HFT and Financial History JUNE 2015

PART 1

Do you mean to say we are still talking about HFT and what to do about it? Perhaps only those old enough to remember when books and records were hand written by real people and trades were executed manually realize what has really happened to our financial system and how it transpired.

Of course whenever something goes wrong we have to allocate blame and in the case of the HFT issue there is no difference. However while recognizing something must change it is important to do what others have not done on this issue: look back at the origins of the problem. While the Michael Lewis book and the creation of the new Exchange IEX have highlighted the current problems with our financial market place they do not reveal the fundamental problems and changes that created the current mess.

First a historical perspective of how the structure of the market has changed over the last 40 years. Without Congress nothing can take place. Congress is the ultimate buck stop because they create all legislation as well as oversee the markets through the agencies it establishes and have oversight. In the case of the securities markets it is the Securities and Exchange Commission and its staff often referred to as the SEC. Underneath this layer is what is commonly referred to as the various self regulatory agencies which are the various Exchanges that are charged with overseeing their members. The most famous of the Exchanges is the NYSE.

So if there are abuses to be corrected. If there is blame to be placed look first to our leaders in Washington that have in many ways got it wrong for so many years despite the best efforts of many well intentioned members of Congress. But like s many things that is an oversimplification of a chain of events that lead us to the current environment.

Let’s look at the 1960’s as our starting point. The bull market of the late 1960’s showed some of the early weaknesses of our financial system. In case you don’t recall the NYSE could not handle the surge in volume as the stock market went to new highs. Paper, paper everywhere (the single day record of 14 million shares) so much so that the NYSE had to close one day a week to catch up with the volume of out trades or DK’S as we used to call them in the good old days.

The solution, automaton through computers, was a disaster as firms tried to solve their operational problems by switching to computers managed by people that did not possess the industry expertise. Firms lost control of their operations or back office and thereof could not determine where they stood financially. The phrase of the day was Fails to Deliver and Fails to Receive. As the bear market of the early 1970’s began many house hold names and blue blood firms went out of business. People with years of industry expertise and training were left to find new careers to survive. What many of the younger set probably don’t know but in those days the NYSE took care of its own and the healthier larger firms’ merged or took over the weaker firms to protect the integrity of the market place as well as to protect customers from losing all their money. That is right there was no Securities Industry Protection Agency (SIPC), no Customer Reserve Rule (meaning firm funds and customers funds were commingled and able to be used for financing the business). In fact there wasn’t one uniform way of measuring how liquid or the Net Capital of the companies.

But if it was bad for larger firms the smaller members of the Exchange as well as firms’ whose business was mainly dealing in Over the Counter market securities was disastrous. And this case customers lost money, firms closed and abuses were disclosed. Cries for reform were everywhere so Congress was called to action (sound familiar). The battle for the self regulatory market was on with the NASD in combat with the NYSE as to who was more capable of safe guarding the public customer interests. The upstart OTC market ,which consisted of individual brokers throughout the country making markets and trading unlisted securities unlinked by any electronic network and regulated by the NASD or the listed Exchanges specifically the NYSE. The NASD lobbied hard in Washington to be the chief regulator not just for the OTC Markets but for the listed market as well.

As the 1970’s progressed Congress was divided not only on the regulatory front but on the very market structure itself. Which system served the public best, an Exchange specialist system where orders were brought to a central market place to compete against other orders for the best execution price for customers or a multiple upstairs market maker system where multiple market makers had responsibility for maintaining an orderly market and competing for customer orders. Many felt that the Specialist System stymied completion and was an outdated monopoly. The market maker system at the time had no sophisticated linkage and therefore price protection could not be afforded customer orders. On top of this was the constant pressure on Washington put on the representatives of the various listed regional Exchanges that were fighting for the precious customer order floor and wanted rules protecting them in the cases where there market had the best representative bid and offer in an individual security. The counter argument was that routing order flow on individual order basis was impractical and too expensive and not in the interests of all customer orders and that the decision to route orders should be viewed on a whole basis not piecemeal. Want even more confusion, the larger New York firms really wanted to do away with the rules that required their customer order to be represented and executed on the floor of an Exchange, not only for a large block trades but for all orders. They wanted to internalize their own orders. Oddly enough firms’ making markets in the OTC world saw an opportunity to use the NASDQ facilities to begin the practice of paying retail firms for their customer order flow which they could trade against. Interesting enough the pioneer of this practice was Bernard Madoff.

The practice was allowed at first really for political reasons and aimed at having an alternative to the monopoly of the NYSE specialist without regard for the inherent conflict of interest in the practice. This, in my view, was the first step in the gradual decline in the structure of the market place. A system based upon the principle of putting the customers’ interest first. Ever so slowly throughout the next four decades in the drive for more profits and competition for volume supremacy between the Exchanges with Congress and the regulators well intentioned at times but always politically motivated and one step behind, the walls collapsed one brick at a time. Well intentioned mandates like linked Exchanges (ITS system) and rules for order flow direction and the development of technology to centralize and direct order flow to various market centers only made the stakes higher and years later laid the ground work for abuse. The reshaping of the credit rules accomplished by continual political pressure by the people with the most to benefit on the SEC and self regulatory staff fueled volume making the volume prize more valuable and in fact the whole point of the game.

During this period the political struggle and philosophical debate was further fueled by the advent of the listed options market in 1973 with the opening of the Chicago Board Options Exchange. The idea of trading options in a listed Exchange through new clearing facility that settled the trades the next day was unheard of. Fashioned after the futures market and particular the Chicago Board of Trade it was a hybrid part security part commodity. How to regulate and whether it should be allowed was an intense political battle especially since the options traders would be allowed to hedge their option positions by trading listed stocks.. The history of OTC options was historically based with abuses rampant. In the early 70’s the historical firm of Roosevelt was put out of business because they had written thousand of naked options without taking any cushion (haircut) against the capital of the firm. Customer complaints, outrageous pricing and firm failures were a part of the landscape of the over counter market. The listed market sought to eliminate these concerns with a centralized fungible product with standardized terms and regulated by a separate set of rules and regulations to be overseen by the Exchange compliance department. Market floor surveillance with monitor the floor trader actively. Still many with the establishment were skeptical and this was why the New York Exchanges would not get involved initially. It was only after the CBOE looked like a success that the AMEX and the other regional Exchanges the joined the business. The federal regulators especially the SEC Division of Enforcement were against the concept.

The listed option business was the shot in the arm that kept the securities business alive, drawing young talent seeking an opportunity. The barriers of entry for young people were lower especially in Chicago where CBOT firms had been providing opportunities for young traders for decades with their ability to finance young traders without any capital. Account executives in the New York brokerage firms had a new sophisticated product to sell. In many ways this new product reshaped for the financial future of the industry in two ways financial innovation in the form of derivatives and the lower barrier of entry and basically allowed for worldwide growth.

The 1970’s and the bear market drove many a broker to selling cars or shoes while operations staff hung on for a while trying to clean up the mess the computers left behind. At the same time ground breaking rules were written to protect customers and require uniform financial reporting requirements and governing how to compute the viability of member firms. But herein lies a very subtle insight to the process that helped shape out discussion regrind HFT and the roots of the 2008 financial crisis. The constant battle between firms and individuals seeking to shape the financial landscape for their benefit and the guardians at the gate, meaning the staff on the federal regulatory agencies and the staffs at the self regulatory agencies worked because the self regulatory agencies were a part of not for profit system functioning for the benefit of its members but more importantly for the service of the public. Important to keep in mind that these self regulatory agencies were responsible to report to the federal agencies. In the case of securities that would be the SEC. The SEC through its staff could deny or require rules changes and had great control of the futures of the Exchanges and the OTC market. In effect the self regulatory arm of the Exchange was a buffer between those of its own members who might for their own benefit detract from the membership as a whole. A delicate balancing act by the staff trying to represent the membership in a completive way yet protecting the members of the public from abuse. Once this par to the system disappeared with the advent of the Exchanges becoming public companies where like another company profits were the guiding force the system was corrupted. This coupled with the collapse of the credit regulations and a system where privilege was combined with responsibility lead to the abuses we see in today’s market place. Somewhere along the way to progress things have been turned upside down and we have been lead to believe in the world of “Doublethink” as Orwell defined as the “power of holding two contradictory beliefs in one’s mind simultaneously, and accepting both”.