Tags: Probe | High-Speed | Trading | Exchange | Stocks

Probe of High-Speed Trading Gets Wall Street's Attention

Tuesday, 18 March 2014 05:51 PM

The party just got crashed for American exchange owners that were getting ready to celebrate the end of shrinking stock-market volume.

New York Attorney General Eric Schneiderman’s probe of whether U.S. stock exchanges are giving high-frequency traders unfair advantages comes just as trading picks up for the first time since the bull market began five years ago. For market executives, Schneiderman’s inquiry threatens to revive public scrutiny that peaked in the aftermath of the 2010 flash crash and had started to recede as investors burned by the financial crisis started caring about equities again.

“You’re probably a little concerned in the sense that if the investigation goes forward and the high-frequency guys get their wings clipped a little bit, volumes will become less, in which case they’ll make less money,” said Rick Fier, director of equity trading at Conifer Securities LLC in New York. “It’s also just bad PR. From a public relations standpoint, it’s not a good story.”

Shares of New York-based Nasdaq OMX Group Inc. fell 3.1 percent Tuesday after Schneiderman’s review came to light, the most since Aug. 22 when a technical malfunction at the exchange forced it to temporarily halt trading for thousands of companies. Atlanta-based IntercontinentalExchange Group Inc., the owner of the New York Stock Exchange, lost 1.5 percent.

‘Incremental Negative’

Citigroup Inc. analysts led by William Katz said the inquiry is an “incremental negative” for the companies that could threaten some of their revenue from market data and access. It “does reinforce our broad concern that relatively high multiples for the sector leave little room for error,” they wrote in a report Tuesday.

Schneiderman is examining the sale of products and services that offer faster access to data and richer information on trades than is normally available to the public. Wall Street banks and rapid-fire trading firms pay for these services, providing millions of dollars in quarterly sales to exchanges and helping ensure their markets are supplied with standing orders to buy and sell stocks.

The investigation threatens to disrupt a model that market regulators have openly permitted for years as high-speed trading and concerns about its influence have grown. Trading firms pay to place their systems in the same data centers as the exchanges, a practice known as co-location that lets them directly plug in their companies’ servers and shave millionths of a second off transactions. They also purchase proprietary data feeds, which are faster and more detailed than the stock-trading information available on the public ticker.

‘Always Engaged’

“We publicly file with the SEC for each and every one of these services, and we’re always engaged with government officials around the world,” Robert Madden, a spokesman for New York-based Nasdaq, said in a phone interview, referring to the U.S. Securities and Exchange Commission. He and Eric Ryan, a spokesman for NYSE, declined to comment on Schneiderman’s investigation. Madden also declined to comment on the drop in his company’s stock, as did ICE’s Kelly Loeffler.

“We are working on these and a wide range of issues as part of our ongoing review of our current equity market structure,” said John Nester, an SEC spokesman. “We appreciate hearing the views of all market participants and other interested parties, including Attorney General Schneiderman.”

The investigation comes amid a rally that lifted shares of the biggest market operators in 12 of the last 15 months. The Bloomberg World Exchanges Index of 26 stocks has also advanced 45 percent since sinking to an eight-month low in June 2012, a period that encompasses ICE’s takeover of NYSE Euronext and about $110 billion of inflows into mutual and exchange-traded funds that own U.S. equities, data compiled by Bloomberg show.

Improving Fortunes

ICE, up 66 percent since the end of 2012, trades for 25 times annual profit, compared with almost 14 for financial companies in the Standard & Poor’s 500 Index. Nasdaq’s price- earnings ratio is 14.6, up from as low as 8.5 in August 2011, according to data compiled by Bloomberg.

One reason for the improving fortunes has been signs that market volume has bottomed. An average of 6.9 billion shares a day have changed hands in the U.S. in 2014, a 7 percent increase from a year earlier and the first increase to start a year since before 2009, according to data compiled by Bloomberg.

The totals show the transformation that high-frequency firms have wrought in American equity markets. While combined volume on the NYSE and Nasdaq rarely exceeded 2 billion shares in the 1990s, today it is regularly three times that in the U.S., thanks to the spread of high-speed computers and new regulations.

Trading Narcotic

“This is a volume game,” said Thomas Caldwell, chief executive officer of Caldwell Securities Ltd. The firm manages about C$1 billion in Toronto. “Exchanges to some degree are addicted to the narcotic of high-frequency trading, which is why you haven’t seen them come out and lambaste this practice.”

Investors scarred by the 2008 bear market that erased $11 trillion from equities pulled almost $400 billion out of funds that invest in U.S. stocks in the four years through 2012. The trend reversed last year with about $18 billion going into stocks, according to data from the Washington-based Investment Company Institute. Another $18 billion has come in this year.

Volume had decreased since the bull market began in 2009, when almost 9.8 billion shares traded daily. The average fell to 8.5 billion in 2010, 7.8 billion in 2011, 6.4 billion in 2012 and 6.2 billion last year. As the average price of U.S. stocks increased, the value of daily transactions rose to $274 billion so far in 2014 from $220 billion in 2009, data compiled by Bloomberg show.

Lower Demand

Nasdaq’s earnings rose 9.4 percent in 2013 to $385 million on a 13 percent increase in net revenue. Income will climb 34 percent to $515 million in 2014, according to the average analyst estimate in a Bloomberg survey.

Within its business units, a division called access and broker services that made up 12 percent of the company’s fourth-quarter net revenue reported lower sales due in part to “modestly lower demand” for co-location and ports, according to the company’s Feb. 5 press release.

While the NYSE and Nasdaq were the site of almost all U.S. stock trading two decades ago, they only host about 40 percent of it now, and the importance of equity markets to their overall earnings has also diminished. Today, investors buy and sell shares on more than 50 public and private venues from Jersey City, New Jersey, to Lenexa, Kansas. Indeed, most orders from individuals never even reach a public market. They’re paired off within brokerage walls at firms such as Citigroup.

‘Who Cares?’

“If the exchanges go away, who cares?” Aswath Damodaran, a New York University finance professor, said in a phone interview. “They serve no social purpose. I’m not going to shed any tears if exchanges are going to go out of business because of high-frequency trading.”

At the same time, “Schneiderman has too much time on his hands and too little to do,” Damodaran said. “A lot of lawyers will make a lot of money, but at the end of the day, nothing will have changed.”

Services such as co-location are accounted for in NYSE Euronext’s technology services segment, a unit that generated $74 million of the company’s $890 million in total revenue during the three months ended Sept. 30, 2013. Market data produced $91 million of that total, according to a filing on Nov. 5.

Nasdaq OMX’s CEO Robert Greifeld received $13.8 million in total compensation for 2013, including a $1 million salary and $9.9 million in equity awards, according to a filing yesterday. His compensation rose 55 percent from 2012 even after an error at Nasdaq halted trading for thousands of U.S. stocks, such as Apple Inc. and Google Inc., for three hours on Aug. 22.

Market Evolves

The practice of selling enhanced access to brokers grew up as American exchanges evolved from member-owned firms amid a flurry of regulation and computer advances in the 1990s. Among other changes, the government-mandated compression of stock trading increments to pennies from eighths and sixteenths of a dollar, a process known as decimalization, squeezed profits for market makers and specialists that had overseen stock trades.

Faced with the need to maintain liquidity on electronic platforms where profits were too fleeting for humans to capture, exchanges developed strategies to encourage computerized firms to post orders. Co-location and customized data feeds developed alongside the hodgepodge of fees and rebates that market operators use to keep high-frequency traders coming back.

‘Ethically Wrong’

“There is something ethically wrong with providing a certain group of individuals preferential access to information and preferential timing to implementation of trades,” Brian Barish, who helps oversee about $10 billion as president and chief investment officer of Denver-based Cambiar Investors LLC, said in a phone interview. “There is some value in really making it a level playing field.”

Market maker privileges have always been a hallmark of equity trading, starting with the placement of firms on the floors of exchanges. LaBranche & Co., created in January 1924, became the first independent specialist firm to sell shares to the public in August 1999. In papers prepared for its initial public offering, LaBranche disclosed that it regularly turned about 71 percent of sales into profit before paying its managing directors. Earnings before that expense climbed at least 25 percent every year from 1995 through 1999.

Results like those, as well as concern that NYSE and Nasdaq were too powerful, helped spur reforms since 2000 such as decimalization and a broader overhaul known as Regulation NMS that was aimed at lowering barriers to trading. Through rules mandating that any order for stock be routed to whoever in the country was transmitting the best offer to buy or sell, regulators hoped competition among a much larger pool of de facto market makers would lower costs for investors.

Fees Drop

That happened. Buying 1,000 shares of AT&T before 1975 would have cost $800 in commissions, Charles Schwab, who founded discount brokerage Charles Schwab Corp., told the U.S. Senate in February 2000. That’s roughly 100 times more than the fees paid by some retail stock-pickers today.

Schneiderman is amping up pressure on high-speed trading firms after federal regulators for years discussed whether new restrictions were needed. In February 2012, Daniel Hawke, the head of the SEC’s market-abuse unit, said the agency was examining practices such as co-location and rebates that exchanges pay to spur transactions. Last year, the Commodity Futures Trading Commission, announced a review of speed trading and sought industry input.

“There are certainly games,” Larry Tabb, chief executive officer of market-research firm Tabb Group LLC, wrote in an e- mail. “It is not a completely fair market. But neither was the old market.”

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New York Attorney General Eric Schneiderman’s probe of whether U.S. stock exchanges are giving high-frequency traders unfair advantages threatens to revive public scrutiny that peaked in the aftermath of the 2010 "flash crash."
Tuesday, 18 March 2014 05:51 PM
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