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March 7, 2008

More Can Be Less in Trading

What Fragmented Liquidity and Entertainment Have in Common

By Bernard McSherry

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In his regular op-ed column in the New York Times, David Brooks recently compared fragmentation in the record business to trends we are seeing throughout the economy. The radio stations that routinely played artists like Sly and the Family Stone in the same format as the Carpenters and the Rolling Stones no longer exist. In their place are hundreds of stations, each programmed to appeal to a narrowly focused listening demographic.

The same is true in television, where the audiences for today's most popular programs pale in comparison with the viewership attracted by hits like "I Love Lucy" and "M*A*S*H." Instead, scores of specialized programs flourish on cable and satellite television, each targeting a small segment of viewers. But as Bruce Springsteen once lamented, there are "57 Channels (And Nothin' On)."

Target and Slice

As companies continue to slice industries and target audiences into smaller and smaller market segments, much of our common ground is being cut from beneath us. While we like the fact that we can watch pretty much what we want at whatever time we choose, there is a growing sense that some essential element of our shared experience is being lost. That we, as a people, are growing apart, driven thus by technological forces.

It occurred to me that we here in the financial services industry have been experiencing this same dynamic over the past few years. Our centralized marketplace has quickly devolved from one in which a handful of market centers (read: NYSE, Nasdaq and a few regionals) dominated price discovery to one in which dozens of new entrants in the guise of dark pools, internalization engines and alternative trading systems have obscured much of what we used to take for granted: centralized pricing, efficient price discovery and relatively easy access to liquidity.

Nothing On

Much like listeners who complain that there is nothing good on the radio today, traders regularly bemoan the difficulty in performing their jobs despite a bewildering array of choices. With order flow dispersed across numerous venues, the idea of a centralized "best" price has gone the way of radio's Top 40 AM stations.

In the absence of accurate information about where true liquidity lies, entire new businesses have sprung up to try to correct the inefficiencies of our fragmented equities marketplace.

We now employ transaction-cost analysis to help us track an increasingly elusive definition of best execution, while smart routers are deployed to determine the best market center for an order.

The alternative trading systems are an attempt to reconnect markets and to help produce a facsimile of a centralized price. There is a growing awareness that we as an industry are groping in the dark, trying to replace something essential that has been lost.

Quants Triumph

While I am not advocating a return to the past, it seems that much of our recent industry reform has primarily benefited quantitative traders, electronic trading service providers and the aforementioned support industries at the expense of traditional institutional participants.

I would also be remiss in not taking to task both NYSE management and its specialist community for their past disinterest in pursuing real reforms that could have impinged upon their privileged positions within the old structure. Once the old hegemony was broken, we witnessed a spasm that washed away much of