Joe Saluzzi: The Markets Are Still Way Too Vulnerable To A Sudden Liquidity Disappearance

HFTs remain a major issue
Monday, September 24, 2018, 2:56 PM

Joe Saluzzi, co-founder of Themis Trading LLC, outspoken exchange expert, and author of the excellent exposé Broken Markets, returns to give us an update on the state of high frequence trading -- otherwise known as HFT.

In the past, Saluzzi has been a vocal critic of the dominant and parasitic role HFT algorithims play in today's financial markets, siphoning off profits at the expense of the "dumb money" (i.e. retail investors) while undermining the integrity and stability of exchanges. Front running, spoofing, flash crashes -- HFTs are the culprits behind them.

Saluzzi actually has some positive developments to note: namely that the obscene profits the HFTs used to make (i.e., steal) are moderating as the arms race in the industry has escalated and the players are increasingly competing with each other. Also, the SEC appears to be moving much faster now towards putting some material constraints in place.

But the unfair advantages that HFTs enjoy, as well as their threat to market stability, are still very real. If we don't continue to fight to bring them under control, we risk a vicious downdraft during the next big market crisis should the algos instantly exit in a panic:

If the HFT algos get spooked and stop trading, then you got a major problem.

In times like this when there's no storm out there, it's time to fix the house now to make sure that when the storm comes the house doesn't get knocked down. So how do you fix the house? By getting rid of the conflicts of interest, maybe adding more obligations for market makers, looking at those off-exchange venues which are considered 'dark pools' and learning what's going on there, looking at all different types of the issues that continue to haunt us -- most of which don't become visible until they don’t pop up at the end.

Can you force a market maker to stand there and buy stock when the stock market is coming down? No. You can't force them to do that. And that's the way it is.

You can't assume that there's going to be liquidity today at this minute because there was a liquidity yesterday. It doesn’t make any sense. The market makers will disappear. So is there enough natural liquidity? And that's really the issue. Natural liquidity is real buyers and sellers, institutions and retail. And unfortunately, natural liquidity is still much, much smaller in the market than the 'artificial' liquidity created by HFTs.

So I still think you focus on fixing the structural issues. You'll have better odds, but will you prevent another flash crash? No.

There was a famous story back in the 2010 crash. They quoted one HFT trader as saying, "I saw it coming. I saw that it was happening, and I went to my keyboard, and I typed the letters "HFT STOP", and I hit enter. And that basically took me out of every market." So basically, he had a ripcord. He pulled the ripcord, and it took him out because he didn't know where the risk was. He didn't know what markets were doing what, and he wanted no part of it. So what happens if everybody types in HFT STOP at the same time? You'll get a major vacuum in liquidity again. You can't prevent it. You can't.

So yeah, when things next get hairy, I'd expect markets to get really choppy out there.

Joe also has some choice words for the crypotcurrency market, where he sees a lot of the worst risks he once saw during the early days of HFT:

I think that this market is just filled with fraud, filled with manipulation, filled with all sorts of abuses. And until you can somehow figure out a way to regulate it, no way – and I'm very strong on this opinion – no way should any crypto ETF be formed or approved by any regulator in the U.S.  How are you going to create a derivative based on a crypto currency which is unregulated? It's a timebomb. 

Click the play button below to listen to Chris' interview with Joe Saluzzi (48m:16s).


Chris: Welcome, everybody, to this Peak Prosperity podcast. I am your host, Chris Martenson. And it is, well, let's see what day it is here – it's September 19, 2018. Well, listen, today we're going to be talking about financial markets, equity markets, bond markets, commodity markets. Today, listen, they all share one thing in common – they're utterly deformed, quite possibly irretrievably so. And if you’ve been listening to me for a while you know I don’t just refer to them as markets without putting not one, but two, sets of quote marks around them now. ""Markets""

Things started to go off the rails some time ago back when computer algorithmic trading took over and so badly outpaced regulatory efforts to a) understand them, or b) regulate them that there was really never any sort of a contest. So here we are. And combine that regulatory lack with the fact that the existing power structure – big bankers, Central Banks, they had really had aligned interest in seeing the markets become more stable, they wanted to see them head higher. So I don’t think there was ever realistic pressure to prevent our markets from becoming the way they are, maybe quite the opposite.

So discussing these markets with us today is a man we first interviewed on this subject back in 2011 – that was before the book, Flash Boys came out – that's by Michael Lewis – great book – and then again in 2015. We're talking today with Joe Saluzzi. Joe Saluzzi is partner, cofounder, and cohead of equity trading at Themis Trading, LLC, a leading, independent agency brokerage firm that trades equities for institutional money managers and hedge funds.

So, obviously, he's got a lot of interest in how those trade go off, and, of course, even more experience around that. Joe is one of the most foremost experts on algorithmic trading, often referred to as high-frequency trading, and the dangerous risks that those trading practices have introduced in our financial markets. He was very recently just testifying before Congress on the subcommittee on capital market securities and investments. That was back in June of 2017, and this was in a hearing entitled U.S. Equity Market Structure, Part I, Review of Today's Equity Market Structure and How We Got Here. I think you need to know how we got here as well, so you can understand where we might be headed.

So along with Sal Arnuk, he is the author of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio. Welcome back, Joe. It's really great to have you back with us today.

Joe Saluzzi: Thanks, Chris. It's been a while, and I'm glad to be back on. Thanks.

Chris: Well, Joe, after our previous podcast, I came away a little bit more convinced than ever, and I didn't need a lot of convincing, that maybe our markets were broken, but that was three years ago. Is it wrong for me to still think they remain largely unfixed, maybe rigged if not broken?

Joe Saluzzi: Conflicted is a good word that we can certainly still use. There are lots of conflicts out there, and we tend to gravitate back towards the exchange model and how the stock exchange has changed over the years as a source of many of those conflicts. But interesting how the high frequency traders that we've talked about for many, many years, there starting to, I wouldn't say go away, but compete with themselves to the point where they're pricing each other out. And certainly in the equity markets where the margins, I believe, got so small and their cost continues to rise because they need to constantly compete with each other.

And remember, an important point is high frequency traders don’t compete with you, the investor, because you're always the loser. They're competing with themselves to be the winner to get to the loser. That's their game. They know. They always win. It's just a matter of which one is going to win, so they have to get faster and faster and faster and continue to have more technology and better processing and better strategies. But it got to a point in the equities markets there's really not much left for them to squeeze out.

So, as always, in other markets, they’ll find other markets. They’ll find other pastures. And years ago we wrote a post about – we call them locusts, basically – and how they're going to strip the farm, and once they're done cleaning out this farm they're going to move on to another. And that's kind of the path we see. We see them still around, they're still out there. They're still causing – they're still doing their thing. You still see these mini flash crashes throughout the day where stocks move ten percent for no apparent reason and then just shoot right back up. That still goes on, but some of the issues that we saw way back are I don’t think as prevalent – I don’t want to say that.

But again, going back to the issue, the market is still conflicted, and that's really more from the brokers, from the exchanges. We still got a lot of issues. That's why I testifies at Congress about structural issues that we need to address, but HFT hasn't gone away I guess is the point.

Chris: Well, let's talk about that for a second just to set the stage. How much of the daily trading volume in equities in the U.S. is done by these HFT machines?

Joe Saluzzi: There hasn't been an estimate lately. I mean, numbers that are still north of 50 percent are certainly probably accurate. The definition of high frequency trading is something that's been debated for years. I actually sat on the CFTC subcommittee, and one of our tasks was to define HFT, and we really couldn't come to an agreement of what is it. Is it low latency trading done by computers without the intervention of a human? Sure. Is it proprietary trading? Yes. Do they hold inventory – no – overnight. So there's all sort of things where certain parts of the industry didn’t want to be labeled HFT because then they were afraid that the regulators would come in and regulate them as HFT.

So the number is a tough number to come up with, to answer your question, because people don’t know exactly what it is. In other words, if you're a firm and you're participating in this type of activity, you don’t label yourself as a high frequency trading firm, you label yourself as a hedge fund trading for proprietary accounts. Well, what does that mean? It means you're trading on your own behalf. And somebody may say, well, you're an HFT firm, and they’ll say no, I don’t what you're talking about. I just trade in and out of positions in a low latency way, and it uses an automated basis. So they're getting cure, you know. But they are where they are.

Again, I think it's more of a structural issue to turn. We wrote the book Broken Markets because we think the market itself, the underlying structure, helped create high frequency trading, namely _____ [00:06:09], which was a regulation back in 2007 that the FCC passed. That helped create a ground which was very fertile for HFT to come in and take advantage of all sorts of easy arbitrage opportunities between one market versus another. And like I said before, they tend to have closed that gap. The arbitrage opportunities aren't there, which is why, by the way, if you notice that some of the biggest HFT firms and players are now moving over to the crypto space because that's a much more fertile ground, much less regulation which is much easier for them to jump in and out of.

Chris: I can't wait to get to that topic, and we will because I've had that – I can't wait to get your insights on that. But let's set this up a little bit further before we get there. So you mentioned earlier that this is becoming more of a competitive space, and you also mentioned that you, the little guy loses. So, first, distinguish for us between investors and traders. I assume when you said the little guy always loses you meant anybody who is trying to trade against these machines, by definition, has to be losing because, and correct me if I'm wrong, but the last time I was aware of the data there were some of these firms that were reporting in their quarterly and yearly earnings that they didn't – they weren't taking any losses at all. They were just money-making machines. Is that still true, and how does that differentiate for us between investors and traders?

Joe Saluzzi: They were, back then, there was actually one firm, and it' was a public company now, Virtue, but they’ve merged with another company, Knight, and it's kind of changed and morphed their business model. But when they were pure HFT they were not shy about the fact that they – I think it was one day that they reported a trading lose. But what's interesting about that number is they way the HFT firms work are they don't count every trade. In other words, at the end of the day they made a hundred trades, they may have won fifty-two and loss of forty-eight. But they're very smart on managing their risk, so maybe those forty-eight losers only lost x-percent and the fifty-two winners made more than that. So net net on the day they made money which is why some – kind of that statement that we make money every day is a little bit deceiving. And yeah, they're making money every day, but they are losing money on trade.

But they are very good, and I'll give them this; they're very good in general. HFT is very good a risk management. They know when there's a bad position; they know how to cap that risk; they know when to sell when something goes wrong. And it's all automated, basically. So when you're automated it takes the human emotion out of it which, unfortunately, for us human traders and human retail folks that's not there, and HFT thrives on that, right. If you're emotional and you're going to go chase the stock well, guess who's going to be out there selling it to you at a higher level?

And the way they work usually is since their latency is much better and much faster, and they can get to a position or get to a quote quicker than you, they'll always be on top of the queue. Their orders will always be best on top of the book where if you want to post a bid, and you don’t want to cross the spread say, and you're trying to buy stock a little cheaper, you're never going to win until the HFT guy gets his because he's out there first. And by the time you get your fill, most likely, the stock's going to roll over and you're going to say okay, I bought it a $0.10, it's now trading at $0.08, well, that stinks because probably an HFT guy sold it to you. That's the game they play which is why I say you'll never win that game.

So you play a different game as an investor. You know, you can't be a day trader. If you're a day trader and you're trying to compete with a machine, it's a losing game. You'll never win. As an investor you can potentially win; maybe your positions are a couple of days or a month or whatever it may be. But if you're trying to flip in and out of a stock within a minute thinking you're going to earn a dime or something, you're going to get hurt. And it's just the machines are that good, and that's what they do for a living, and that's why they spend billions of dollars on an industry like this.

So tough for the little guy there, but what we always say – and we trade for institutional accounts – so we don’t trade – one important part of our business model is we don’t trade on behalf of our own account. In other words, I never have a position. I don’t have any proprietary money in this game. I'm trading for my clients, so we're agency only. And our game is not to – so institutional investors who are our clients are long term mutual funds, pension funds and so on. And they're not competing with HFT on a minute to minute basis. So, in other words, we're not playing their game. I don’t need to chase them all day long and run around all over the street with them. I'm going to play my own game and pretty much try to play with them and see if they can go into my trap. It's trading, right? This is what we do. I'm trying to get a better price for my clients; they're trying to get a better price for their proprietary account. We'll see who wins at the end of the day.

Chris: Now here's something that seems obviously to me at the surface I've never quite understood. If you do have a company like formerly Virtue or Citadel or one of these other ones who are reporting like just these massive gains or even the prop desks for some of the big banks – JP Morgan proudly saying we only had two days of losses in the last year, or zero, or whatever the numbers are – to me those billions that they're pulling out had to come from somewhere. Where do those come from?

Joe Saluzzi: Sure. I mean, they're earning profits. They will say that they're taking risk, and this is the biggest thing when you talk to an agency or anybody at a brokerage or bank. We're earning money by taking risk. We're putting our capital at stake, and therefore, we deserve to earn a return. And to an extent I agree with that. If you're a market maker, a legitimate market maker who's supplying bids and offers throughout the day with a decent size quote, you're trying to earn the spread. You're tying to earn the different between the bid and the offer, and you're taking your capital and you're putting it at risk at that point. Well, then you deserve to earn something because you're supplying liquidity to the market, and you're adding to the capital base.

But if you're not really a legitimate market maker, which I would argue many of these HFT players are not, they're more proprietary traders who trade on one side and trade only when they feel like trading – in other words, they're not supplying bids and offers all day long to a two-sided quote – they're coming and going as they please – well, that's not supplying liquidity, that's taking liquidity. So not only are they taking money out of the market for their own, they're taking liquidity which is a double bang for you. I'm not getting anything out of that.

So that's why we take issue with many of these proprietary style agencies where some of the more, if you want to call it, the nine [PH] market makers, if they have legitimate obligations and legitimate quotes, could add a benefit to the market.

Chris: Joe, this brings up a really important point, and I just want to take a half-step back, and this helps set up my next question too. I'm wondering if you can help all of our listeners understand the difference between volume and liquidity. These often get confused. We use the words, so can you separate them and help us understand what you mean when you say liquidity?

Joe Saluzzi: Sure. Liquidity is, at this moment, if I want to enter or exit a position, what can I get? In other words, not only is the displayed quote or what's available for me to buy – let's say you're a buyer – how much is available not only displayed but on ATS's or on alternative trading systems or various offer exchange venues, what can you capture at this moment? How much liquidity is out there? And not only from a point to point, but throughout the day. A client may come to me and say hey, I need to buy a hundred thousand shares of xyz, the stock doesn't look very liquid is something that we might hear often, or the stock is extremely liquid.

So if it's extremely liquid maybe it trades ten million shares a day, but that's the volume. That's what you were saying before versus the liquidity meaning the quote is thick. There's lots of bids and offers; it doesn’t tend to move; the spread is fairly tight. I can enter and exit a position fairly easily without moving a name. So something like Ford, the letter "F" for Ford is an extremely liquid stock, There's tons of volume out there. You can pretty much buy and sell ten thousand shares at a clip anytime you want. That's liquid.

However, you can take a stock that trades maybe a million shares a day, which might seem like a lot of volume, but it could be a very illiquid stock because the quote is maybe $0.12 wide, and there's a hundred shares bid for, a hundred shares offered, and then you go out and try to say okay, you know – perfect example – stock is $0.10, $0.20, $0.10 bid offered to $0.20, and I go in and I place a $0.12 bid that I'm trying to tighten the spread. Next think I know I've got some joker out there who's placing a $0.13 bid. He jumped me. And then another guy goes $0.15 bid. Now the $.20 offer disappears; it's offered at $0.25, stocks $0.15, $0.25, and nothing's traded.

All the sudden, because I placed a bid trying to tighten the spread the stock went up a dime and nothing traded. That's not a liquid stock. That's what the HFT guys love. They love to play that game to see that if you, the retail investor, posted that bid, now you're going to get frustrated. You're going to go oh, man, the stock is up $0.10, maybe something's going on and I should just take the offer at $0.25 when, in fact, you buy it at $0.25 an all sudden it drops right back down to $0.18. You're like boy, that was dumb. But those are the games that go on throughout the day. So when I look at volume, it is important, but it's not as important as liquidity, what I can and cannot get into the stock at this particular time.

Chris: All right. So let me see if this is a workable metaphor because I know people struggle with this. I've just been trying to think of a way to explain this. Maybe this won't work. Let me know. But I'm thinking of a river right now, and so we have a river that's only a foot deep, the depth would be its liquidity, but it could be pretty wide. It could be moving a pretty decent volume across, but if I tried to dive into this river this might be a very unpleasant experience for me. Whereas, if we had a deeper river that had more liquidity, like you could put more of a dive in, you could put a bigger bid in on that thing before you would risk sort of hitting the bottom of that particular piece. So is this sort of like a – can I use that – width versus depth?

Joe Saluzzi: Yeah, I think you can. I think that's good. And we actually using the term depth of liquidity all the time or depth of the quotes. In other words, what a lot of retail investors will see is the top of the quotes. In other words, the bid is $0.10, it's offered at $0.12, but that's a consolidation of all the different quotes out there and it doesn't include off exchange quotes. What I'm looking at – so, in other words, that's the top of the river, that's the top of the water. I need to know what's underneath that river, how far deep does it go? And so I'm looking at level two quotes which are more quotes out there, all the various exchanges, I'm looking at time and sale quotes that trade throughout the day, I'm looking for volume and so on. I'm looking for all sorts of things that would tell me how deep is that water? I don’t have a yardstick. I can't necessarily see how deep it is, but I can kind of judge it. So I think that's a great analogy, actually.

Chris: Okay, well, thanks. Joe, it sets up this question. And I'm looking now at an academic research paper. It came out in May of 2017. It's by Michael Goldstein of Babson College and the University of Sydney's Amy Kwan and Richard Phillip which came to this conclusion, and I quote:

"Examining the order book and balance immediately before each order submission, cancellation and trade, we show high frequency traders supply liquidity on the thick side of the order book and demand liquidity from the thin side."

Please translate that for nonmarket mortals.

Joe Saluzzi: So that's basically an example of a stock that's about to move. So you'll see the quotes, and then sometimes it isn’t always the case; it may reverse, but you'll see a real thick bid. So the thick bid may be this fifty thousand shares bid for various venues, ten different venues totaling fifty thousand, and there's only a couple hundred shares on the offering. So that tells me the bids are heavy, most likely this stock should be going up, they'll probably take out the offer soon, and it'll tick up a little bit from there.

So he's saying what's going to happen is that the HFT guy will be part of the bid because he has very low risk of adverse selection, shall we say, but he's most likely trying to take that offer out too. And he's going to go out and grab and take that liquidity, which is probably be the buyer, retail investor or institutional investor is not going to be paying attention to the book size or paying attention the liquidity that Professor Goldstein said. And then the stock is going to go up. So they will be demanders of liquidity often and at times when it's usually adverse to the regular investor.

Again, that's why the HFT guys can spend billions of dollars on publication facilities at the exchanges or buying proprietary market data from the exchanges because the need all that information to make those trades to make money to offset those costs. So it makes sense. Professor Goldstein is right-on.

Chris: Okay. So then this gets me to this idea of flash crashes. What I'm trying to build here is so the people can understand what's really going on out there. And so as I understand it, again, please correct me if I've got any of this wrong, that what might happen is we see all these apparent orders that are sitting out there. You look at the bid and the asking, and there's a bunch of orders on each side of it. But then, something happens. And so we're looking at this and we're saying wow, this pool is seven feet deep; I'm going to dive in. But the minute you start to take your dive you find out five feet of that water was just a mirage. It just evaporates. I'm thinking now of the times when Eric Hunsader out of Nanex is showing these moments where liquidity just evaporates, just literally sometimes in milliseconds. But normally it's just a couple of seconds and all the sudden you discover the pool is not deep. It's very, very thin. Is that's what's being talked about here?

Joe Saluzzi: I believe so. We'll refer to those quote often, and other people will expand some quotes. So there may be ten quotes out there for a thousand shares, but in fact, there's really only one. The other ones are pinging off of that, and those are the faster ones who are doing the pinging. So if an HFT guy is one of those guys pinging off the other quotes, trying to get a free ride, essentially off the one real quote, and they sense that something is going on – maybe they see a trade occur at an exchange that they have a faster line into – they have lower latency to that exchange. So they can see the print before it hits the general tape which is called the SIP – and this used to be a much greater disparity. By the way, the different between the two used to be much greater which is why it was easier for the agency guys to make money.

Since, over the last few years, they’ve tightened that up dramatically, so the public feed is actually very close now to the proprietary data feeds timewise. But let's just say that HFT guy can see that, what they’ll normally do is as soon as they see something going wrong they will cancel all their bids because they don’t' have an obligation. And here it goes back to what is a market maker? What isn't a market maker? Who's a proprietary trader? If that agency guy is a proprietary trader they don’t care about you trying to sell stock to them. They want to get the heck out of the way.

Their job, again, is to minimize risk so that they don’t lose money in the proprietary account. So if they see something going wrong, boom, they hit the button. And then, even worse, they will exasperate the problem often by now going short. So there they were bidding for stock, they see something going wrong, they cancel the bid, and now they become a short seller. Well, do they have to borrower, which is a question that's been asked forever – short sellers have to have a borrower or locate [PH]. And if you're a market maker you do have some exemptions, so some of these guys hide behind the market maker fact. But they may not be – let's assume they have the borrower, which I doubt many of them do, not they'll become a short seller and start demanding liquidity from the bid site.

So guess what? Now you're in a cycle. So all the sudden – and this happens within milliseconds or microseconds – so what we see as a second is almost no time at all. What they see as a second is an enormous amount of time where enormous amounts of quotes go back and forth. So they're out there starting to bang on the bids saying oh, I can bang out this bid before this thing plunges, now the next thing you know the stock's down five percent. And they got the heck out of the way and sold some short in the meantime making it worse rather than trying to help cushion or, back in the day, market makers were known as shock absorbers. They would try to supply capital to cushion these types of blows because they also had customer order flow.

Now, proprietary traders have no customer order flow, they could care less about what goes on in the market, they just want to make money, so do you think they care if the stock drops ten percent and they don't have a position? They could care less. If anything, they’ll see it as a buying opportunity down ten percent and, in the meantime, they’ll try to make some money.

So that's how a mini flash crash starts. It's kind of a cycle. Maybe sometimes it's generated by a quick news event, an algo reads something off of the news, and off she goes, and you’ve got a ten percent move. Or sometimes it's driven off a related stock or whatever it may be, whatever the cause is, you'll get these rapid moves, ten percent. They do have now circuit breakers in the market where single stock circuit breakers will kick in at five or ten percent levels, and then they'll tend to stop these events. But, in the meantime, the damage is done.

Here's the worst thing you can do. Either you have a market or a _____ [00:21:52] order in there, if you have a stop loss and it converts into a market order, so if you say okay, if the stock goes down five percent I want to automatically sell. Well, that market order will feed right into this thing. And that's what happened during the flash crash of 2010. A lot of these stop losses converted to markets which is the worst thing you could possibly do. So put limits on either your stocks or your regular orders.

Chris: Just to flush out one stop further, because if you put a stop on there and you say okay five percent, that it, but if that converts to a market order and the market is down ten percent you're going to eat a ten percent loss not your five percent stop.

Joe Saluzzi: Right. And you're going to go home and you're going to say why is my sale at $22.00 and now the stock closed at $25.00? Well, you converted to a market order and it – so a market order hunts looking for a bid at that point, and they're trying to find it and there's nothing there because all the HFT guys and everybody disappeared. All those so-called liquidity providers are now liquidity demanders, and it's a problem. Rule number one, never, ever – you can't put market orders in unless you're sitting there watching it every minute.

Chris: What about the flip side of that? What about putting in a stink bid that sits like twenty percent below in equity thinking that it might flash crash down there and you could pick that up?

Joe Saluzzi: You could try. We tend to see a lot of bids that sit right above the limit up/down level. So, in other words, the circuit breaker kicks at say ten percent, you'll see lots of buyers hanging right above that ten percent level because they know exactly that. They're trying to sit down there and hope for one. And that's fine. However, it could be real news and you could get smoked. You got to be careful there too.

Chris: What's been happening to market liquidity and volume over the years? Where are we relative to the past?

Joe Saluzzi: Volumes have been fairly consistent if not towards the low end compared to say five years ago or certainly a financial crash back in '08. I mean, there were huge volumes then. I would say volatility is very ______ [00:23:46] obviously it consists of mixed index. Volumes are not great. I think what happened is the passive world over the last few years have taken over, the ETFs, obviously, have taken over. The active money is shrinking to an extent, which is sad in a way, which is very sad because those are the real stock pickers who go out there kicking the tires of companies and finding out what's really going on as opposed to some of the ____ [00:24:07] which is just kind of, obviously, combining all of those. But either way, it is what it is. That's the market. You can't argue with the market; that's what people want.

So volatility is lower. Liquidity – it depends, depends on the day. If there's news and there's all the sudden a tariff story comes out or something like that, you'll see liquidity evaporate within minutes and then come back later on. So it's still not buffer zones out there. You still have major potential. And I still blame a lot of the structural issues for that that haven't been fixed.

Chris: And we saw some of the structural issues lead to flash crashes that were in really large markets. The largest there happen to be. The ten-year treasury market had a flash crash in yields which was a panic buy. We had a flash crash on the dollar at one point. This really seems to me like something where it you say my gosh, by the time we're having crashes and markets that large, allegedly that liquid, that really speaks to some sort of a broken system at that point in time. Is any of that awareness coming into either that Congressional testimony you gave or into the SEC at this point?

Joe Saluzzi: I do think they're looking – first of all, I give the SEC a lot of credit over the last year since Jay Clayton came in. They're moving much quicker, and they're doing a lot more than we saw in previous administrations over the SEC. So they are starting to see that.

To go back to the 2007 flash crash, it took them six months to come up with a report as to what happened, and that's still debatable as to how the flash crash happened. No one agrees as to what was going on there, and I think that basically it goes to one serious deficiency which still exists in the market. They don’t have the proper surveillance. The surveillance that's out there is good for a market from 2010, but it's not – not even – say 2000 – the surveillance is not good enough for 2018 when you have high frequency trade zipping in and out at microseconds, short sales that do not have borrowers.

Across market, basically what happens now is is not just the equity world, right. They're trading every asset. Any high frequency trader worth anything is trading multiple asset classes. So they may be saying, okay, I'm going to trade stocks versus options, futures versus stocks, maybe the bond versus options, whatever it may be. There's no surveillance system currently out there that can see across different asset classes, and that's a major problem. So there could be a guy spoofing on the equity side, in other words, putting fake bids in stock, and he's laying it off on the options market, and you can't tell right now.

FINRA, which is our self-regulatory organization which oversees a lot of the exchanges, they have to kind of piece that together, and it's a massive job for them. I compare it to a quilt where they're putting pieces together, and they're sewing it all, and they're trying to figure out what happened. It could all be fixed, and it has been addressed, something call the consolidated audit trail where the SEC has been trying to get this thing built since the flash crash. They’ve been putting it out there.

Unfortunately, they let industry do it, and here's the major problem – don’t let the industry police themselves. Rule number one. Rule one, they should put that on top of the SEC charter. But the industry, the exchange, got to build this consolidated audit trail. And, to make matters worse, they subbed out the build. When they went to build it – it's still in the build process – it's getting delayed, by the way – they said okay, who wants to build it? We'll put to out – the exchanges made the spec, and they said this is what we need. Okay, we need someone to build it. FINRA would have been a logical choice because they have the ability to do something like this and the knowhow.

Instead, they chose a firm called Thesis Technologies, which is a small firm, and I don’t most of the folks there, but Thesis came out a firm called Trade Works which was an HFT firm. Trade Works had a subsidiary called Thesis Technologies, and now they’ve created Thesis CAT which is building the CAT. Now, I don’t know if there's anything wrong with that or not, but I just think it's kind of odd that you would have an HFT offshoot build the consolidated audit trail which is set to kind of figure out if the HFT is doing some bad stuff. It's kind of weird.

But it keeps getting delayed and delayed. It was supposed to live as of November this year. It's been delayed again. The industry wants to drag it out because I believe that they know there's all sorts of bad stuff out there. And the last thing they want are a bunch of eyes and ears looking at what's going on underneath the quote, if you want to call it, because that would kind of kill a lot of their business models.

Stock exchanges are built on selling data; they're not built on listing IPOs anymore. How many IPOs are out there? They're not built on trades. They don’t get paid really on trade, they're built on data sales and anything related to data. So if you start looking and saying hey, you're data is garbage, basically, because they got a bunch of noise in there, but a bunch of guys who are spoofing and loitering the market, well, maybe their business model is now being challenged. And they're afraid of that. So, in our opinion, again, they're slowing this thing down. They’ve been slowing it down for years because they don’t want anybody looking underneath.

Chris: I completely get that. And I'll tell you from my own very limited experience as somebody who was trading gold and silver futures for a while, I would never think of trading the futures without having both the related options and the underlying shares of gold mining and silver mining stocks up on my screen because I could see that when a big slam was going it would get telegraphed early or a big move either way would get telegraphed in those other markets. So I knew that as just a duff on the streets with a fat finger pressing my buy and sell button. I knew that in 2008. So I assume this has been going on a long time.

Joe Saluzzi: Oh, absolutely. They call it arbitrage, right? It's arbitrage. And they'll say oh, we're helping the market because we're putting prices back in, but, realistically, they're proprietary traders trying to take advantage of one market versus another. And to an extent, okay, we get it. But when the exchanges are selling them tools to make them faster and allow them to get more robust information, your information, by the way, and able to process that information, just like the social media companies are doing, just like taking data and parsing it and selling it, that's what stock exchanges do.

They take your data, you give it up the rights – when you sign on to become a broker, if you're a broker on an exchange, you give up your rights to the data, basically. They can do anything they want with it, and they figured out a way to monetize it, and they monetize it a lot. And they're making a ton of money off it.

There's two sources of revenue, by the way, for exchanges when it comes to data. There's the SIP revenue, which is the Security Information Processor, that basically, it could be four to five hundred million dollars a year that they just divide up. And those are fees that regular retail investors pay, that I pay, and then there's the much more robust proprietary data feeds that they sell for thousands and thousands of dollars per month per subscriber, and they're making a lot of money on the data. So it's the data, stupid, to coin a phrase.

Chris: And they make money at it because the data is worth a lot of money to somebody else who's buying it, obviously. So when we look at that, what I really want to get at here, ultimately, Joe, is this idea of market structure. And so let me just quick take the other side of this. And I'm going to quote now from second paragraph you have here in your written testimony before the U.S. House of Representatives, Committee on Financial Services.

And you wrote here, "We've been in a bull market for many years, and volatilities at record lows. Often, in such times when everyone is pleased when they open their brokerage statements, it becomes easy for our industry and regulators to become complacent and not to ask tough questions that should always be asked getting to the market structure."

To this market structure at this point, what questions really ought to be asked here, particularly by people who are please with their brokerage statements?

Joe Saluzzi: It's a great question. We will talk about one issue until keep beating it down. It's called payment for order flow. Payment for order flow, which was really kind of advanced in the industry way back by Bernie Madoff when he had Madoff Securities where they were a third market market-maker and they would buy flow to try to trade if off exchange. They would buy retail flow essentially.

Payment for order flow is everywhere in the stock market today; it's at the exchanges; it's better than paying rebates to attract liquidity and access fees; it's at the market makers trying to buy your retail flow. And a lot of people are talking lately about this firm called Robin Hood which gives out zero – it's a zero to trade; it's free. Everybody knows there's nothing free in this world. The way Robin Hood makes money, apparently, is not only margins, but they're also selling their order flow to these various market makers. So they have a nice revenue source. And the question becomes what's going on with your order? That's what you need to be concerned about.

But as a retail investor you should know what happens when you hit that button? You need to know the mechanics of the market. You need to understand underneath – people think we're kind of dorks and geeks because we study this stuff so much – but if I don’t know how to operate an engine, if I'm a racecar driver and I don’t know how the engine works, well, I shouldn’t be behind the wheel of that car; I need to know the engine. And one of the biggest parts of that engine is this payment for order flow and how it's corrupting broker order routing processes. It's been going on for a long time and basically distorting how trades should be happening.

So the SEC saw this. And I'm very happy about this, actually, because about a year ago they had their own advisory committee that they formed, and they recommended what they call a transaction fee pilot. In other words, a pilot program, and the SEC actually just proposed it last month, where they will start to eliminate rebates or eliminate some of the payment for order flow that's going on on the exchanges which is a fantastic way to address the issue which is a core problem here.

So the proposal is out there right now. Well, there's been a ton of comment letters as you can imagine because this is a big thing for the industry. Lots of people are in favor of it, and most institutional investors that we deal with are in favor of it. Most exchanges, as you can imagine, are against it because this goes to the heart of that data that we were talking about.

We're hoping that the SEC finalizes the proposal soon and this goes out, and then you can study. And then you can look at the data that you're getting from the fee pilot saying hey, we did have a problem with order routing. Brokers were taking advantage of retail flow by selling it to market makers. That's not a good thing. Although this program, I must caveat that, won't cover the payment for order flow off-exchange. It only covers the payment for order flow on exchanges. I know it gets confusing, but I hope what will happen is once they do this one then they'll extent it out to off exchange trading as well.

Chris: Let's look at this now with the idea of – you mentioned passive versus active investing. Obviously, a huge structural shift in that where people and investors wandering away from active into passive. And a lot of that passive comes that exchange rated funds, or ETFs. Talk to us about those ETFs and their relationship to this overall structure you're talking about. One, we have this ecosystem of these Wild West sort of taming down as they fight each other to a standstill, OK Corral happening over here with all the financial and electronic shenanigans over there. Okay, great, we got the computer world.

And on the other side we have most of the market really trading through these passive funds. When we put those two together are there any risks here we need to be aware of?

Joe Saluzzi: Well, I think there are risks in some of the more esoteric ones, shall we call them, things like the double and triple leveraged volatility products. That was a huge problem recently, and people didn't know what they were buying. So do I have a problem with an ETF that represents the NASDAQ 100 and it holds those securities? Absolutely not. Because that's a vehicle that actually diversifies risk; that's a good idea for a lot of investors who don’t want to find particular names and they're not sure which part of the industry they want to but, so buy that. Do you want to buy a financial sector and you're not sure which bank to go? Buy the ETF. As long as it's holding the securities and it's a legitimate company, I think it's a great idea, a way to diversify risk and not have to do that much of a kick in tires if you don’t have that time.

But when there are issues and an ETF – or they even call them ETPs, exchange traded products – because those are the ones that may have underneath not necessarily the core holding, the stock, they may have derivatives based to a certain – they drive off of an index – they may have a swap in there; they may have a counter party risk in there.

There's a lot of stuff that goes on in those doubles and triples and volatility ones that you really need to read the prospectus. You really need to. And I think that anybody who trades those, I really booed the lobbyists for a while. Brokerages should make them sign a from similar to an options disclosure requirement which says that you understand how trade options. You should really, really understand those volatility products and those leveraged one because they're dangerous.

I mean, look at that one, the VXX. It keeps going to zero, they reverse split it. It goes back to twenty-five. It goes to zero. Stupid. Right. It's just absolute stupidity. How they're allowed to list in the first place, it makes me wonder where is the SEC on this? Because those are gambling instruments. They're not meant to be traded. They intraday trade, if you want to call it that, but they're certainly not meant to be held overnight.

So bottom line is know what you're buying. Know what's inside the ETF or ETP. And if you're comfortable with it, well, they definitely serve the right purposes. If it fits your risk parameters then that's great. I would never argue against where the market wants to go, and the market is saying hey, we want passive products, so so be it.

Chris: Well, it's certainly something that I think we absolutely had a lesson on around that VXX piece a while back. The counter agreement here that I'm trying to build in is this idea, look, there's been a bull market, volatility has been really low, people's portfolios have gone up. Some people might say well, then the market is working great. Nothing really needs to be addressed here.

On the other side of this we might say but we have these things called flash crashes, and we have concerns about liquidity, and we know that the Central Banks have just been throwing massive amounts of cash into these markets for a long time. They're starting to slow that down a little bit. The question would be what could happen at a time, if we ever did get back to it – or in many cases where you have increasing voices out there saying there will be another moment where there is a financial panic or a global liquidity drying up event.

My concern is won't these markets be tested in a way they haven't been tested? And isn't the concern that they might just – if you have enough algorithms say I'm not participating – we don’t have market makers anymore? What happens, do you think, in that moment, if that sort of dystopian future comes. Markets dry up. There's no market makers. You have all these algo's that are so far out of parameter nobody can turn them back on again. What happens then?

Joe Saluzzi: Then you got a major problem. And you're right, it hasn't gone away. And that's what my point was in times like this when there is no storm out there, it's time to fix the house now to make sure that when the storm comes the house doesn't get knocked down. So I think that's exaclty what you're saying. So how do you fix the house? By doing some of the things that we're talking about when it comes structurally, getting rid of some of the conflicts of interest, maybe adding more obligations for market makers, looking at those off-exchange venues which are consider dark pools and what's going on there. Looking at all different types of the issues that continue to haunt us, but they don’t pop up until the end. And can you force a market maker to stand there and buy stock when the stock market is coming down? No. You can't force them to do that. And that's the way it is.

Going back to liquidity, you can't assume that there's going to be liquidity today at this minute because there was a liquidity yesterday. It doesn’t make any sense. The market makers will disappear. So is there natural liquidity? And that's really the issue. And natural liquidity are real buyers and sellers, institutions and retail. Unfortunately, natural liquidity is still much, much smaller in the market than let's just say artificial liquidity if you want to call it that.

So I still think you fix the structural issues. You'll have a better chance, but will you prevent another flash crash? No. Will you prevent another problem when all the sudden everybody hits…You know, there was a famous thing back in the 2010 crash. They quoted one HFT as saying, "I saw it coming. I saw that it was happening, and I went to my keyboard, and I typed the letters HFT STOP, and I hit enter. And that basically took me out of every market." So basically, he had a ripcord. He pulled the ripcord, and it took him out because he didn't know where the risk was. He didn't know what markets were doing what, and he wanted no part of it. So what happens if everybody types in HFT STOP at the same time? You got a major vacuum in liquidity again. You can't prevent it. You can't. It is what it is there. And you can deal with some structural issues to try to encourage more liquidity, but you cannot prevent that. And yeah, when things get hairy I would expect markets to choppy [PH] around.

But, like you said before, we're fortunate we're in a market now which is different. It's based on fundamentals. We've got some good earnings out there. Companies are still strong. GDP is growing. And there's a lot of good things in this market right now. People are buying those dips, right, because they see the dips as opportunities. That's a fundamental analysis that I tend to agree with at this point. But it doesn’t mean that in a year from now it's not going to get really choppy out there.

Chris: Great. Joe, in the time we have left, let's turn now to cryptocurrencies. I know a lot of people who have been in them, and I think there was a really exciting story and case to be made for how these were going to be very transformative. But over the last several months, and particularly after I looked at what was happening with Bitfinex and some of exchanges, and this whole idea of the Tether and not really trusting the audit scale, and having read some great works by Ben Hunt of Salient Partners at the time talking about how this is a market that's highly unregulated, and, over the last few months, watching the entire universe of the top coins basically moving in lockstep now, I couldn't come to any other conclusion other the computers now have these markets by the short ones. What are you seeing there?

Joe Saluzzi: Yeah. I'm a big fan of Ben as well. He does some great work. The crypto market, in my opinion – I don’t trade cryptos, but I see a lot of similarities to what we saw years ago in the equity market. But the problem for crypto – I don’t have an ax to grind either way. If you want to buy Bitcoin, you want to buy Tivit or whatever it may be, I really don’t care. That's people's business. But when you try to get into the markets with ETFs and futures and options, well that's where I tend to raise my eyebrows and say, wait a second. You have an unregulated product that trades across all different exchanges around the world that no one is looking at.

There's no cross-market surveillance of these exchanges. Somebody could be spoofing in one market and laying it off in the other, just like we were talking about before in the equity market with the consolidated audit trail. But this, there's nobody looking. And I think the crypto to be serious, for them to grow up, and for anyone to take crypto seriously, they need, unfortunately, I hate to say it for them – they need regulation. The need an adult in the room to take a look and say wait a second, we're watching. There is money behind Tether. There is something here. They have been audited. The exchanges have been audited. We're looking for spoofing and layering. So therefore, we're okay with the futures market at that point.

But right now, no one's doing that. And the firm recently, Gemini, came out and said they recognize this. Those guys are pretty smart, the brothers. And they created something called the Virtual, I think it's Commodity Association, to try and create FINRA for crypto which I think is a wonderful idea because you need an oversight. The problem is they’ve got about three or four exchanges underneath their oversight. What about the other hundred that are trading these or whatever it may be. What jurisdiction watches them? Who's watching Bitcoin in Hong Kong? It's very tough to do.

So I think that this market is just filled with fraud, filled with manipulation, filled with all sorts of abuses. And until you can somehow figure out a way to regulate it, no way – and I'm very strong on this opinion – no way should any crypto ETF be formed or approved by any regulator in the U.S. I know they tend to exist – there's a couple – I think one in Sweden. But how are you going to create a derivative based on a crypto currency which is unregulated? It's a timebomb. That is a timebomb that will then seep into – what's going to happen – if they ever created it and pushed it out there, you can bet an asshole [00:44:18] out in Kansas City is going to have a broker, and that broker is going to say, "Guess what, you want to get a little extra return in your portfolio? Let's put this ETF Bitcoin in there; it's been approved by the regulators; it's safe."

But it's not because know what's going on in the underlying markets. And then, before you know it, people who should not have exposure to the crypto markets are going to be exposed. So we're looking at major problems if they ever approve that without regulation. Now, if they somehow figure out a way to regulate and monitor and surveille the underlying markets then I don’t have a problem with it. Then go ahead. They have derivatives on gold. They have derivative's on agricultures products. So be it. But they don’t have regulation now, so you can't go there.

Now the industry, by the way, who's pushing this? It is the same players from the high frequency trading industry. The exchanges, the market makers, the same people who pushed their way through the equity market back in '08 and '10 who were having a field day because it was easy to trade back then, are now trying to get into the crypto space. And they know they need to link various products so they can have an arbitrage opportunity. So they're the ones pushing the ETF.

_____ [00:45:20] and BATS or Cboe are the ones pushing ETF. They keep filing, and the SEC keeps rejecting it. The SEC – they're very strong in saying until you get a cross asset surveillance, cross market surveilled, don’t come back. What do they do? They come back again with the same stupid proposal. So those guys are pushing it because they see it as a new ground to sell data, to list products for their revenue stream because guess what? Exchanges of public companies, they have stock prices, they have shareholders, and you can make more money. How do they make more money? They list new products. But what are they creating here? They're potential timebombs.

Again, so I'm very concerned, extremely concerned, about derivatives of the stock market. If you want to trade stock market and you got an app that does it, play at your own risk, basically. But that's your own money, and it's an isolated effect, in my opinion, so it wouldn't be a contagious effect. But once this thing seeps into the regular markets, I think we have to be very careful.

Chris: It's always about the money, isn't it? I love this delicious irony that you have this highly regulated product built on top of an entirely unregulated market. It puts a level of gravitas that really doesn't belong there. But you're right. .It will be used. And in Ben Hunt's terms he talks about coyotes which are people who are too smart for their own good and racoons which are just basically thieves. A lot of racoon's out in the space of the crypto space. Why? Because there's a lot of money to be made there. And if there's money to be made there and it's unregulated and you can get away with it, trust me, you got racoons all over this thing. Trash pandas everywhere. It's an astonishing thing.

So as we look at that, hey, first, Joe, thank you so much for your time today. It's just, again, such a found of knowledge, and I've learned a lot myself. I know my listeners will as well. How can people follow your words and your wisdom offline?

Joe Saluzzi: We still maintain a blog. We'll post it once or twice a week. themistrading.com. I'm on Twitter; Joe Saluzzi. We tend to tweet a lot. My partner is Sal, his name is Sal. He's on Twitter as well. And we pretty much tweet on market structure issues, and we tend to be critical, and that's just what we are. We tend to be – some people call us cynics or critics or whatever. I like to look underneath the hood and see what's going on. So we use those social media platforms certainly as a way of kind of getting out our message and talking to everybody. And we like to interact with people on Twitter as well.

Chris: All right. Well, thank you so much for doing that. I really appreciate it personally. And we do need people who are critics and looking under the hood because otherwise you get what we had for a while there. So it does feel like we're headed in the right direction. So thank you for your time today and your efforts and getting us pointed in that new direction.

Joe Saluzzi: You got it, Chris. Thank you, and maybe we'll talk in a couple years and everything will be great again, right?

Chris: Absolutely. Thank, Joe.

Joe Saluzzi: Thanks, Chris.

About the guest

Joe Saluzzi

Joseph Saluzzi is a partner, cofounder and co-head of the equity trading firm Themis Trading, a leading independent agency brokerage firm that trades equities for institutional money managers and hedge funds. He is also co-author of the book Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio. Prior to Themis, Joe headed the team responsible for equity sales and trading for major institutional accounts at Instinet corporation for more than 9 years. He’s a frequent speaker on issues involving market access, algorithmic trading, other sell and buy side concerns.

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