2. The Mystery
Are equity markets what
they seem…?
Or something else
altogether?
NIRI Tri-State Mar 2012 By ModernNetworks IR LLC. Not for distribution. 2
3. Markets Seem Vibrant
• VIX Volatility Index:
– Mar 16, 2012: 15
• Historical average: c. 20
• High near 80 in 2008, 45 in Aug 2011
• Conclusion: LOW volatility
• Nasdaq: Over 3,000
• NYSE: Above 13,000
• S&P 500: Over 1,400
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4. But Surface Deep Only?
How Many Stocks are in the Wilshire 5000?
What’s the Average Trade Size?
How Much Volume is “Rational”?
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6. Fewer Companies…
National Market System stocks. Source: Wilshire Associates index composition.
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7. But Growing Volume…
Source: SIFMA. US Key Statistics, published February 2012. Includes volume for
NYSE, Arca, Nasdaq, BATS, Direct Edge. Excludes Pink Sheet OTC market.
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8. And 10-Yr Flat Returns
• Dow Jones Industrial Index – returns inconsistent since the
number of public companies began falling.
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10. Via the National
Market System
“Our national market system, as it has
evolved since 1975, has sought the benefits
of both market centralization -- deep, liquid
markets -- and competition.”
Source: SEC Final Rule – Regulation ATS, 1998
• Result: Legislation transformed formerly
private markets, with private prices and
private data, into a semi-nationalized
system.
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11. Key Rules
• 1975 – Congress Mandated Natl Market System
• 1997 – Reg ATS/Order Handling Rules - PRICE
• 2000 – Decimalization – SPEED & PRICE
• 2002 – Spitzer settlement – TRADING
• 2007 – Reg NMS (523 pps) – PRICE, SPEED, TRADING
• Rule 605 - Best Execution Standards – UNIFORMITY
• Rule 606 - Order-Routing - AGGREGATION
RESULT: Fragmented, high-speed, quantitative market
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12. A Structure Upended
Buyers
• 1792-1997 • Today
Rebate Traders
Specialists, Black boxes
Buyers Market Makers Liquidity providers
Arbitragers
Resting orders
OMS/EMS
Proprietary traders
Linkage/Interdealers
Prime brokerage
Risk management
Sellers
Sellers
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13. Exchange Evolution
• Previously Non-profit; now For-Profit
• Adapting to Rules
• Profits driven primarily by data/transactions
– „11 NYSE Gross Rev: Listings $446m; Other: $4.1b
– „11 Nasdaq Gross Rev: Listings $369m; Other $3.1b
• Data revenue
– Proprietary products and feeds
– Share of revenue from consolidated tape:
• Since Reg NMS 25% share of trading, 25% share of value traded,
and 50% share of quoting
• Transactional revenue
– Trading in derivatives, bonds, equities
– DERIVATIVES is the most profitable business
• Incentivized arbitrage, HFT, data=profits
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14. Maker/Taker Model
• “Making” and “Taking” shares
• “Liquidity Provider” = HFT= “Making”
• Buyers of shares=“Taking”
• Liquidity: Exchanges PAY $0.29/100sh
• Taking: Exchanges CHARGE $0.30/100
• GOAL: Low spreads, price stability
• REAL GOAL: PREVIOUS SLIDE
– To sustain market share
– Encourage trading in many assets, securities
– For DATA/TRANSACTIONAL REVENUE
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15. Volume vs. Liquidity
Volume: How much of something trades
Liquidity: How much of something exists
EXAMPLE:
If I give you an apple, and you give it to
another person, who passes it to yet one
more, who gives it to a fourth person:
Volume=4, Liquidity=1
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16. Algorithms
• If this flock of birds
were trades: half
would be trying to
hide their
intentions, and the
other half, trying
to divine what‟s
hidden.
• Algorithms
fragment
institutional orders
into a million
pieces – while
other algorithms
scans millions of
orders for patterns.
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17. Patterns in Trading
Strategic selling Statistical Arbitrage
Nanex “Crop Circle” showing
patterns in high-frequency
trading over fractions of
seconds:
ModernIR data showing
patterns over days: 1. Strategic
selling (tiptoeing an elephant
across a putting green); 2.
Statistical Arbitrage
By ModernNetworks IR LLC. Not for
NIRI Tri-State Mar 2012 distribution. 17
18. Cisco HFT Router
Who can compete with this? Only other algos.
NIRI Tri-State Mar 2012 By ModernNetworks IR LLC. Not for distribution. 18
20. How to Buy/Hold?
• 2000-2012: How do you buy and hold? Better to speculate
• EXCHANGES encourage arbitrage, transient trading
• The RULE STRUCTURE best suits fast-moving money
• RESULT: Buying and holding assets to leverage for trading
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21. Order Routing
• The Market becomes a giant funnel
• What starts as “investment” can
transform into algorithmic trading
• INCENTIVES change how orders are
routed:
– “Liquidity Providers” aggregate executions to
earn money from orders at exchanges
– A few large brokers dominate
• Results:
– More uniformity
– Fewer vibrant, competing
investment theses
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22. Macro Factors
• Global=“Everywhere”
• Statistical= “we’re using math”
• Arbitrage=“to profit on spreads” Global
• Dollar, currencies
– Fed policy moves markets Statistical
– Other central banks too
– Forex: $4 trillion day, US alone
– Constant fluctuations
• Floating currencies, HFT, Arbitrage
regulated trades and prices,
global multi-asset class trading…
• =ARBITRAGE
“Fluctuations in the value of currency are always injurious, and to reduce these
fluctuations to the lowest possible point will always be a leading purpose in wise
legislation.” – Abraham Lincoln – Dec 1862 State of the Union Address
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23. WHAT THIS MEANS
TO PUBLIC COMPANIES
By ModernNetworks IR LLC. Not for
NIRI Tri-State Mar 2012 distribution. 23
24. Three Truths
• Your stock price, volume, reflect a mix of
behaviors with differing purposes and
time horizons – not just “investment” but
also crowd behavior, speculative trading
• More than HALF your volume, regardless
of market cap, is INTERMEDIATION
• Trading is math, and math can be
measured
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25. Three Behaviors
• Market Share of behavior, not WHO, is key to understanding price
• Three major forms: Rational, Speculative, Programs (the crowd)
By ModernNetworks IR LLC. Not for
NIRI Tri-State Mar 2012 distribution. 25
26. Owners vs. Traders
• OWNERSHIP, TRADING, are not the same.
• Looking to changes in ownership – which
are important – for why your price
changes does not reflect market structure
• Akin to tracking the owners of apartment
buildings to know who’s renting units.
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27. Trading Behaviors
• A different approach: Program sentiment
5-day Ave 42.93% Prev 5-day 44.35% Diff: -3.2%
• INSTEAD OF: negative
– “We heard that…”
Rational sentiment
– OR “Fidelity sold 500,000 shares”
5-day Ave 13.56% Prev 5-day 10.84% Diff: 25.1%
• WATCH FOR: positive
– What behaviors are up, down Speculative sentiment
– To what degree they set price 5-day Ave 32.62% Prev 5-day 33.58% Diff: -2.9%
negative
• AT RIGHT:
– Programs are DOWN Directional signal
– Rational investment is UP Ave Midpoint Price
– Speculation is DOWN 5-day $8.26 Prev 5-day $8.05 Diff: 2.6%
– By MARKET SHARE, these translate into positive
likely forward price performance: Market Share - past five days:
– POSITIVE
Program -1.38%
Rational 3.41%
Speculative -0.94%
Sum 1.09%
Plus Price 3.69%
positive 3.7%
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28. Learn New Terms
• Describe market behavior differently:
– Program trading (correlated “crowd behavior”)
– Speculative Trading (trading volatility)
– Rational investment activity (fundamentals)
– Statistical Arbitrage (trading gaps)
– Institutional Re-risking (balancing assets, hedges)
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29. Timing Matters
OPTIONS EXPIRATIONS –
VIX/RVX, stocks, indices,
currencies…
Most trading speculative
or crowd behavior,
hedges common
Money moves to address
RISK, find SHORT-TERM
GAPS
You must beware of this
and factor it into your
thinking – see ModernIR
calendar for more
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30. Go on the Offensive
• Educate yourself on market structure
• Rational investing a lesser force; GOOD
NEWS! Small actions, big results.
• Read Market Rules – Speak up
– http://www.sec.gov/rules/sro.shtml
• Ask for Analytics – Ask your exchange to
provide better information on trading
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33. SEC Budget
SEC Budget relies
on HFT
Source: SEC 2012 Budget Request: http://www.sec.gov/about/secfy12congbudgjust.pdf
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34. Dodd-Frank
Trading costs will increase:
Dodd-Frank routes regulatory charges for IPOs,
secondaries, follow-ons, repurchases and proxy
solicitations to the US Treasury. Since 1934, these
fees have “offset” regulatory costs:
H. R. 4173—577
(1) SECTION 6(b) OF THE SECURITIES ACT OF 1933.—Section
6(b) of the Securities Act of 1933 (15 U.S.C. 77f(b)) is amended—
(A) by striking ‘‘offsetting’’ each place that term
appears and inserting ‘‘fee’’;
‘‘(5) FEE COLLECTIONS.—Fees collected pursuant to this subsection
for fiscal year 2012 and each fiscal year thereafter
shall be deposited and credited as general revenue of the
Treasury and shall not be available for obligation.
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35. Crystal Ball
• Exchange Competition
– BATS, Direct Edge, Chicago/National -LISTINGS
• Market Risk: UNIFORMITY
• Money Will Continue to Seek Alternatives
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Notes de l'éditeur
Answers: Dec 31, 2011: 3,675 companies in the Wilshire 5000Average trade size – Modern IR client base - 225 shares/tradeRational volume estimate: 13% (Jan 2012)
What does this slide add?
BECAUSE OF RULES (see end of preceding page)The rules of the equity markets have changed drastically over the past ten years: -“Order Handling Rules” – Required exchanges to display quotes from ECNs (electronic comms networks), putting focus on price, speed -Decimalization – 100 price points per dollar, rather than 16 -Spitzer Settlement – Deemphasized research; shifted focus to trading with algorithms -Regulation National Market System - All trades at the best bid or offer -- total focus on speed, price. Fragmented data, fragmented markets. -Rule 605 – Best Execution standards mean brokers must meet certain price and speed requirements in matching trades, or they may be subject to fines. Result: brokers at risk route the orders to others capable of complying.-Rule 606 – How orders are routed must then be reported, so that the results of Rule 605 can be tracked .
-For 200 years, capital markets quite simple. There were buyers and sellers, matched by a handful of intermediaries. The Buttonwood Agreement 1792 – 2 sentences – set a commission and said the brokers would give each other preference. From it came the NYSE. -Capital markets more complex after 1930s regulation but trading still fairly simple. Most buyers and sellers were investing. A few were speculating. -In the past decade, explosion of rules, transformed the intermediary role. -Result a structure the exact OPPOSITE of what we had before, with an enormous number of intermediaries. -Understanding that buying and selling for the sake of owning things has greatly diminished, and buying and selling to intermediate transactions has exploded , is crucial to grasping why your price often behaves unexpectedly and inexplicably. -Intermediaries set prices way more frequently than do buyers or sellers.
The NASD spun off the Nasdaq via private placements in 2001 but there was no IPO until 2005. NYSE followed a year later. All around the globe, exchanges are publicly traded entities now – Singapore, London, Germany, Toronto, on and on. Exchanges are beholden to divergent audiences: -Broker-dealers who match up buyers, sellers-Customers who want to trade-Public companies that want to raise capital BUT growth comes from the customers who want to trade. Notice that the broker-dealers have become customers who trade too. But public companies are the smallest – about 10% of gross exchange revenue. The rest? Transactions and data, plus IT services. Rules serve trading customers: markets are fragmented to minimize the power of intermediaries – and intermediating has shifted from the book of business, to every single trade. With fragmented markets, fragmented data, low cost trades, and intermediation occurring with every one, automation is essential. Markets become about trading things only – price, speed. MERGERS: BROKERS have taken back the market. So for Exchanges to succeed they must duplicate the data-and-transactions model across more liquidity and asset classes.
Cisco Router for HFT. Description below courtesy of Securities Technology Monitor. To resolve all questions about how stocks trade now, study this for a few seconds. We’ll have a short quiz at the end. OPTIONAL descriptionAutomated trade: <100 milliseconds: DATA from exchanges, vendors like Thomson Reuters, Bloomberg To SELLSIDE, which repackages for BUYSIDE which applies to STRATEGY ENGINES, trading algorithms, pricing engines, pre-trade risk management applications and real-time portfolio modeling and a TRADE ENGINE triggers a trade according to presets which re-checks a risk application which sends to an Order Management System that uses a SMART ORDER ROUTER to send the trade to an EXECUTION VENUE based on speed, liquidity, competition for shares, and other factors and the order is submitted in Financial Information exchange (FIX) format, and if not canceled after a speed test the order sends to the venue’s MATCHING ENGINE and is MATCHED with the opposite side and confirmed by return message and clearing begins.
It’s more and more difficult to distinguish individual stories when markets are highly correlated to macro events
