Quant.SE roundup - 2018-01-23

Some interesting reads . . . What happens if a custodian bank defaults? Have your money elsewhere, and don't let those securities get rehypothecated.

How credible is Knight pointing the finger at Rule 107C? Not very - looks like they released test market making software into prod.

Passenger markets!

Added a new article to Wikipedia yesterday. Everyone contribute!.

IEX FTW

On Friday the SEC delayed ruling on IEX’s Exchange Application for three months – to June 18th 2016. Having read over 400 comment letters, they issued this notice, and request for more public comment. They state they did not have enough time to ponder IEX’s early March amendments to its application.

SEC seems to be getting pressure from existing players. Time to write some letters?

The Old New Market Structure

Seems like a good plan to me.

The article has a creative solution to the equity market structure problem of fragmentation: only allow stocks to trade on one exchange but have multiple exchanges compete for listings. The authors propose:

“The remedy is to create multiple trading venues and then limit trading in a particular security to one of them. There could be 10 licensed stock exchanges, and they could split among them the approximately 8,000 companies whose shares trade publicly in the U.S.”

As opposed to now, when we have companies all under essentially identical exchanges due to, I think, the consolidation of regulation under FINRA, and the exchanges compete to get the most volume.

Rule 606 woes

And more crazy issues with market structure.

With all the yelling about order types and the complexity of the markets, you would think that there would be an angry mob calling for transparency. But that doesn't seem to be the case, despite 606, the existing disclosure rule, being hopelessly outdated and failing to require the disclosure of most routed orders.

Exchanges and HFTs versus internalizers

A plan to limit internalization and market fragmentation. I guess the HFTs are for it so that they can see more order flow, but I really do think it's a win.

Wedbush fights back against FINRA

About time.

On August 18, Finra, through its Department of Market Regulation and Department of Enforcement, filed a complaint against Wedbush Securities alleging deficiencies in its policies, procedures and controls related to its market access operations from January 2008 until August 2013. In a counterstrike against the equity market regulator, Wedbush said that it believes that its risk management controls and supervisory procedures in the area of market access were reasonably designed to achieve compliance with evolving regulatory requirements, and that they were consistent with the rules and guidance provided by FINRA.

Why bother having laws, when we can have regulations that no one understands, including the regulators themselves?

Financial Apartheid

Strong title, but basically true. The toxic brew of regulations over the past decade or two has pushed companies and trading out of the lit markets into darker corners, where only the elite can meet and greet. One example from the book of unintended consequences:

One of the big drivers of the shrinkage in our public markets is that we no longer have a different market structure specialized for smaller companies, like we did in the bad old days. The old Nasdaq dealer market had a very different market structure from the old NYSE auction market. In the old Nasdaq dealer market, only dealer quotes were disseminated to the general public. Customers had no way of getting wide exposure for their limit orders and competing with the dealers. The result was a bid-ask spread so wide you could drive an IPO through it.

The wide spreads that we thought were a scandal did have one redeeming social benefit: They motivated the industry to market smaller companies to investors.

CBOE Wins!

CHICAGO, IL - May 13, 2013 -- The Chicago Board Options Exchange (CBOE) announced today that the Supreme Court of the United States denied the International Securities Exchange's (ISE) petition to review the Illinois Appellate Court's decision that permanently restrained and enjoined ISE from listing or providing an exchange market for the trading of S&P 500 Index (SPX) and Dow Jones Industrial Average (DJX) options and enjoined OCC from issuing, clearing or settling the exercise of such ISE options. This brings to a close over six years of litigation.

Not sure why this excites me so much . . . perhaps just because I find the ISE difficult to deal with.

Behold the ETMF

If approved by the Securities and Exchange Commission, the investment vehicle could make it unnecessary to disclose portfolio holdings every day -- and in so doing potentially reshape the mutual fund industry, which has relied on infrequent disclosure of holdings to protect the ability of managers to achieve above-average returns and avoid front running.

It does seem challenging to maintain a market in something that you don't know the value of:

But Ben Johnson, director of passive funds research at Morningstar, said that the lack of portfolio transparency might prevent market makers from buying into the idea of EMTFs and participating. “We’ll have to see what this looks like in practice once you get these products in a live trading environment,” he said

But maybe no worse than making a market in IBM, a feat that always amazes me.

The SEC and market structure problems

The most pernicious rule is Regulation NMS, approved in 2005, which forced the New York Stock Exchange to accept automated executions of trades. That led to today's all-electronic marketplace, complete with high frequency trading, overly complex order types, flash crashes, and botched initial public offerings, according to Wunsch.

"The SEC destroyed the greatest market in the world for capital raising and investing and replaced it with a casino of rapid fire trading," Wunsch wrote. The old models of the New York Stock Exchange auction and the Nasdaq dealer market were best, but vanished due to SEC meddling, according to Wunsch.

Pretty much what my impression of the situation is. Though it doesn't mean I'm right - fools seldom differ, as the saying goes.

Some issues at the SEC

The Federal Circuit is not happy with them, and various laws limit their ability to function sanely as a deliberative body, as Prof. B notes in his observations on the paper he links to.

Tighter spreads, but less liquidity

FINRA really seems to like this stuff.

While many-including the SEC-applaud the leg-up the rule changes give to limit order traders, others fret that displayed liquidity will shrink. Coulson, for instance, predicts over half of the 10,000 securities quoted on his platform will see a reduction in posted size.

Thanks to TM for the writeup.

Market discipline

In relation to the recent problems on the NYSE and whatnot:

"Given the issues with Knight arising from coding to the NYSE's new RLP program and the BATS withdrawn IPO in its first attempted company listing, the SEC is going to be particularly focused on coding associated with the introduction of new functionality," Gawronski said. "That could mean not only attempting to establish best practices around testing and better ways to respond and coordinate among market participants when market disruptions inevitably still happen, but even an attempt for the SEC to hold brokers and exchanges accountable through officer or other forms of certification."

Perhaps the market could hold brokers and exchanges accountable by having them go out of business when they screw up badly. That might give the officers some incentive to make sure that bad software isn't released. Of course, that might require a large change in market structure and market speed, but perhaps both of those would be good. I think not too many erroneous trades went through when the specialists and their clerks were pushing buttons on the floor of the NYSE, eh?

What is market making?

Before Reg NMS went into effect, the government had this big crackdown on the New York Stock Exchange specialists. They were sued civilly. They were indicted. I defended some of them. It was probably the greatest embarrassment in the history of the U.S. Attorney's Office of the Southern District of New York. They lost case after case.

A timely issue, with the fracturing of liquidity and the reduced role of the designated market maker.

NYSE and sub-penny

In October, the two NYSE Euronext exchanges asked the SEC for permission to set up a special program intended to make the NYSE a more competitive destination for retail orders. The service would compete with those of brokers that internalize retail orders, such as wholesalers like Knight. The NYSE is also positioning the service to attract flow from those internalizers.

. . . .

Joyce is not the only executive of a wholesaler to view the NYSE's proposal with skepticism. Jeff Martin, president of ATD/Citi, found fault with the idea of letting a market maker's hidden order take precedence over a displayed quote.

Unless I'm missing something, a market maker's hidden order already takes precedence over a displayed quote, if that market maker is the retail client's broker. So basically, this opposition amounts to the privileged few not wanting to share.

Weekly options

Volumes are increasing! It's a bit funny, this is one of those times when we've built a bunch of things that say "Weekly options are irrelevant, discard them", and now they're not so irrelevant. Alas!

The problem with Soverign CDSs

But jokes aside, TMM are incredulous that banks have been able to get away with selling Sovereign CDS for so long. The ill-design of the product is palpable - for it not to pay out in the event of a 50% haircut (60% in NPV terms) because the restructuring was "voluntary" is laughable. Sovereign CDS has turned out to be less useful as a hedge than a glass panel in a nudist camp. This is an exceptionally serious issue for the credit market as banks have used CDS to hedge their bond holdings, loan books and other related country exposures, particularly from CVA desks.

A glass panel in a nudist camp. That is what a Soverign CDS is.

Fees for heavy quoters?

Could calm things down, or quite the opposite?

"If entities are sending a significant amount of quotes and never generating a trade, then it's not a good idea for us to support that," Finzi said at STA.

"But one must also be careful because there are certain models and folks who provide value to the marketplace," he added. "That includes market-maker strategies with two-way prices in stocks. In volatile times, they have to address those and amend those quite regularly."

Regulatory discoordination

Wherein the CME notes that halting stocks in a fashion uncoordinated with futures and options markets is probably a dangerous game. Of course, the SEC and the CFTC are too busy comparing their respective anatomies to put their heads together and get something sensible done I'm sure.