There is a fascinating speech by InteractiveBrokers founder, Thomas Peterffy to the World Federation of Exchanges in Paris posted on IB’s website. It is highly recommended for a look into how the brokers and markets work today from a technical perspective, how your orders are treated and why there is a big problem brewing with transparency, trust, fairness in dealings of exchanges and brokers and ability to handle market meltdowns such as the May flash crash. He seems to take stance that the troubles we’ve been seeing with flash crashes isn’t rooted in algo trading / HFT but with fragmentation of exchanges, clearing houses and ubiquity of internalizers. Here is the gist of it, the full speech is available here in PDF.

The root of the problem, as always, is short-sighted greed on the part of the brokers. Transparent commissions are not enough for them. They want to take more from their customers but without the customers seeing exactly what it is that they are paying. This is done by what is called internalization, which is easiest to illustrate with OTC products. The banks simply take the opposite side of the customers’ orders at prices that leave the banks with undisclosed but huge profits.
How do we know that the profits are huge? Just look at the banks’ quarterly financial reports on derivatives dealings. Even the more modest estimates exceed $100 billion per year, worldwide. Customers are on the other side of those trades. Customer losses are on the other side of those bank profits. The amazing thing is that those banks are able to convince their customers that this is good for them and moving these contracts on to the exchanges would harm the customers.

It should be shocking, but it probably is not, that according to the Rule 606 reports mandated by the U.S. Securities and Exchange Commission, no major online broker, with the sole exception of Interactive Brokers, sent more than 5% of its orders to an organized exchange. More than 95% of their orders go to internalizers!
These brokers ignore the exchanges and sell the orders to internalizers, thereby avoiding exchange fees and getting a nice little payment from the internalizers in return. This payment for order flow adds up to real money after millions of orders are taken into account. The internalizers are supposedly matching the best prices prevailing at the exchanges, so that they can argue that the customers get the best prices.

But do they really? Of course not. If they did, an independent study would not have found that the one broker that actually routes the vast majority of its orders to public exchanges — and I will not name this broker again — obtains executions that are on the average 28 cents better per 100 shares in the U.S., and an absolutely stunning 2.84 Euros better per 100 shares in Europe.

The steps he proposes are mainly 3:
1. Forcing brokers to route to exchanges
2. Defragmenting the exchanges.
3. Consolidate clearing houses. Peterffy raises some good questions here about liquidity, solvency and ability of small clearing houses to handle crises.

H/T TraderGav

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Tags: clearing houses, derivatives, Exchange, fairness, hft, interactive brokers, internalization, market, online broker, securities and exchange commission, Stocks, Thomas Peterffy, transparency, U.S. Securities

I get Gary Smith (aka The Chartman) daily picks email to my mailbox (the free version, yes I’m a cheapskate) and todays email sums up nicely the current “action” in the market.

Daily picks, 6/17: Never, as far as I can remember

Written by Gary Smith    
Tuesday, 16 June 2009 17:06

The title refers to the time we’re in right now, in which I can’t recall in almost 20 years of doing this, having so few picks (or “none” as the case may be) for so many days in a row.

 But, that’s what I have as we sit here and wait for somthing –anything! — to happen!

And that is the final word from gladwell.com where the author of Outliers claims one needs 10,000 hours at something to be world-class.  So, let’s see: I now bike about 18 hours per week.  That means that in 10 odd years, when I’m 61, I’ll be a champ.  Boy, I hope I last that long!

Btw, I don’t subscribe since I like doing my own research but his charts do make sense.

I’m taking half of July off but I might as well have stopped trading beginning of June as there are very very few opportunities. The new swing strategy is making a modest contribution to the bottom line but other than that it’s mostly treading water now.

Everyone is familiar with the January effect, which means it’s not easily exploitable over the last few years as it started to creep into December or not happen at all. With the current major decline, and general public dismay with the market I wonder whether the early/end of the year effect will return. On the one hand less people are bullish so they’re less likely to be eager to to pump in money ahead of the Jan effect, while on the other hand redemptions from funds have risen dramatically (as they usually do when the going gets tough) and there’s money on the sidelines waiting to go back in or flip from short. Either way it will be interesting to see if we get any effect or if rallies keep getting hammered back. So far this morning it’s surprising to see the market making new highs after 10am :-)

Tags: Investing, January Effect, Stock Market