Macro Economics
The Evolving Exchange Landscape

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By Rimpynths
October 29, 2009

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Earlier today, there was a Senate hearing titled "Dark Pools, Flash Orders, High Frequency Trading, and Other Market Structure Issues". I'm not sure if anyone has been following these issues. They seem to get mentioned more often in the mainstream press and the blog ZeroHedge, one of my favorites, discusses these topics regularly, usually with much criticism.

I've been a software developer at one of the exchanges for a few months now, and during that time, I've gained a lot better understanding of how exchanges operate. I hope to be able to share some of my thoughts about the exchanges with this board from time to time. I don't care if people know whom I work for, but I will definitely be careful to not share any inside information and I would still like to refrain from mentioning them by name. I'd prefer to keep these posts away from Google's extensive reach and let the company handle its own image. And needless to say, please don't interpret anything I write to be at all representative of the company's policies because they are just my personal observations and opinions.

To get you up to speed on the evolving landscape among the exchanges, this NY Times article is a good summary of some of the changes that have occurred in the past five years. The exchange that I work for is the one in the photo at the top:

If anybody is interested in some of the technical details of how exchanges operate now compared to five years ago, this white paper submitted by Goldman Sachs in response to the SEC's request for comments is an excellent overview of the current market structure. (Their conclusions/recommendations are still subject to debate though.)

The media (and the Senate apparently) tend to discuss Dark Pools, Flash Orders, and High Frequency Trading all in the same article, even though each of these issues are very different. However, I do think that they get lumped together because they do all have one thing in common: they are a form of technological or information asymmetry between retail investors and institutional investors.

Exploiting a technological or information asymmetry for profits is of course as old as the markets themselves. One frequently cited example is that in 1815, the Rothschilds made a killing on British bonds after a carrier pigeon brought them the earliest news that Napoleon had lost at Waterloo. And here are ways that all of the modern market bugaboos are just another form of asymmetry:

Dark Pools -- A form of information asymmetry such that dark pool participants can see what's happening in the public market, but the public markets can't see what's going on in the dark pools.

High Frequency Trading (HFT) -- A form of technological asymmetry because HFT participants have more sophisticated equipment that can react more quickly to information arriving via data feeds direct from the exchanges and make literally thousands of trading decisions in a second.

Flash Orders -- A form of information and technological asymmetry because information about flash orders is propagated only to members of the exchange and it requires expensive technology to act upon.

Asymmetry will always be a part of the market, but fortunately I believe that the playing field between retail investors and institutional investors gets more level every day. It will never be completely symmetric, but fortunately it's much improved from the days of market makers pocketing quarter spreads or the need to shell out millions of dollars for an exchange seat so that you can be a part of the inner circle. The difference between entering a trade over a dialup modem via E*Trade versus having a quad-core computer co-located in the exchange's data center is much, much smaller than for example being the first brokerage firm on the West Coast with a ticker tape.

One thing that has really surprised me since I started working for an exchange was just how much exchanges strive for information symmetry between all participants. As far as I know, no other market for any other type of good really compares to it. For example, here's what the used car market would be like if market participants had to play by the same rules as equity exchanges:

1. If you sold your car to your neighbor based on a private agreement between the two of you, that would be a form of Dark Pools.

2. If you wanted to advertise your car in the company newsletter to see if one of your coworkers wants to buy it before you buy an ad in the local paper, then that would be a form of Flash Orders.

3. If somebody offered to buy your car for $5000 but you knew that a dealer in a nearby town was selling the same make and model for $4900, you would have to either have lower your price to $4900 too or direct your potential customer to the other dealer (i.e. you must abide by the NBBO, or National Best Bid-Offer).

4. If you did sell your car for $4900, you would have to report the trade to an industry newsletter so that all of the other dealers know what the latest car sold for (i.e. the Consolidate Tape).

There are lots of different activities that are considered perfectly legal in other markets, but the equity markets must abide by a much more strict set of rules to encourage information symmetry between all participants. I think this is a good thing and it makes for a more efficient and fair market. But on the other hand, any aberration in this perfect information model receives a lot more scrutiny in the equity markets than it would in any other market.

That's all for now, but I hope to write on more topics in the future. I could write a long essay on my thoughts on High Frequency Trading. Another important topic is the option markets. In short, all of the massive changes that have occurred in the equity markets over the past five years will also be taking place in the option markets over the next year or two. It's a really interesting time to be a part of the development of exchanges and I hope to share more of my observations with the board in the future.