there has been no shortage of op-eds and opinions about modern markets angrily yelled in media (social and mainstream). Kessler’s refreshing Op-ed is undoubtedly the very best I have read to date.