This podcast was recorded ten days ago. It's publication was delayed a week due to last weekend's annual Peak Prosperity seminar.
As luck would have it, we had Joe Saluzzi lined up to record a podcast the day the news broke recently that the suspected culprit for the 2010 flash crash, Navinder Singh Sarao, had been arrested. Saluzzi is co-founder of Themis Trading LLC, long-time cautionary on the dangers of high-frequency algorithmic trading, and co-author of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio.
In this discussion, Joe shares his suspicions about Sarao (a contributor to the crash, but highly unlikely to be the actual cause) and then provides his expert assessment of what has been done in the intervening years since the flash crash to safeguard the market against a similar failure (precious little). In his opinion, a winner-take-all high-tech arms race, clueless and toothless regulators, and central bank price distortion are conspiring to make us more vulnerable — not less — to another systemic breakdown:
What’s happened is the markets have evolved and they've obviously embraced computerization and technology. Some things have been very good for the markets and brought down cost. But regulators don’t seem to have evolved. They don’t seem to have caught up with times and they don’t necessarily have the eyes and ears out there to monitor things on a micro-second or nano-second level.
Just as an example: the SEC has proposed putting together a consolidated audit trail. This came about after the flash crash back in 2010. And we’re five years into this and they’re still out for bid, waiting for someone to bid on the project, and it’s nowhere near completion. And even when it does get completed, it’s still not going to be an all-encompassing view. They won’t be able to see futures, because the CFTC monitors that group. So it will be an incomplete set. It will be better than what they have now — which is called Midas, basically a bunch of a direct data feeds that are supplied by the exchanges. And Midas, by the way, was built by a high frequency trading firm named Trade Works that still gets paid by the FCC over couple million dollars a year for this thing. So it makes you wonder how they're properly equipped to monitor it. And when you see cases like spoofing pop up and you’re like “How could they have missed it”? As you mentioned Eric Hunsader from Nanex, he sees this stuff all the time and he tweets it. I mean if I was a regulator I would just follow Eric and I’d say: "There’s an example right there, I don’t have to do the work, I’ll just follow Eric, he’s doing the work"
What happened to the price discovery mechanism? Is it really being set by fundamental investors who have looked at a company and its long term aspects, or is it now being set by Fed policy or some algorithm that’s tied to one currency pair or another?
And we're getting bubbles in certain areas because no one is really looking at valuations. All they care about is “Okay I made money today and I start fresh tomorrow because every night I go home flat and I start the game all over again”. That’s a scary thought. That’s a scary thought that these multi assets are now playing into each other and the correlation is so tight that when one market sneezes they all catch a cold really, really quickly.I think we have to blame central bank intervention. How can we not? It’s all around the world. They’re setting interest rates at a ridiculous level. Quantitative easing is distorting all sorts of prices of assets. How do you price things anymore when you have such a giant manipulator out there?
Click the play button below to listen to Chris' interview with Joe Saluzzi (40m:53s)
Chris Martenson: Welcome to this Peak Prosperity podcast, I am your host Chris Martenson. Today we’re going to talk about markets, equity markets, bond markets and commodity markets. And today they all share one thing in common, they are utterly broken. At least they are if you think markets should be fair and level playing fields where prices are determined by the collective actions of thousands, if not millions of market participants who are carefully weighing and sorting through the same information as they make their decisions. However if your intent is not to have a level playing field and your intent is to rig the markets either for gain or policy purposes, then these markets aren’t broken, they’ve never been better. Discussing these markets with us today is a man we first interviewed on this subject back in 2011, long before the book Flash Boys by Michael Lewis came out and shined some additional light on this much needed subject.
Joe Saluzzi is partner, co-founder and co-head of Equity Trading of Trading LLC, a leading independent agency brokerage firm that trades equities for institutional money managers and hedge funds. Now, Joe is one of the foremost experts on algorithmic trading, often referred to as high frequency trading or HFT, and the dangerous risks it has introduced into our financial markets. Along with Sal Arnuk, he is author of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio (paperback). Hey welcome back Joe it’s great to have you back on again.
Joe Saluzzi: Chris thanks for having me, it’s been a while, I appreciate it.
Chris Martenson: So Joe after all the attention of the excesses of HFT, after all these years what, if anything has been done by the regulators to right the wrongs and give us back our markets?
Joe Saluzzi: They haven’t done too much. They’ve done some what we call Band Aid fixes after the flash crash of 2010 they put through the limit up, limit down circuit breakers which will basically prevent a stock from moving more than 5 or 10% in a matter of minutes, which is a good thing, don’t get me wrong. I think it’s prudent and they should have done that a while ago. And they got rid of something called a single stock, a stub quote but those are kind of cosmetic changes. They haven’t really addressed the bigger issues which we consider fragmentations, all the excess exchanges, all the market structure issues that have led to this type of trading that is changing. The market has certainly changed over the last 15 to 20 years. You don’t have those fundamental investors that’s setting price kind of like you mentioned earlier; you have more -- it’s an algorithmic race, you’ve got spoofing, you’ve got all sorts of stuff going on now setting price. So I think they still need to address the market structured areas that we’ve talked about many times and the SEC just came up with something called the market structure advisory committee after, you know five years, after the flash crash—that will meeting for the first time next month to discuss certain market structure issues, but we’ll see if anything comes out of that.
Chris Martenson: Do you know who is going to be sitting on that?
Joe Saluzzi: Yeah actually we do and it’s actually a large group, much larger than we thought it would be. There’s 17 members on the group, we were actually -- we were proposed to be in it. Unfortunately we didn’t make the final cut. I think there were some vetos to our nomination and that doesn’t surprise us at all. Many of the members are what we consider status quo industry types who want to leave things just the way they are and are basically making money and what we call them arms merchants, some of the exchanges and so on who have a vested interest in leaving things just the way they are. But then there are also some others who are out there and they’re going to ask some good questions. Unfortunately we think they’re in the minority of the 17.
Chris Martenson: Well yeah let’s keep an eye on that but I have to tell you after all these years of seeing the glacial pace at which the SEC has decided to move—and the CFTC on these things—it’s clear to me that technology is still winning this race and many of the things that they talk about which should be to me obviously and patently illegal, like spoofing or throwing quotes in there that you have no intention of filling. Those still happen to my eye all the time, I follow the guys at Nanex, I look at their market liquidity structures. It’s obvious there’s shenanigans going on all the time.
Joe Saluzzi: Yeah and I think what’s happened is the markets have evolved and the markets have certainly obviously embraced computerization and technology and all which things have been -- some things have been very good for the markets and brought down cost. But regulators don’t seem to have evolved. They don’t seem to have caught up with time and they don’t necessarily have the eyes and ears out there to monitor things on a micro second or nano second level. Just as an example they have proposed putting together, the SEC has proposed putting together a consolidated audit trail. This came about after the flash crash as well, back in 2010. And we’re five years into this and they’re still out for bid waiting for someone to bid on the project and it’s nowhere near completion. And even when it does get completed, it’s still not going to be an all encompassing view. They won’t be able to see futures because the CFTC monitors that group; so it will be an incomplete set. It will be better than what they have now, which is called Midas, which is basically a bunch of a direct data feeds that are supplied by the exchanges. And Midas by the way was built by high frequency traders named Trade Works that still gets paid by the SEC over a couple million dollars a year for this thing. So it makes you wonder are they properly equipped to monitor it. And when you see cases like spoofing pop up and you’re like “How could they have missed it”? As you mentioned Eric Hunsader from Nanex, he sees this stuff all the time and he tweets it. I mean if I was a regulator I would just follow Eric and I’d say -- there’s an example right there, I don’t have to do the work, I’ll just follow Eric, he’s doing the work.
Chris Martenson: Yeah just put Eric on your payroll for a couple of days, throw him a few bones and see what he comes up with. It’s --
Joe Saluzzi: He would do it very cheaply because he wants efficient fair markets as well.
Chris Martenson: Absolutely. So let’s talk about markets for a bit. You mentioned the flash crash, that event on May 6, 2010 where markets really plummeted; originally blamed on a fat finger trade by a trader out of the Midwest, out of Reed and Waddell. Today big news, I’m sure you’ve been swamped with calls around this. The SEC has decided no, no it was some guy operating out of a small bungalow in London. Tell us what your thoughts are on this?
Joe Saluzzi: It’s truly amazing. I don’t know how they come up with this stuff. But the case actually brings up so many more questions than answers but let’s go back to what you just said. Originally they all blamed a mutual fund trader out of Kansas City for basically entering an order for his own clients. So they’re blaming someone who actually turns out to be the victim. And they were the victim because there was a spoofer—this fellow by the name of Sarao trading out of the UK who they now have -- they have all the documents. He was 20-29% of the orders in the e mini futures contract for the three hours prior to the flash crash. This guy was enormous for one guy coming out of an apartment with a software package that was modified by one of his vendors. So it makes you scratch your head and say “Wait a second, how could they not have seen this” and why did it take them so many years? And let’s be real, do we honestly think that there’s only one person in the world running the same strategy that this guy was doing? I can’t imagine it was one guy but I do think that he certainly exacerbated the move on that day because if he was that significant amount of orders he certainly had something going on but it wasn’t the cause of the flash crash.
The flash crash was caused by a poor market structure that went out of control and actually when the CFTC and the SEC did put out a report five months after the crash they noted that it was -- they called it hot potato trading. Where basically market makers are flipping back and forth and once their inventory positions got exhausted or their risk levels got too high they were shutting down. And many of them were quoted afterwards saying that we just stopped trading and exited the market. That’s why you had a flash crash because it was a void in liquidity, which makes you think well where are the obligations? What is a market maker today? Do they have any obligations to supply real liquidity or can they enter and exit like this guy in the UK and pretend to be adding liquidity when in fact he was spoofing. So the case is troubling, it’s troubling for so many reasons. I mean it’s -- where was his broker? Why weren’t they looking at it? Where was the CME where all the trades were being done? Why didn’t they come after him although they did but then they seemed to do nothing five years ago and then finally where was the CFTC? So who is watching the shop here and to me it’s very troubling.
Chris Martenson: You know this whole idea of market structure is really important to me because again following the work at Nanex by Eric Hunsader is -- shows that this volume it comes and goes at the blink of an eye and so I had Bart Chilton on this show recently, formally the CFTC commissioner there, now out in private world, and he said that he thought recent reports had proven to him that HFT programs and the like were good for investors because they brought down prices, which I agree with, and provide liquidity to the markets. I disagree with that one. Where do you stand on HFT and liquidity?
Joe Saluzzi: Well liquidity and volume what are they? They’re different types of things but let’s differentiate amongst HFT. HFT is a hard thing to define. I was actually on a CFTC sub committee where we were trying to -- my task was to define HFT and in the end we didn’t -- they came up with a definition that I actually dissented to; I didn’t think it was a good definition because it didn’t have an inventory component in it, which at the end of the day most of these HFT’s are flat or relatively flat when maybe it’s one instrument versus another. But the bottom line is there are different types, right? There’s electronic market making which for the most part is a good thing in the sense that there’s no other market makers now a days. The traditionals left, so someone has got to make a market and these electronic market makers do quote two sided spreads although the quantities are much, much smaller than you would expect a real market maker to commit. But let’s just assume for a minute that that’s benign and that’s good for the market and that’s what Bart’s talking about. Well if Bart’s defending that I don’t think I would take an issue with that.
But now let’s talk more about the predatory and some of the momentum ignition and things like spoofing like we were just talking about and more of the proprietary trading HFC that’s out there just looking to take off an order or front run demand and supply. And I use the term very carefully when I say front run. Not front running an order because that’s illegal, if I had an order from a client and I traded ahead of this myself, that’s illegal and I go to jail. What they do is they basically -- they take a look at the order book and they say “Okay where’s the buyers and where’s the sellers”? Once they think that there’s more buyers than sellers I’m going to try to front run that based on the technological advantage that I have due to my co-location ability or my microwave networks or whatever it is. So they front run demand and they front run supply. It’s not fundamental based trading at all, they don’t care what they’re trading; they’re just getting ahead and they’re trying to sell it to you or flip it back before you even know it. So that’s not helping anybody; that’s not adding to the price discovery process. That’s just scalping in an automated fashion, which is very hard to detect or very hard to monitor for the regulators.
So Bart, in the past Bart Chilton has said that there’s white hats and black hats of HFT. Okay and I’ll agree with that but what I don’t hear from Bart is tell me more about these black hats? Who are they, what are they doing? What have you seen them do? Can we go after them? Let’s find out some details because if there really are you need to start spilling the beans and as a guy who represents the industry I would think he would know.
Chris Martenson: Well absolutely. I found that a little shocking at the time because certainly I’ve seen and read enough to understand that there are black hats out there and so here’s an area perhaps that sort of brings this out to light a little bit for me; so and let’s talk about this idea of providing liquidity. I think that we need to reverse that word providing. I think this should be called sucking liquidity. There’s a firm out there that recently was describing the results of their trading and in this HFT universe and over an entire six year span they reported that they had somehow lost money on one day. Every other single day they were pulling in on average one and a half to two million dollars a day from whatever it is that they were doing. And publically the CEO came out and said explained this by saying, “Well we win more than we lose”, right?
Okay so let’s do some math. If there’s even ½% chance of losing, one-half of 1% chance of losing on any given day then the odds of that happening, of that company turning in one trading loss day out of six years is over one out of 58,000. So the odds, if we decide to say there’s a 50/50 chance of real trading involves risk you can’t even -- my Excel is incapable of calculating the odds on a 50/50 chance because a get a div zero error in there and there’s probably not enough atoms in the universe to actually make the denominator of the one out of X statement of probability. So is what this company is doing, it’s not really trading then is it? Because it seems to be risk free.
Joe Saluzzi: Well I think what he’s saying is that there are losing trades, right? But what they appear to have is a risk management system that is able to minimize those losses quickly and then on the buy side or on the winning side maybe they’re letting the winners run a little bit more, I’m not sure. But and I think also one of the parts that he left out was a scratch trade, the ones that he didn’t make or lose money, what percentage was that? So it appears that it’s more -- it’s a law of large numbers, that’s what they’re trying to explain where they’re trading millions and millions of times a day and they’ve built this model. And the model also by the way is not just equities and it’s not just futures, it’s multi-asset and it’s kind of interesting. Multiple books of currency bonds, futures, options, all different instruments where I would imagine that there’s some big interface which tells them where their risk exposure is at all times amongst these instruments, which somehow produces money. You know it does scare me that obviously in the days of technology and software and hardware there could be failures at any point in the system and what would happen if part of that Rube Goldberg machine all of a sudden collapses and the marble doesn’t get to the end where it’s supposed to go? I don’t know, that’s what happened to Knight Capital and they lost 440 million dollars on one day.
Chris Martenson: Yeah and before they figured out where the electricity plug was to this thing just yanked out of a wall.
Joe Saluzzi: Pull the plug quick.
Chris Martenson: Right so an important point came up which is that these companies who are in this space, they’re not just -- they’re not really focused on any one particular asset; they might be in options, futures, across indexes, ETF’s, individual shares, trades. They’re kind of -- they have tentacles in all kinds of things and their system would involve being positioned in one arena or asset compared to another, let’s make it tangible. Let’s say I want it to be long oil futures but I thought that at some point I was going to reverse that and go short, it wouldn’t hurt to have some puts on USO, the oil ETF. It wouldn’t hurt to have some individual puts on individual energy companies, etc. and so forth. Like you’re saying they might have more of a complete map across a set of related assets when they’re running strategy.
Joe Saluzzi: Yeah I think so and I think the goal is to be as close to neutral when it comes to risk as possible. You may be long the oil, like you said long the oil and maybe short the ETF or whatever it may be and you’re trying to minimize that and it may actually require them holding positions over night as long as they are hedged into neutral. Now really they’re obviously not investors like you know, Warren Buffet or you know some long term investor and they don’t necessarily care about the long term health of the company. But what I would like to see is if they are truly market makers I would like to see more obligations on these market makers. Right now there really isn’t much of an obligation to quote an equity.
I mean you can be within 8% of the market and you’re considered a market maker; so that’s nothing. And I think actually there are a couple of these larger electronic market makers who have actually argued for more obligations. And they said, “You know what? I don’t have a problem putting in a larger obligation”. So what’s happening is there’s kind of a divergence going on amongst the larger HFT’s and then the smaller ones who are more kind of what we would consider parasitic that are just kind of playing the game and then kind of hovering around. If you’re going to come in and you’re going to make a larger market and you want to be -- I don’t have a problem if they want to get compensated obviously by earning a spread, well then they deserve it if they’re going to supply an obligation to the market. We need a market maker. Unfortunately the traditional ones have gone and so there is a void out there when times like the flash crash happen you hope that there’s a market maker there to hold it and you know as the old saying goes until calmer heads prevail, but right now there’s a bit of a void there. So we’ll see. That is an argument that’s going out there whether market makers should have more obligations.
Chris Martenson: Well that would certainly I think go a long way as well as putting maybe some latency on the trades as well; so you have to hold something for I don’t know, let’s pick something ridiculous, 200 milliseconds.
Joe Saluzzi: That’s ridiculous, way too long. [Laughter]
Chris Martenson: All right. Well let’s talk about correlations then because today it seems to me, this is my observation, I’m out here in the cheap seats remember. But it seems to me that you can explain a lot of what happens in both US stocks and global commodities if you simply follow the United States dollar index against the Japanese Yen, that correlation explains a lot of other things. The correlations are really high. So what it appears to me is that we now have global strategies that are being traded where I’m not sure fundamentals really come into play, or at least I have a hard time myself fundamentally explaining why a change in the value of the Yen should really radically alter the price of gold in London. How do we begin to understand this?
Joe Saluzzi: Yeah and I think what we were talking about before with the multi-asset strategies that tends to explain it a little where when a currency starts to move then I better get short equities whatever it may be. It does scare me in that I am wondering are prices now -- you know what happened to the price discover mechanism? Is it really being set by fundamental investors who have looked at the company and look at long term aspects or is it now being set whether it’s on Fed policy or some algorithm that’s tied to one currency pair versus the other. And then where are we going? Are we getting into some bubbles in certain areas because no one is really looking at valuations, all they care about is “Okay I made money today and I start fresh tomorrow because every night I go home flat and I start the game all over again”. That’s a scary thought. That’s a scary thought that these multi assets are now playing into each other and like you said the correlation is so tight that when one market sneezes they all catch a cold really, really quickly.
Chris Martenson: It’s true and that is my concern. I’m having a hard time quantifying it but the idea is that it feels like we’re just in a large speculative environment where the relative movements of these asset classes is what’s important, not the absolute underlying value.
Joe Saluzzi: Yeah well I think we have to blame central bank intervention, how can we not? It’s all around the world. They’re setting interest rates at a ridiculous -- at a ridiculous thing -- quantitative easing is distorting all sorts of prices of assets, the amount of supply on a lot of these bonds is going down, it’s almost zero. So how do you price things anymore when you have such a giant manipulator out there?
Chris Martenson: Well let’s talk about that manipulator real quick because here’s some other slight sources of concern for me. We learned in 2013 that I think 13 out of 60 central banks were buying equities, right? Switzerland, Israel, obviously Bank of Japan, so we knew that. And we knew that the CME introduced a central bank incentive program; so this is -- the CME is where futures and options are being traded on equities, commodities and other things. So how do we -- we know that these central banks are not just manipulating things, or influencing, whatever word you want to use by driving the price of money down and flooding the world with liquidity. But they are actively -- active enough in the CME that they have their own preferred buyer program and now we know that the New York Fed is moving a staff office out there to be closer to that action too. How do we interpret -- how do you interpret those moves?
Joe Saluzzi: I mean I shake my head. Incentive programs just in of themselves really—a lot of times the CME and some of these exchanges put them out there to stimulate a new product. So say new hog futures contract comes up, or whatever it is, and they want to get some activity in it, and they’ll stimulate a market maker to quote a two sided market by giving them an incentive program. Somehow these incentive programs don’t tend to go away; they’re always there. Once they’re there they continue to get paid and that’s how you distort asset pricing when you’re starting to give all these rebates and whatnot. For central banks, I don’t know -- I don’t know what the Fed is doing -- I don’t know what they’re buying. Apparently the Bank of Japan is a little more active I guess when it comes to ETFs and a little bit more transparent about what they’re buying, but sure these are assets that they’re buying not based on fundamentals or based on what they like. They’re buying it because they’re trying to get some -- some of the money they’ve created and they’re trying to juice the markets. It’s so -- I shake my head like everybody else -- guys like us who think this is ludicrous and that they’re distorting market prices. There are others out there which think that these are part of market forces and if the central bank is coming in to buy stocks, well that’s a source of demand; therefore the assets should be going higher and the market is being priced appropriately. I think that’s ludicrous. I think by printing money and stimulating asset prices is basically just a distortion and eventually it will come crash to the real price; so I don’t know. I don’t think it’s -- it’s certainly a key driver in what’s going on out there but I really don’t know what to make of these guys or how long they’ll continue doing it.
Chris Martenson: Well yeah I’m sure you saw that Wall Street Journal article about the Bank of Japan's ETF buying activities and they had bought a lot and they preferentially would step in and buy on the days when the market was down, you know to like 79% of their trades were, if the market was down they were in there buying. So that feels supportive obviously and I don’t think it’s illogical for somebody to look at that and say “Maybe I should buy this too”. But where I do depart from the script is when the Wall Street Journal today announced the Nikkei had broken 20,000 and they listed a variety of reasons why that might have happened including improved corporate profitability. All this stuff they didn’t mention central bank buying.
Joe Saluzzi: Forget that part, heh?
Chris Martenson: How’d you miss that one, you just did an article on it?
Joe Saluzzi: It is -- basically what it is is the biggest buy back in the world, right? Talk about corporate buy backs it’s obviously another way of distorting asset prices. But what central banks are doing is the largest buy back in the world, it’s crazy. They're doing it with borrowed money they don't even have.
Chris Martenson: Why didn’t we think of this before, it seems so simple.
Joe Saluzzi: I think there was a guy named Ponzi that thought of it a few years back.
Chris Martenson: Well so let’s imagine for a moment that you’re writing a financial thriller, okay? And in this masterpiece of fiction, Joe, let’s imagine that a variety of centralized powers, they’re interested in stocks going higher for a set of policy reasons maybe and they want to communicate economic vigor so they use higher stock prices as their signaling mechanism perhaps. You’re a central bank and you want to create the so called wealth effect and you want to drive equities higher. Hypothetically in this work of fiction if you did want to gun markets higher, defend breakdowns, critical sport levels all that, describe how that might be done and whether these computer algorithms would make that job easier?
Joe Saluzzi: Well that’s an excellent question and it would be done -- you can be very sloppy. I trade -- my job for a living is to trade for institutional clients, that’s how we get paid here. I need to go in and out of stocks quickly and efficiently and trying to leave as little footprints as possible so that no one can kind of find out that my institutional guys are either buying or selling. If I leave big footprints, guess what happens? They come like a parasite they jump on top and they will drive that asset up or knock that stock down really quickly and then there are certain algos that some people use certain algorithms that will just continue to chase the price whether it’s up or down. Obviously what I’m doing here is I’m going to be a little more discreet. If I think someone is trying to goose a stock, I’m not going to chase them, I’m going to wait. We’re going to be more strategic, but let’s just say I was somebody who really wanted that stock price to go higher. I could be very sloppy in how I wanted to buy the 10,000 shares of stock that I needed to buy on the day and guess what? The parasites will jump all over me and they will drive that price up even higher; so it is a very interesting point where I think -- I don’t know if I’ve ever tweeted this out but QE plus HFT equals real dangerous stuff. It is dangerous; there is that parasitic effect that doesn’t care what it’s buying or selling and then if you’ve got somebody else out there saying “Well I really don’t care, I’m going to be sloppy. I’m going to go out there and just goose it up because I want that price higher”. Yeah, I wonder -- I wonder what would happen. I can tell you for a fact that if you’re not careful and you’re trying to execute a large percentage of a stock, say 10 to 20% in a single day, you will drive that stock up very, very quickly. It doesn’t take much. All it takes is -- for instance, say the stock is $10.10 bid offered at 10.15. If I go out there and I place a $.12 bid for 1,000 shares out loud on an exchange, that stock is off the races assuming there’s no natural seller out there. Let’s assume no one is hanging around in the dark or whatever. Next thing you know it will be $.13 bid, offered at 16 and then it will be $.15 bid offered at 20, $.20 bid offered at $.25 and then maybe 500 shares is traded. And now a sloppy algo will come in and buy the $.25 stock. What happens? 1,000 shares traded and the stock is up $.30 because you were sloppy, right? So you have to be careful.
Chris Martenson: Careful or perhaps that’s -- that weakness is also a strength. This is my hypothetical thing—if you wanted to goose a market it seems easy to me today potentially with all these piranha’s in the water waiting for blood. In fact, you would want to be sloppy, do something really dumb like throw 200 million dollars at market into one corner and you’ll get an outsized sort of response to that I would bet.
Joe Saluzzi: Yeah you can even take the argument, a little side step to corporate buy backs. Corporate buy backs have very strict rules what they have to follow. They can’t cross the spread, they can only be a certain percentage of volume, they can’t trade in the beginning of the day, the end of the day… But let’s just say while it’s running these corporate buy backs normally are put into what they call 10B18 algos, which are pretty stupid in my opinion. They just go out there and they just mechanically go about it. Well they’re fairly easy to spot by sophisticated traders and machines let’s just say. So let’s say you were a corporate executive and you needed to buy back some stock, would you be upset that some guy just drove up the price of your stock and you didn’t get to buy any that day? Which means you got extra ammunition for the buy back to continue and maybe it goes to an options period where you are due some options? Who knows?
Chris Martenson: So this all feels like a game you know and I was reading a book once about late dynamic Roman Empire where they were really heavily debasing their currency and several observers were bemoaning that people had basically given up productive enterprise in favor of speculation because speculation was far more rewarding on a work per unit of return effort sort of thing. And so again you had all what felt to me like similar behavior sets that I think we've got today, which it does feel less fundamentally driven and far more speculatively driven. Obviously we see this when the Fed comes out and makes statements and the market responds as if you know, God himself had spoken.
Joe Saluzzi: Yeah and there are a lot of folks who say the market dictates the price and the market is never wrong and you know look I understand that and I understand the market is the price, but what about the blend of -- I think what you’re saying is the blend of market participants has changed so much where it used to be a -- let’s say 100 people in the room and some were institutions, some were retail, some were prop trading scalpers, that’s okay. Everybody was -- there was this nice blend of different buyers and sellers and at the end of the day you set price based on really fundamental valuations. Where as now that blend of 100 buyers and sellers has changed to the point where scalpers and prop trading guys are the predominant ones and the retail and institutional are so small the real long term owners don’t really represent -- don’t have that price setting ability any more and that’s a very scary thought.
Chris Martenson: So let’s finish our financial thriller novel and in this novel here’s a plot twist: And a former head -- a former chairman of the Federal Reserve exits his post and shortly thereafter actually joins a firm that is huge, it’s a huge firm. I mean it might be so large that it trades approximately 13% of all US consolidated volume and equities and maybe 20% of US listed equity options volume. Optically, would that look good do you think or do you think people would find that plot twist unbelievable?
Joe Saluzzi: What a movie you’re creating by the way. I can’t imagine anything like this would actually happen; it’s got to be fiction, right? You know it’s baffling. Of all the firms he could have went to, of all the firms, of all the investment banks why would you go to that one? I just don’t understand it and obviously we all know there’s money involved and what not. But it really was -- I mean it took the air out of -- I couldn’t believe it, I was like really? Come on, is that really, really necessary? It’s too bad and of course what kind of secrets does he have and then obviously nothing going forward but he certainly knows a lot about what went on in the past. So that’s the largest amount of money tends to get that and I’m sure he was offered quite an attractive contract.
Chris Martenson: Yeah and it just optically from where I said it, it just looks awful.
Joe Saluzzi: Terrible.
Chris Martenson: And was not a big fan of that. So in your mind as you look -- you’re in the markets every day. You’ve seen what changes have been made. Are we still in danger of having another flash crash type event?
Joe Saluzzi: Absolutely. I think it can happen any day and this Sarao case from the UK flash trader -- flash crash spoofer—proves that it’s still going on every day, that there is manipulation in the market and that regulators really don’t have a grip on what’s going on. So am I more comfortable now than I was five years ago? No. And I’ll bring up Eric again, Eric sees it every day and it’s in more of a smaller -- it’s not flash crash but there are stocks that move, there are asset classes, there are exchanges over seas all of a sudden that come out of nowhere and move 5%. The DAQ moved the other day real quickly; it happens all the time but maybe not in the severity of a flash crash of you know 10%, whatever it was then. But absolutely I think it could happen again. I’m not comfortable. I think regulators are slowly moving through and when it happens again they’ll all get trotted before Congress and they’ll hold up their right hands and swear to tell the truth and they’ll say, “Gosh, honest I really didn’t see it coming”. No, you did, you really did and you dragged your feet and you did nothing about it and it’s very frustrating to us and we’ve had numerous conversations with regulators over the years. I’ve sat before the SEC, I’ve sat before the CFTC and I think -- I mean I really like Mary Jo White a lot. I really like the SEC, what they’re trying to do but they just seem to be hitting road blocks every time they make a turn. And the industry loves it that way. The industry doesn’t want it to change because it’s a cash machine right now; why would they want it to change? So it’s a very tough thing for them but they got to get on, they got to get by this and push through those road blocks and really go out there and say “Okay how do we make our markets more fair and more transparent" is really what’s the issue here. "We need more disclosures, we need to learn what’s going on in the dark pools, why there are all these exchanges, do we really need them, should we put minimum market shares?" There’s lots of things they can do to clean this thing up relatively quickly but they just don’t seem to be acting.
Chris Martenson: So have you traded at all on the new exchange that got stood up as allegedly and hopefully an HFT proof exchange?
Joe Saluzzi: Yeah we’re actually members of IEX, they’re not a full exchange yet. They’re still an ATS or alternative trading system. They’ve applied for exchange status and we are big fans. I can tell you, huge fans of IEX. And we’ve got some of our best fills for our institutional clients on IEX. Size liquidity, block volume is being done which is what I’m trying to do here without the movement that you would get—I refer to it as wiggle—remember what I was saying before if I place a bid for $.10, $.12 bid for 1,000 starts to move. You don’t get that in IEX because it’s -- it basically is a dark pool right now, you’re in there. But they don’t have, for whatever reason they don’t have the predatory, whether it’s their magic shoebox or whatever they call it. They don’t have the predators that hang in there and they do have HFT, which is very interesting. Some of their biggest clients and they’ve admitted this are high frequency trading market makers who don’t seem to have a problem with the way IEX is set up. And like I said earlier I don’t have a problem trading with an HFT. If the HFT is the other side of my trade and wants to put up 5,000 shares, hey let’s do it. I want to buy it, you want to sell it, let’s go. But if the other guy is just trying to ping me and sniff me and then goose the price, I got a big problem.
So we’re not finding that type of negative behavior in IEX, which is why we like them a lot. I hope they succeed. I hope they become an exchange. I hope they keep getting bigger and I hope more real liquidity keeps going in there because that makes the price discovery process better and it makes for efficient allocation of capital.
Chris Martenson: I love that story and it seems as simple as the magic shoebox with 13 miles of fiber optic coiled up in it or whatever they’ve got. That’s enough to get the most of the HFT out of the way and that’s a good thing. So that’s a positive development but on balance do you think the market structure still looks a little broken and so how confident are you that we’ll avoid some sort of a flash crash going forward? Let’s say in the next five years?
Joe Saluzzi: No I mean we’ll have an event. There’s no doubt there’ll be events. Will it be as severe as the last one? I don’t know. There will be events. I mean it’s caused -- once volatility starts to spike and we’ve been in this kind of mundane dreary market -- just kind of marches up every day, right? And it’s very quiet most days; once you start to get some spikes in volatility and some more shenanigans you’re going to have an event, there’s no doubt in my mind. And how will it be managed? I think people want to feel confident in the market, that’s where the regulators have to come out the next day and say “We found it, we caught the cause, we’ve got them, we’ve arrested them already," that’s not going to happen by the way. But if they did at least I would feel a little bit more comfortable that they were on top of this. But there’s no doubt there will be more of these events. For us it’s market structure, it’s not necessarily market participants that bother us the most. There are things they can do whether it’s limiting— like I said before, the exchange is the fragmentation in the equity market is really what’s causing a lot of the problems and a lot of the noise volume that you see. They got to start to limit, there’s no need to have 12 exchanges. There’s no need to have one exchange. There’s some number in between; I don’t know that number but maybe you should put a minimum market share on an exchange for them to have a protected quote, that’s one of our suggestions.
And when it comes to dark pools, maybe dark pools that trade on average, less than 300 shares really shouldn’t have a license to have an ATS, an alternative trading system, because they’re really not adding any value at that point. If you did that you’d knock out about 25 dark pools over night. You start to get rid of the fragmentation which means that you then start to bucket liquidity, where you get a much better price discovery process. You know, small things, you don’t have to do a lot. Rebates, you know might take a model on our opinion is noise to the market, you don’t need to pay for liquidity. It should be a flat fee like IEX by the way charges a flat fee whether you make or take, we think that’s the model that all exchanges should adopt. So again not too much there in the way of fixing things but small fixes can go a long way. They have done some work on order types; the SEC has mandated a little bit more disclosure there which is good on the lid exchanges. But they haven’t done anything on the dark pools. You really -- the Barclay space we can talk about that. But the Barclay space brought up a whole bunch of noise when it came to dark pools as to what was going on inside the dark. You need more disclosure. When 35 to 40% of orders are being executed off exchange, we really need more disclosure as to what’s going on there.
Chris Martenson: And so remind me of the Barclay’s case, what was that?
Joe Saluzzi: Barclay’s which is ongoing [Inaudible 00:36:25] attorney general found that Barclay's was misrepresenting their dark pools through their institutional clients they were saying things allegedly that were untrue, that were -- HFT wasn’t in their pool or whatever it was. There was all different types of things going on there. Essentially most people have no idea what’s going on in a dark pool. There was a UBS case recently also where they were fined 14 million dollars because in their dark pool they were having misrepresentations as to who was doing what. There is very, very little disclosure when it comes to dark pools; so that’s where -- I mean if you want an easy target for regulators to go after, go after the dark pools and say “Listen we need more disclosure on your order types, your participants, how your orders are being filled, where they’re being routed, are you paying for flow? You know this is the stuff that goes on.
Here’s a perfect example. If you’re an institutional trader they have these algorithms on their desks where there’s routers supplied by brokers. The router basically goes through a pin wheel of different destinations before it executes the trade. While it’s going through the pinwheel it may be leaking information to certain dark pools who in those dark pools there are predators hanging around just waiting to see who is coming through. As soon as they find out there’s a buyer, what do they do? They cancel the offer and off they go and they take the stock in front of your face. That’s not a good thing but those are all because of monetary incentives designed inside these routers of the brokers. Very easy to clean up, very easy. Make it a flat fee, get rid of the noise. Make or take a model and so on but again the industry has a vested interest in keeping things just the way it is and they don’t want to change it.
Chris Martenson: Well and why would they? I mean if you can turn in zero loss trading days and just take one to two million dollars a day out of the market, that’s yeah, I’d work very hard to preserve that if that was my business.
Joe Saluzzi: Well let’s just say I think one thing on the HFT side as well as on the broker side that supply these algorithms and the technology, the margins are shrinking and they’re shrinking quickly. The profit opportunities aren’t there anymore. The equity market has been saturated for a while which is why you notice a lot of these HFT firms have started to go into bonds, go into foreign asset, currencies, all different types of asset classes that haven’t been as exploited, I’ll say that. And that’s where they’re making their money because they've striped the equity market bare, there’s nothing left and we’ll move on. As their costs rise and their profit margins tend to decrease some of the smaller players will exit and we’ve already seen a couple of them combine and merge because they can’t handle it anymore because their technology costs are enormous. To shave a micro second now a days costs them a ton of money, right? So not many players can do it.
So you’re starting to see a concentration or an increase in the larger ones and the drifting off of the smaller ones. I don’t know how that’s going to play out but I do know their industry is changing.
Chris Martenson: Now you dedicated Broken Markets, which is a book I recommend to everybody. You dedicated that to the various participants in Washington D.C. and Wall Street without whose actions you never would have been outraged enough to write the book. Do you have another book in you?
Joe Saluzzi: [Laughter] No I don’t think I do. Writing that book -- I thought it was going to be easy and we were like “Okay let’s not do that again…” But we write daily. Every day we write -- we’ll write a note to our clients and we usually -- we’ll post two or three of them to our blog everyday and they’re usually thought stimulating, topical areas. Today’s post was obviously on yesterday’s UK flash crash spoofer. But we try to just keep current and we look at things differently. We’ll take an approach that the industry normally wouldn’t take and ask a question that will probably upset folks in our own industry because we think it’s the right thing to do. We think that these questions need to be asked and a debate needs to be had and we have a decent following. It’s wonderful that people quote us occasionally and that it causes some debate and that’s all we’re trying to do is get this thing moving forward and gosh we’ve been doing it since 2008 talking about this, it’s crazy. Seven years we’ve been talking about market structure and it’s still frustrating as ever.
Chris Martenson: Well I share that in my own corner of the world that I tend to look at. Movement is not coming near fast enough for my taste but that’s for me to manage. Thank you so much for your time today. Thank you so much for spending those eight years and maybe another eight helping us get our markets back and making it all free and fair because that’s necessary essential work. If people want to follow your blog where do they go?
Joe Saluzzi: Themistrading.com and our website there’s a blog there. I’m also on Twitter, Joe Saluzzi and then my partner Sal, is MS Sal; we’re both on Twitter. We tweet enough; we have some fun with it.
Chris Martenson: Excellent. Well Joe thank you so much for your time today. I really appreciate it.
Joe Saluzzi: Chris thanks for having me on, I really appreciate it also.