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The most frequently flouted law in modern American society is Murphy's Law.
As a result, unintended consequences buffet the amber waves of the fruited plain daily, and the winds blow well beyond Yankee shores too. In essence, we foster frameworks of behavior that fail to consider side effects.
Illustration: You've heard that the IRS Code, which is Title 26 (of 50 total) of the United States Code, is 67,000 pages long? It's not the biggest. That, er, title goes to Title 42, Public Health and Welfare, roughly three times longer.
Speaking of large, for algorithmic trading and its tie to Murphy's Law huge thanks are owed to Joe Saluzzi and crew at Themis Trading, whose white paper linked below is sheer brilliance. Read it. You won't view your volume the same way again.
Joe and his Themis cohorts describe how rebate traders (we've talked about them before), predatory algorithmic traders, automated market makers and programs inflate volumes and feed volatility. For sake of time, think of these as forces leveraging mathematics and speed to take advantage of the rules.
You might shout, "Let's outlaw them!"
Ironically, they exist because of laws. One, Regulation National Market System (Reg NMS), mandates that markets meet the National Best Bid/Offer (NBBO), the best price available. Thus, systems were created to find it faster, get to it faster and move it faster. So a law created to reduce gaming in market centers has in fact exacerbated it in ways that were entirely unintended. Murphy's Law.
Let's focus on one item relevant to your Investor Relations job: rebate trading. Exchanges and market centers offer incentives to attract business. Think of it like a coupon or discount for doing business there. Since trading requires the presence of liquidity, market centers pay firms to provide it, around a quarter-penny per share. One unintended consequence is proliferation of firms doing nothing more than trading to capture these rebates. Joe and his Themis experts describe how it works:
"Our institutional investor is willing to buy shares in a price range of $20.00 to $20.05. The algorithm gets hit, and buys 100 shares at $20.00. Next, it shows it wants to buy 500 shares. It gets hit on that, and buys 500 more shares.
"Based on that information, a rebate trading computer program can spot the institution as having an algorithmic order. Then, the rebate trading computer runs ahead of the algo by a penny, placing a bid to buy 100 shares at $20.01. Whoever had been selling to the institutional investor at $20.00 is likely to sell to the rebate trading computer at $20.01. That happens, and the rebate trading computer is now long 100 shares at $20.01 and has collected a rebate of ¼ penny a share. Then, the computer immediately turns around and offers to sell its 100 shares at $20.01. Chances are that the institutional algorithm will take them.
"The rebate trading computer makes no money on the shares, but collects another ¼ penny for making the second offer. Net, net, the rebate trading computer makes ½ penny per share, and has caused the institutional investor to pay a penny higher per share."
There's more, including how algorithms, which are necessary for institutional execution today, feed predatory algorithms that front-run and game order flow, costing real investors money and efficiency. Traders Magazine reports that these traders may enter up to a million orders for every 100 executed trades. Joe and company further explain in the white paper.
How much of this activity is occurring in your own stock? You'd no doubt be surprised, as our clients frequently are. This is why we hound the notion that the well-informed Investor Relations Officer (and by extension, the rest of the management team) must know market structure. It's just essential today.
Lessons? You must understand your trading. And more rules won't stop bad things. We're not advocating anarchy in the markets, or anywhere else. All games need rules. But the more complicated they are, the easier it is for someone to gain an advantage over others. Look at the tax code, or the welfare system.
Bottom line, Caveat Emptor and common sense are elixirs, not errors. Or to phrase it the way Themis Trading does, we need to re-learn how to watch the tape.
Themis Trading onToxic Equity Order Flow
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