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May 1, 2011

Why Choice Should Not Be Stifled in Schools or Markets

The lottery ball drops from its cage and rolls to a stop. A number is called out. One young mother leaps with joy, while another holds her head in despair. The recent documentaries Waiting for Superman and The Lottery covered agonizing selection scenes where a few lucky kids win the prize of going to a charter school. The rest will end up languishingin the failing local school, waiting in vain for someone to come rescue them.

 But Superman is unlikely to save the day, due to a successful decades-long campaign by teacher unions to oppose competition and parent choice at all costs. Since the truth would not make for great union protest chants ("Raise my pension plan, not your kid's attention span!"), teacher unions instead make two basic arguments: (1) that charter schools are not as good as they claim to be, and (2) that they are bad for society because they divert students and dollars away from the core public schools.

Fighting choice is always tough politically, but if you have a weaker product, sometimes it's your only hope. And so I wasn't all that surprised when several exchanges across the globe began calling for the demise of dark pools in the wake of the "flash crash," using eerily similar logic to the unions arguing against charter schools.

Dark pools are in many ways the charter schools of the trading world-innovative niche venues aimed at those seeking an alternative to the default markets. In the U.S., Rosenblatt Securities estimates that 13 percent of trading has migrated to dark pools, up from only 4 percent three years ago. Like parents fleeing public schools, investors are increasingly choosing to flee public markets. Opponents of alternative markets make almost identical arguments to those of the teacher unions as they watch their customers increasingly heading for the hills: (1) that dark pools are not as good as they claim to be, and (2) that dark pools are bad for society because they divert liquidity away from the core public markets.

Imagine for a moment that we lived in a world where the party that was losing customers, whether public schools or public markets, took a long hard look in the mirror, rather than seeking a regulatory solution to shut their competition down. In this imaginary world, the teacher unions would realize their policies sometimes don't cater to the needs of the children, and the exchanges would realize their policies sometimes don't cater to the needs of long-term investors.

The underlying problem driving customers away is a culture that doesn't reward quality. Teacher unions violently oppose merit pay, and so the schools have evolved into egalitarian paradises where no one need fear discrimination based on their lack of teaching ability. Similarly, at most of the world's exchanges, no attempt is made to evaluate or incentivize based on the quality of order flow.

In the relentless drive to maximize quantity over the past decade, many exchanges transformed into technology firms and adjusted their rules and policies to cater to a subset of sophisticated high-speed players. An arms race ensued as exchanges competed to build the fastest possible data feeds with the most information jammed into them, followed by efforts to allow customers to "co-locate" their servers right next to the exchange's matching engines. Exchanges and high-speed trading firms entered into a happy symbiosis, with the exchanges engineering ever-faster data feeds, and the trading firms reciprocating the favor with vast rivers of flow.

I am not implying that the exchanges have done anything wrong. Nor have the high-speed traders who use these services. Adam Smith taught us more than 200 years ago that society functions best when businesses are free to pursue their highest return on capital, and individuals are free to make their own choices. When the exchanges decided to cater to the needs of the high-speed community, they were being economically rational and acting as good fiduciaries to their shareholders.

But as a result of these logical policy decisions, the exchanges may have eroded some of their credibility with the long-term community. Investors have been voting with their shares, and for three years now, we've seen dark pool volume climbing and exchange volume dropping. Rather than seeking to recapture this market share through innovation and experimentation, a few darkaphobic exchanges are instead taking a play straight out of the teacher unions' playbook: Frame the alternatives as damaging to society, and then try to constrain them or kill them with a regulatory club.

The weapon of choice to destroy competition in markets is called the "trade-at" rule. Under a trade-at regime, exchanges would expressly be given priority at any price over dark pools, market makers, block traders or other alternative liquidity sources. The competitive advantage would be so great that most dark pools and market makers would likely shut down. And that is why trade-at would be shortsighted policy: It would reduce investor choice, driving up costs for retail clients and big institutions alike.

 

Against The Tide

The argument for trade-at goes like this: If exchanges got first dibs on all orders, people would be more likely to place their limit orders on the exchanges, and therefore the size of bids and offers would increase, which would make the market more stable and save us from another flash crash. But even if you accept the wishful notion that more display size could save us from Flash Crash II, ask yourself whether this same result could be achieved without government mandates that restrict choice. I think it could.

Displayed orders already have a big advantage because of the current "trade-through" protection, which gives them considerably higher fill rates over dark orders. A forward-thinking displayed venue that adopted "long-term friendly" policies could potentially create the best of both worlds: a venue with high fill rates and high quality fills. If each exchange launched one "long-term friendly" book, the resulting flood of displayed bids and offers could be a free-market solution to the underlying problem of exchange market share loss, without the arbitrary wealth-shifting and unintended consequences typical of government action.

Ultimately, the regulators would be swimming against the tide of history in passing trade-at or any similar rules that would kill alternative venues and restrict investor choice. American history falls firmly on the side of choice, and organizations that resort to fighting it destroy their credibility. The teacher unions were once paragons of virtue, seen as defending the hard-working people who educate our children. But after publicly fighting against choice, teacher unions find themselves regularly cast as the villain in books and documentaries. Pressure against the unions will continue to build, and in the end, they will lose and choice will win.

So look for charter schools to continue sprouting, dark pools to continue flourishing, and "long-term friendly" exchanges to begin popping up and rescuing the forgotten investor. Superman may not be here quite yet, but he's on the way.

 

Dan Mathisson is a columnist for Traders Magazine and the Head of Advanced Execution Services (AES) at Credit Suisse. The opinions expressed in this column are his own, and do not necessarily represent the opinions of the Credit Suisse Group.

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