You are on page 1of 5

May15,2014

Ms.ElizabethM.Murphy
Secretary
SecuritiesandExchangeCommission
100FStreet,N.E.
Washington,DC205491090

Re:FileNo.EquityMarketStructure2013

DearMs.Murphy:

ThankyouforthechancetocommentontheSECsnewmarketstructureportal,andcongratulationstothe
SECforlaunchingsuchaninnovativewebsite.Notevenayearold,theportalalreadyhasvaluabledataand
analysesaboutourmarketsandisausefultoolforunderstandingatleastsomemarketdynamics.It'shard
tothinkofanotherregulatorthathasreachedouttothepublicinthisway.It'salsoastrikingcontrastwith
theSECofthepast,wherequantitativeanalyses,iftheyweredoneatall,wererarelyandonlyvery
reluctantlysharedwiththepublic,andthedataitselfkeptsecurelywithintheagency.

TheSEC'snewlylaunchedMIDAStoolisalsoagoodstepforward.ThetooltakesinSIPdatafeedsand
proprietaryexchangedatafeedsandmaintainsaconsolidateddatabaseofitall.SECanalystscanuse
thatdatatostudyaspectsofthemarketsdowntomicroseconds,brokenoutbystockandexchange.

MyinterestinthesefacilitieswaspiquedbysomerecentremarksfromChairWhiteaboutMIDAS.During
herrecentappearancebeforetheHouseFinancialServicesCommittee,shesaidshewasmakingcertain
thattheSECanditsexpertshadthedatatheyneededtofullyunderstandallofthemarketstructureissues
andthenrespondappropriatelyiftheresaneedtorespond."(Emphasishers.)Shethenhighlighted
MIDASasacoreinitiative,"TheknowledgebaseoftheCommissionhasbeenenhancedsignificantlyby
beingabletobringontheMIDAStechnology."

MyinterestsharpenedfurtherafewdayslaterwhenBloombergreportedthataseniorSECstaffmember
haddismissedcriticismtheagencywasbehindthetimes.Bloombergreportedthatatanindustry
conferenceinTexasthestafferpointedto"anewsurveillancesystem,knownasMidas,thatcollectsprice
datafromallU.S.exchangesandthathelpstheSECevaluatepracticessuchascolocation,inwhich
traderscuttradingtimesbyplacingcomputersinsideanexchange,andproprietaryfeeds,orstreamsof
datasen[t]toclientsfasterthantopublicsources."Bloombergparaphrasedtheofficial'sbewildermentat
criticismoftheSECbywriting,"Theagencycantbebothignorantofmarketbehaviorandhaveaccessto
suchexpansivedata"Bloombergthenquotedhimdirectly,"'Oneofthosestatementshastobewrong,'"
and"'Thosebothcantbetrueatthesametime.'"

ImwritingtobrieflycommentonthedatainMIDASandonsomeofthatdataslimitations,andtocomment
ontherisksofdrawingbroadconclusionsfromthatdatawithoutaccountingforthoselimitations.Itall
suggeststhat,atleastfornow,bothofthosestatementsaretrueatthesametime.


1
Data

TheportalnotesthatMIDASincludespostedordersfromtheexchanges,butit'simportanttobeprecise:
theexchangedatainMIDASincludesonlydisplayedandpostedorderdetail,andonlythatfromasubsetof
exchanges.

Whileordertypestatisticsfromalltheexchangesarentpubliclyavailable,someexchangesdopublish
thosestatistics.Oftheexchangesthatdo,somewherebetween50percentand65percentofallorderson
thoseexchangesarenotdisplayedorareatbestconditionallydisplayed.Ifanorderisntdisplayed,its
detailisntdistributedoverexchangedatafeeds.Ifitisntdistributedoverexchangedatafeeds,itisntin
MIDAS.Thatmissingdataperhapsasmuchashalftotwothirdsofallexchangeorderdetailisa
significantsourceoferrorunlessitiswellunderstoodandallitsimplicationsaredisclosed.

Thereareothersourcesoferror.Amongthem,NYSEdoesntdistributeorderleveldetailoveritsproprietary
feeds,soMIDASdoesntincludeorderdetailsforNYSEtrading,alossofabout12percentoftheoverall
equitiesmarket.ThisisamuchgreaterlossthanitsmarketshareimpliesbecauseNYSEistheprimary
marketforsomanyofthecountryslargestcompaniesandmostactivestocks.MIDASalsodoesnt
includedarkpoolandOTCmarketmakerdata,whichleavesoutperhapsanother40percentoftheoverall
equitiesmarketfromitsdatabases.

ExtrapolatingandthencombiningtheselimitationstounderstandwhatMIDASdatabasesincludeimplies
thatMIDAShasorderactivityforonlyabout25percentto40percentoftodayslitmarketsandonly15
percentto25percentoftheentireequitiesmarket.Thisisstillvaluableinformation,butitisfarfrom
completeinformation,andanyoneanalyzingMIDASdatashoulddoitcautiouslyandwithalotofdisclosure.
ThoughinonesectionoftheportaltheSECdiscussesatleastoneofthesegapsinthedataNYSEorder
detailtheportalshoulddiscloseafullaccounting.Asubpopulationlikethisinevitablybreedsselection
biasandisfarfromChairWhitesgoalofmakingcertaintheSEChaswhatitneedsto"fullyunderstandall
ofthemarketstructureissues."

MIDAShasotherlimitations.Ofthedozensofdataelementsafirmcanputonanorderbeforesendingitto
anexchange,asaruleMIDASreceivesonlyfourofthemfromexchangedatafeedsstock,price,size,and
side.Andthen,ofthosefourdataelements,threeareclippedbeforetheyevergettoMIDAS.Ordersizeis
clippedtocontainonlythedisplayedsizeoftheorder.Thesameistruefororderprice.Theorder'ssideis
clippedtosimplebuyorsellanddoesn'tincludeanyshortsaleindicators.Ordersarealsonotmarkedwith
capacityindicators,likeprincipaloragency.Crucially,tradesandordersinMIDASdontincludeaccount
dataorotherparticipantidentifiers,meaningthere'snowaytoidentifywhoisdoingwhatinthemarkets,to
isolateafirm'strading,ortoidentifywhatfirmswereinvolvedinanyparticularmarketevent.Italsomeans
there'snowaytoconsolidatemarketactivityintoparticipantcategories,likeinstitutionalorproptrading,and
understandwhereandhowtheseparticipantsenterthemarket.Thesemattersareimportantenoughto
deepanalysisthattheSECsownrecentreviewofhighfrequencytradingresearch,availableontheportal,
deliberatelyexcludesstudiesthatdonthaveparticipantidentifiers.Itexcludesthosestudiesbecausethey
don'thavethe"tradingaccountdatathatcanbeusedtodistinguishdifferenttypesofmarketparticipants,"
makingitimpossibletosortoutwhoisdoingwhat.PresumablyresearchbasedonMIDASdatahasthe
samehandicap.

MIDAShasalmostnoinformationatallaboutordertypesandordermodifiers,otherthantheobviousfactit
containsonlydisplayedorders.Itdoesntincludeanyinformationaboutintermarketroutingbehavior,about
2
whatordersareroutedintoandoutofamarket,soMIDAScan'tgiveanyinsightintomarketwide
interactionsevenastheequitiesmarketbecomesmorefragmentedanddispersed.

Altogethertheseadduptoverysignificantlimitations,andtheyaregettingworse.Moretradingismigrating
tooffexchangevenues,andattheexchangesdisplayedorderusageisshrinkingfast.Lastyearone
exchange'sdisplayedordersdeclinedasaproportionofallordersbyalmost15percent.Atthatratethe
alreadysmallproportionoforderdataMIDASingestsnowwillbecutbyathirdbytheendof2016,andat
anextreme,andwithoutintervention,MIDASmightthenseeaslittleastenpercentorlessofalldetailed
orderdata.

TheexchangefeedsinMIDASsuitmanypurposes.Theycertainlydoagoodjobforthehighfrequency
firmsforwhichthesefeedswerefirstdesigned,especiallysincethetimeandsalesdatatheyincludecan
leakinformationaboutcertainhiddenorders.FormorethanadecadeHFTfirmshaveusedtheexchange
feedsinmanycleverwaystodominateexchangemarkets.Butashorttermalgorithmictradingdecisionis
differentfromapolicydecision,andpolicydecisionsshouldbebasedondatathatequipsregulatorstofully
understandtheirmarkets.MIDAScantanddoesnt,andevenlesssoasthemonthstickbyandmoreof
themarketgoesdark.Ifregulatorswilleverunderstandthemarkettheyneedtoseemorethanoneendof
it,howeverwelllit.WhileeveryonehopestheCATwilldothis,theCATisyearsaway.Inthemeantime,
regulatorsshouldbecompletelyupfrontabouttheirowndataslimitationsanddisclosewhatthose
limitationsmightmean.

Judgments

Datalimitationsaffectpolicyjudgments,andthatswhysomecommentsinarecentspeechbySEC
AssociateDirectorGreggBermanareworthexploring.Thoughhepointedouthespokeforhimselfandnot
fortheCommissionorforotherSECstaff,heisseniorstaffandhisspeechislikelyaninsightintopolicy
decisionsbrewingattheSEC,decisionsbasedonMIDASdata.

Mr.Bermanreportedthatwhile39percentofallordersfoundinMIDASwerecanceledwithinahalfsecond,
27percentofalltradeswereagainstordersthathadbeenrestingforahalfsecondorless.Drillingfurther
intothatdatahefoundthatwhile23percentofallorderswerecanceledwithin50ms,19percentofalltrades
wereagainstordersthathadbeenrestingfor50msorless.

Forordersthatwerepricedatorbetterthantheinside,hefoundthatmorethanhalfofallorderswere
canceledwithinahalfsecondand25percentofalltradeswereagainstordersrestingforahalfsecondor
less.38percentofallorderswerecanceledwithin50ms,and19percentofalltradeswereagainstorders
restingfor50msorless.

Fromallthis,Mr.BermansaidhisanalysesonMIDASdatashowedthatthespeedofsystemsthattake
liquiditybyaccessingdisplayedquotesseemstobekeepingupwiththespeedatwhichthosequotescan
becanceled.Itisaverysignificantjudgmentandshowsplainaffectionforthecurrentstateofthings.
Whilethemarkethasalotofveryfastorders,italsohassometradesagainstthoseorders,whichhe
believessupportsthatjudgment.Butwithoutbetterdataitisnomorethanwishfulthinking.

Thefirstquestionweshouldaskabouttheseresultsiswhatitmeanswhennearly40percentofordersator
betterthantheBBOarecanceledwithin50ms.Atleastoverordinaryelectronicpathways,itsnotnearly
enoughtimeforaquotetomakearoundtripfromNewJersey,wherequotesarecreated,toanywherenear
thewestcoast,whereabout15percentofthecountrylivesandnearly20percentoftheeconomyis
3
produced.Itscertainlyfarlesstimethanhumanbeingsneedtoreacttoitnomatterwheretheyare.
Structurally,then,nearlyhalfofindividualBBOsaresomethingthatonlymachinescanhopetorespondto,
andthenonlyifthosemachinesaresomewhereeastofCalifornia.

Next,giventhelatenciesinroutingdatatotheSIP,andthenfromtheSIPoutward,wecanmakeanother
structuraljudgment,namely,anymachinehopingtorespondtoanyexchangequote,fastandslowalike,
needstohaveexchangeproprietaryfeeds.SIPdatajustisn'tfastenough.Evenamillisecondlostshipping
datatotheSIPorinprocessingdataattheSIPmeansmissingasignificantnumberofquotes,especiallyin
busymarkets.Theexcellentdatavisualizationtoolsontheportalimplythat15percentormoreofallorders
atorbetterthantheinsidearecanceledwithinamillisecond,atleastamonglargestocks.

Thefirstcertainjudgmentsofaristhataccessing[all]displayedquotesrequiresacolocatedsystemand
proprietaryfeeds.Whatdoesthatmean?Atcurrentprices,arackanddatafeedsatanyoneofthemajor
exchangesstartsomewherearound$10,000/month.It'sanextraordinaryamountofmoney,andabouttwice
whatitcosttoleaseaseatattheNYSEinearly2005,justbeforeNYSEannouncedplanstogopublicand
seatpricesjumped.

Becausesomuchquotingissofast,fullandcompetitiveaccesstodisplayedquotestodayatanyoneof
themajorexchangesnowmeansspending$100,000ayearormoretogetinthedoor,nearlytwiceas
muchasaseatonthenationslargestandmostprestigiousexchangecostlessthan10yearsago.Its
djvualloveragain,whereprivilegedinsidersseealltheflowandactonitasoutsidersnevercan.

Andsoitisn'tfarfetchedtocallthesekindsofmechanicsrigged,thoughatleastoneFINRAexecutive
preferscallingthem"firstclass." Theoldinsidersboughtorleasedseats,andthenewinsidersleaseracks
1
andbuydatafeeds.Forallthechangesofthelastdecade,westillsufferatwotieredmarketutterly
dominatedbyasmallclubofinsiders,excepttheentryfeesaremuchhigherthantheyusedtobewhile
regulationsmeanttoconstraintheclubhavebeenpassionatelydismantled.

It'stoobadMr.Bermandoesnttakehisthinkinginthisdirection,thoughthesequestionsmightbebeyond
hisroleorinclination.Insteadhesaysthatifasignificantnumberoftradesareagainstshortlivedordersits
evidencethemarketkeepsupwitheventhefastestquotes.

Butwhoisitkeepingup?Aretheyinstitutionaltradersorproptraders,orevenretail,orordersfromother
markets,oramixofallthese,andinwhatproportions?WecantsaybecauseMIDAScanttellus.What
ifthequickesttradesareinitiatedalmostexclusivelybycolocatedpropfirms?Whatifthequickesttrades
areinitiatedalmostexclusivelybythesamesmallhandfulofpropfirms?Whatifthefastestorderscome
fromthesamesmallhandfuloffirms?Whatifcolocatedpropfirmsarenearlyalwaysfirstinpricequeues,
squeezingoutthepublic?Oftheorderscanceledwithinamillisecond,doanyofthosefirmssoontradeat
thatprice,andwhatistheirordertotraderatio,orisitallquotespam?Whowasontheothersideofthose
trades?Whatifaggressivetradesbypropfirmssomehowneatlypredictsubsequentpriceaction,and
includetheirmostprofitabletrades?Howfrequentlydomarketmakingfirms,armedtotheteethwithan
arsenalofregulatoryprivilegesnooneelsehas,turnaggressive,andwhatistheeffectonpriceswhenthey
do?Whatothertradingstrategiesdomarketmakingfirmsdeploy,anddotheyusetheirprivileges
privilegesintendedonlytohelpthemprovideliquiditytoinvestorswhentheydeploythem?Howfrequently
domarketmakerssellshortaggressively?Howfrequentlydotheyturnandrun,coweringbehindminimum
quotingstandards?Howmuchinventorywillamarketmakerholdbeforeaggressivelyliquidatingit,risking
1
Seehttp://wealthmanagement.com/blog/highfrequencytradingbuyingfirstclasssaysfinraenforcementchief.
4
thekindof"hotpotato"tradingthatslammedpricesintheflashcrash?Whatportionofdisplayedliquidity
comesfromthesamefirmsscatteredacrosstheexchanges?Whenafirmtradesononeexchange,doesit
cancelorrepriceitsquotesonothers?Doesitthentradeaggressivelyonotherexchanges,andinwhat
direction?Doesitevensellshortaggressivelyonotherexchanges?Andisanyofthisbehaviordifferent
dependingontheexchange,orwhenmarketsarevolatile?

Knowingatleastsomeofthisisessentialbeforemakinganynormativejudgments.Andasconsequential
asanswerstothesequestionswillbe,whatifmanyofthosefasttradesarejustcoincidences?

Foranexampleofthat,wecanlooktoMrs.BettyJohansseninRedLake,Minnesotaassheentersan
ordertobuy100sharesofMMM.Ifherarthritisisn'tactingupittakesherlessthanaminutetologintoher
brokerswebsite,setupamarketablelimitorder,andclicksend.Itmighttakeanotherhalfsecondorsofor
herordertomakeitswayfromhercomputerthroughherbrokerssystemsandonitswaytoanexchange
(letspretenditactuallydoesmakeittoanexchange).

NomatterhowlongittookMrs.JohanssentoentertheorderandfortheordertomakeitswaytoNew
Jersey,thatorderisgoingtotradeagainsttheinsidemarket.Sincealmost40percentofallordersatthe
insiderestfornomorethan50ms,Mrs.Johnanssensorderhasasignificantchanceoftradingwitha
shortlivedordercompletelybyaccident.Anotherwaytoputthisisthatofcoursealotofshortlivedorders
tradeifenoughofthemareattheinside,becausetheinsideiswhereorderstrade.Withoutfirststudying
whoisbehindthem,nooneshouldthinkthesekindsofrandomcollisionsarepurposefulandthenturna
coincidenceintoapolicyjudgment.You'llhitsomethingifyouthrowpebblesintoafan,butthatdoesn't
meanyouaimedatwhatyouhit.

Theimportantquestionisntwhetherfleetingordersattheinsideorevendeepinthebookaretradeable.In
anyautomatedsystemtheyaretradeable,bothonpurposeandbyaccident.Theimportantquestionsare
whatportionofexchangeliquiditytheyprovide,whatcoststheyimposeonotherinvestors,whoorwhatcan
tradewiththemonpurpose,andwhatthatkindofaccesscosts.OncetheSECanswersthosequestions
wecanframenewquestionsandperhapsbegintomakenormativejudgments.Nomatterhowmuchwe
mightwantitto,fornowMIDAScanthelp.

Inlightofallthis,it'sprematuretocallMIDASa"surveillancesystem,"atleastasthattermisusedin
industry.Unlessthere'smoretoMIDASthanwe'vebeentold,it'salsoprematuretosayMIDAShelpsthe
SECkeeppacewithorstayaheadofitscritics,orhelpstheagencyfullyunderstandmarketstructure
issues.Thedatatoachievethosegoalsresidesinsideexchangeaudittrails,oratFINRA,ormightbe
collectedsomedaybytheCAT,butit'snotyetinMIDAS.

It'sacommonfailingtobelieveanexcitingnewtoolwillfitwhatevercomesalong.MIDASisagreatstep
forwardbutthere'smuchfurthertogo.FornowtheSECshouldthinkverybroadlyaboutwhatquestionsit
needstoanswerandnotstraintoanswerthemhastilywithatoolthatisn'tsuitedforit.Doingusnogood
atall,thatwillonlynurturemorecynicismabouttheindustryatatimeweneedtonurturegoodwill.

Sincerely,

R.T.Leuchtkafer