In this Q&A, Alfred R. Berkeley III, a 30-year industry veteran, argues that the growth of high-frequency trading has hurt the ability of traditional buyside firms to execute orders with limited market impact. Exchanges and broker-dealers, pursuing market share, cater to high-frequency firms at the expense of institutions, said Berkeley, chairman of Pipeline Trading Systems, a block-trading platform geared to institutions and broker-dealers.
Berkeley joined Pipeline in 2004. From 1996 to 2003, he was president and then vice chairman of Nasdaq Stock Market. Prior to that, he was a managing director at investment bank Alex. Brown & Sons. He co-founded the firm’s technology group in 1975, three years after joining Alex. Brown. In this interview, conducted by Senior Editor Nina Mehta, Berkeley discusses block trading, high-frequency firms, pattern-recognition software, the national best bid and offer, and the regulatory landscape.
Traders Magazine: In your view, what distinguishes market centers from one another?
Alfred Berkeley: It’s about what systems are optimized to do, and who they’re optimized to serve. A recent TABB Group report said that 73 percent of trading is attributed to high-frequency traders. Displayed markets and large brokerage firms, in order to have a large market share of the larger market, have to optimize their systems to attract high-frequency traders. High-frequency traders are the natural enemy of the individual investor and the large institutional investor. Most market centers are doing things that disadvantage the individual investor and institutional investor, because they’re doing things to advantage the high-frequency trader.
TM: What’s an example of this?
Berkeley: A great example is co-location. The idea that an exchange would let one set of market participants locate their computers inside their data center and not give the same speedy response to everyone is a blatant tilt in favor of high-frequency trading. There are very few people who can resist the heroin needle of trade volume and do something that optimizes the market for institutions. Pipeline’s business model is premised on optimizing around the institution’s needs, even though they are just a quarter of the market now.
TM: Are there other ways in which the growth of high-frequency trading has led to changes in business models that disadvantage institutional investors?
Berkeley: The development of algorithmic trading favors high-frequency traders. The creation of so-called dark pools that many broker-dealers run benefits high-frequency trading firms, including a broker’s own internal prop desk. That’s why you see such small execution size in those pools–250 shares on average. Institutions don’t trust those pools and can’t put large orders in them.
TM: Does high-frequency trading have an impact on the quality of liquidity in the market?
Berkeley: Of course it does. The best way to see that is to look at the size at the inside and see how many orders are canceled when it looks like momentum is going from the buyer to the seller. And the average trade size is just lousy.
TM: The public markets provide price discovery. There’s now more volume getting done than ever before. Have changes in the market had an impact on the quality of price discovery?
Berkeley: There are prices that are discovered on the basis of retail orders vs. size on wholesale orders. The issue of price discovery can’t be disengaged from the issue of size discovery. Most of America’s trading rules have been focused on price discovery at the expense of size discovery. Another issue is that there are informed and uninformed orders in the market. Most high-frequency trading is about picking off short-term imbalances in supply and demand, both long and short. That price discovery is perfectly legitimate.
Many people now think blocks should be part of the price discovery process. But the argument to me is a little bit specious, because blocks are not interested in prices determined by 100-share lots. Institutions don’t care about the immediate short-term price. If they’re moving 5 million or 10 million shares of stock, they know that the price can’t be set accurately by the last 100-share trade. They’re looking for a way to discover price for that size. In 1975, the average daily volume in all U.S. markets together was 25 million shares, and we were delighted with the quality of price discovery. Now 25 million shares trade before the market opens in big stocks like Intel.
Blocks were not part of the price discovery mechanism. They were bid on by upstairs desks. Blocks rarely went to the floor of exchanges, and if they did, they changed the price. They upset the pricing equilibrium because they produced big temporary imbalances in supply and demand. The U.S., Western Europe and some Asian markets have beautiful price discovery–magic price discovery. But we are vastly over-concerned with the argument that all orders should be in transparent markets to promote price discovery. It’s being raised by price discoverers that are losing market share to other venues.
TM: I suppose you could look at changes in market structure in recent decades by looking at the evolution of the national best bid and offer. What was the relationship between block prices and the NBBO 10 or 20 years ago?
Berkeley: There wasn’t a relationship. Blocks got discount bids. They could be a few dollars away. Those were negotiated markets, not auto-ex markets. Blocks traded where blocks would trade depending on how willing a broker-dealer was to put up capital. The NBBO became a reality in 1975 with the National Market System Amendments to the Securities Exchange Act of 1934. Before that, you had to call around to three or four places to get quotes, and you might trade with someone you called 20 minutes earlier.
TM: After 1975, did the Securities and Exchange Commission want blocks to be part of the price discovery process, or was there ambivalence about that?
Berkeley: Blocks have always been a difficult problem because size discovery and price discovery are inextricably bound up with each other. Conflict exists because price discovery and size discovery work against each other. The existence of a verbal wholesale market worked well until the Order Handling Rules and Order Display Rules, when [SEC Chairman] Arthur Levitt basically said that all Americans get to buy wholesale. We don’t do that in any other market, such as automobiles, sugar or telephones. They have separate markets.
Until then, we had a perfectly functional market in four segments. In NYSE stocks, the retail market was on the floor, and blocks were done upstairs at firms like Salomon Brothers and Goldman Sachs, and brought to the floor to be blessed. If a few retail orders were around to be price-improved, they would be included with the blocks. When electronic markets became a reality with Nasdaq in February 1971, and later in 1979 with Instinet, there was a functioning retail market on Nasdaq with wide spreads, and a functioning wholesale market at Instinet with quite tight spreads.
But the block market was a separate and distinct thing–it had a legal definition. For most stocks, it was defined as 10,000 shares or more. Everybody knew blocks were exempted from all sorts of things, including being displayed in quotes. Levitt changed all that, essentially at the request of the day-trading community, who wanted access to better prices in the wholesaling market.
TM: What about the price-fixing scandal on Nasdaq that academics Bill Christie and Paul Schultz exposed in 1994?
Berkeley: I wouldn’t put too much weight on that. There’s some debate about whether that was correlation without causation, and whether the results were statistically valid. I’d look at the Christie issue more as an immediate political tool for generating support for the SEC’s actions than as causation.
TM: Why would Arthur Levitt want to appeal to the day-trading community?
Berkeley: He thought he was helping the individual trader, helping the mom-and-pop trader by giving them access to wholesale prices. His intentions were fine, but the unintended consequences have cost citizen-savers using mutual funds and other institutions a lot of money.
TM: Regulation ATS led to the creation of a lot of new electronic markets, and Reg NMS ensured that the public markets were automated and linked. In this new world, is the market better or worse for blocks?
Berkeley: The markets are better overall, since there’s more liquidity, but they’re worse for institutional investors and the citizen-savers they represent. These markets have never been better for hedge funds and high-frequency traders–they’re magic. We have optimized our market for hedge funds to make money. How do they make money? They front-run institutional trades. Traditional long-only traders have had to go into defensive mode because of the pattern recognition software that statistical-arbitrage and other funds have deployed to look for institutional orders–to look for the tracks they leave in the tape and on the bid-ask montage.
In trying to defend themselves, one of the only tools available to institutions is to cut the size of their orders, to vanish into the river of small orders. But pattern-recognition software sees that. If I have 10 million shares to trade and I slice that into 300-share pieces, I’m leaving tracks in a huge way. Someone doesn’t have to see an order to know it’s there. I can give you a Pipeline commercial here–that our business is about confounding that pattern-recognition software. We have some of the smartest guys in the country figuring out how to make it hard to see customer orders either in our block facility or through our outbound switching engine [for algorithmic orders].
TM: But institutions do have options. Pipeline exists, Liquidnet exists. Is that not enough?
Berkeley: We and Liquidnet are the only true wholesale markets. The average execution size on our markets is over 50,000 shares, rather than 250 shares in the public markets. We’re trying to earn a living by serving the underserved institutional investor. And it works pretty well. But our market share plus Liquidnet’s is just a teeny piece of the overall market share.
TM: But that shouldn’t matter if most of the volume in the market comes from high-frequency trading firms, which is not your audience.
Berkeley: Right. That audience isn’t relevant for us, but it’s very relevant for our customers because those high-frequency firms are front-running institutions.
TM: Are the current regulatory rules sufficient to enable institutions to trade blocks easily? What rules do you think should change?
Berkeley: Rules aren’t keeping most brokers optimizing their systems for high-frequency traders. It’s the high volume of high-frequency trading and the profit opportunities that are causing ECNs, exchanges and broker-dealers to say, "I want to increase my share of high-frequency trading, and therefore I’ll allow high-frequency traders to co-locate with me, or allow small inbound orders to probe for institutional orders, or invest in very high-speed systems which only high-frequency traders use." Large institutions, by and large, don’t have a financial motive to invest in all the things high-frequency traders have the motive to invest in.
TM: What should regulators focus on with block trades that may not be high on their to-do list at the moment?
Berkeley: Public policy issues almost always have to balance more than one good. Rarely is there a bad in the equation. Vested interests will describe something as bad, but another constituent will say, "That’s my good." Regulators are trying to figure out how we raise our standard of living–which is the goal of public policy–in the face of competing interests. There are vested interests in rules that exist, and in rules that are as yet undefined.
Regulators are approaching these issues with genuinely open minds. They are inventorying these goods, such as price discovery vs. size discovery, and the issue of off-exchange trading vs. on-exchange trading. A good regulator doesn’t see one as better than the other. They say, "Why is this suddenly an area of contention between different factions of people? What have we done in evolving since the 1934 Securities Exchange Act to deal with exchanges and markets, and is that the right model? What’s going on in other countries? How are other people dealing with trade reporting?" We now have a trade reporting discussion going on in the U.S.–should trades in dark pools be reported immediately with the name of the dark pool? Some countries allow trades to be reported with delays appropriate to keeping the existence of the block secret.
TM: Do you think blocks should always be printed to the tape?
Berkeley: In the cultural milieu of America, we print blocks to the tape, but we make it ambiguous where and when they occurred–the tape doesn’t tell you where they were done, and there’s a 90-second delay. If the tape did tell you where it was done, no one would print a block there again, because blocks are part of larger blocks. Would you really want to destroy the liquidity available in the wholesale market? I don’t think so. If high-frequency firms could identify the venue where blocks were trading, that would give them that much more free information to aid their front-running. If you went to a movie theater and were lined up to get a ticket and somebody ran to the front of the line and bought all the tickets and scalped them to you, would you say that was fair? All this front-running is a version of scalping.
You must look through to the ultimate beneficiary. Do we want a handful of bright high-frequency traders front-running the citizen-savers in the country? It’s bad public policy to have tilted our markets so far in favor of speculators. We’ve created the greatest casino the world has ever seen in our equities markets, because we’ve got so many tilts in favor of speculation and against investment.
TM: How do you fix that tilt?
Berkeley: You’re looking for a regulatory answer, but I’m more interested in free-market ideas. We have a viable solution at Pipeline. Other firms have developed viable solutions. What I don’t want is one-size-fits-all regulatory rules cramping my ability to innovate. The market will tell me if I have a viable solution or not. I’ll keep modifying my product until I have something institutions want.
TM: If you were starting a new company in the markets now, what type of firm would it be?
Berkeley: I would do exactly what Pipeline is doing. The great unsolved problem is optimizing a system for the traditional mutual fund, investment manager and pension fund. The traditional buyside is the neglected part of the market. I would want to build a system that solves the problem for the buyside moving large blocks in and out of the market. Almost everyone else is addicted to the volume that comes from high-frequency trading.
