Bradley: Affirmative Obligations Are No Fix for Market’s Gyrations

A lot of Senatorial talk time is devoted these days to the perceived evils of high frequency traders. The SEC’s apparently sympathetic response to guilt-by-association aside, the only thing I know for sure is that the new high frequency players trade enormously higher volumes of stock for a fraction of the “take” of yesterday’s market makers and floor specialists.


The nation’s investors pocket the savings. Stock trading no longer feeds the still giant bonus checks at the big investment banks the way it once did. That’s left to the non-transparent markets in the swaps and over the counter derivatives space.

Clearly, practices like flash quotes, quote stacking and quote stuffing are unacceptable variations of software gamesmanship in the marketplace that have been reined in by regulators. And clearly some of the new market entrants derive enormous trading profits from clever use of integrated systems. Despite these identified issues, the fierce competition among these new players has driven trading costs for retail and institutional investors relentlessly lower.

It’s always bad news for new entrants to a market when a derisive adjective accompanies a change in that market’s profit engines. High frequency trading is used increasingly and simplistically to demonize a whole class of market participants. That classification throws a hundred different business strategies in the same basket and ignores incredible efficiency gains that are increasingly shared with buyside clients.

Among the most wrong-headed of possible SEC proposals to “fix” the markets is a sentimental appeal to establish a “special status” for market makers like the days of old when “the specialists on the dominant exchanges were subject to significant trading obligations designed to promote fair and orderly markets and fair treatment of investors.”

Such special status might include a brief time advantage for those altruistic traders.

Unfortunately, I now fear that our SEC leaders may be ensnared by the narrative fallacy about the economic importance of financial markets middlemen. Such standards were applied to specialists and market makers on October 19, 1987 when I stood on the commodity floor and watched the breakdown in arbitrage between the S&P 500 futures contracts and the physical securities market.

What do I recall from that time?

One: Traders at market making firms refused to answer the telephone and they quit trading.

Two: Specialist firms reported high profits on principal trading during that period as LaBranche and Co. discussed prior to its initial public offering in 1999. (An article of market faith holds that institutions pay excess fees during good markets so that intermediaries will be willing to stabilize markets and help us during bad markets—yet this generous narrative remains unsupported by a shred of empirical evidence).

Three: Institutions were blamed for using portfolio insurance techniques that created a feedback loop bringing the markets to its knees back then. (P.S. Has anybody looked at institutional use of ETFs todayto hedge portfolios and to implement portfolio completion strategies? Sounds like portfolio insurance in a new wrapping to me).

Here’s something else I know that is lost in all the hyperventilating over high frequency trading. In 1992, the average cost of trading a $20 stock on NASDAQ was about 23 cents per share, including commissions and market impact; about 19 cents a share at the specialist post. The time to fill an order on the floor in 2005 was still about 10.1 seconds.

In the fourth quarter of 2009, ITG analysis of $5.2 trillion in trades shows that the institutional investor paid less than 10 cents a share. The trading intermediaries’ share of profits from institutional traders has plummeted 60 percent for NASDAQ equities and 50 percent for NYSE shares. The time to fill an order at the NYSE today is a fraction of a second.

It is critical to note in any "Man Versus Machine" debate that at no point during the historically unprecedented volatility of late 2008 and early 2009 did trading costs remotely approach the norm of the era when market makers had a duty to stabilize markets.

Furthermore, the average market maker netted about 4 cents in profit for every share traded in 1988, when I started in the business. The high frequency trading firm of today nets about 7/100ths of a cent for every share traded.

The high frequency guys are willing to work for 98 percent less than what the typical market maker yesterday demanded as his share to put buyers and sellers together even though today’s folks put a whole lot more buyers and sellers together. Why else do you think that the big boys on Wall Street have invoked the Senators’ wrath?


Harold Bradley is Chief Investment Officer of the Ewing Marion Kauffman Foundation.