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The Failure ofContinuous Markets

BIMA, Spring 2012Chris Sparrow

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Agenda Where we are

How we got here

Problems with what we have

How can we fix the problems?

Benefits

Workflow

Impact to HFT

How do Venues differentiate?

Issues

Conclusion

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Where we are Todays market structure is a complex web of

venues, order types, fee structures, participants andregulations

Issues such as explosion of market data, trade-throughs, dark pools plague investors trying toefficiently allocate capital

Participants have entered the trading ecosystem toexploit niches created by the complexity leading to

rise of HFTs Natural investorsretail and institutionalhave lost

confidence in the equity markets leading to reducedvolumes, enhanced volatility and fewer IPOs

In short: the market structure is broken

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How we got here Regulations were introduced allowing for

competition of secondary trading venues

(Alternative Trading Systems) Competition was seen as a positive for equity

trading and it was hoped that execution feeswould be reduced and innovation spurred

Idea was good, but there were unintendedconsequences

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Problems with what we have Each lit venue trades on a continuous basis

Quotes can be submitted and/or cancelled at anytime

Trades can be executed at any time There is no synchronization between venues

Potential for latency arb exists and participantshave exploited this

Lack of synchronization leads to a differentialdistribution of information regarding avaialbleliquidity and executed trades Participants can pay for a first-look

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Problems (cont.) Venues are no longer utilities providing a

societal benefit (effcient allocation of capital)they are now for-profit entities serving theirshareholders Competition between venues leads to incentives to

attract liquidity (maker/taker fee structure)

Order types that are designed to attract new

participants Non-trading services including co-location and

direct low-latency data feeds

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Problems (cont). Continuous trading in a non-synchronized

fashion leads to: Race conditions Missed liquidity Trade-throughs Locked markets Latency arb

Technology arms-race Data explosion Quote stuffing/denial of service Technological adverse selection

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How can we fix the problems? Starting point: the raison dtre of markets

To allocate a scarce resource (capital) in an efficient manner Most important participants are Natural Investors (i.e. those

with capital to allocate)

Identify the factors leading to the crisis in confidencethat natural investors have in the market Latency arb and ability to pay for a first look at market data

Proposed solution is to discretize the market: change

from continuous to quantized Physical systems have a minimum temporal resolution (Planktime)

Continuity is a mathematical concept that provides a goodapproximation of reality in certain regimes

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The illusion of continuity

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Fixing the problem Allow all participants time to react

Various participants may receive informationearlier than others but if all are given enough timeto react, then advantage is removed

Remove time-priority in order books, reward size=> liquidity

Require venues to synchronize their

executions and order entry Executions and quote updates all occur

simultaneously, removing potential for latency arb

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Benefits Only one quote update per call dramatically

reduces data requirements

Trade throughs eliminated Locked markets eliminated

Stocks can be halted in co-ordinated manner

Market can be re-played accurately

Technology arms race can be avoided

Volatility based circuit breakers can beapplied pre-trade

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Workflow From t1t2, all trading venues open for order entry

Orders are not made visible to market participants Participants allowed to cancel any open orders while order entry window is open

At t2, order entry window closes for all markets Allow a short time (t2-t3) to ensure all venues order entry windows are closed

(venues confirm closure to each other) At t3, initiate matching process (regulator could provide signal to initiate)

Determine unique clearing price for the current call by having venues compare theirbooked orders

Each venue matches orders at the clearing price (do not allow intra-call time-priority) Cross-venue matches determined as per bi-lateral venue agreements Allow dark orders and crosses to execute at clearing price

Orders that would lock or cross market are cancelled or re-priced Allow passive orders to book in order to attract liquidity to next call

At t4, matching process completes, trades are reported to tape and regulator,passively booked orders reported

At t5, next order entry window opens Lather, rinse, repeat

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Workflow (cont.)

OrderEntryOpens Time

OrderEntryCloses

MatchingProcessBegins

MatchingProcessEnds

Trades& quotesreported

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Workflow (cont.)

Time

Venue 1

Venue 2

Venue 3

Venue 4

All Venues synchronize operations

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Impact to HFT Latency arb is only one aspect of HFT HFTs are very innovative and will find new

niches to replace latency arb Existing strategies may be tweaked but

should continue Stat arb Multi-asset arb Pattern recognition Market making/ELP Other?

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How do ATSs differentiate?

Creating synchronized trading does notpreclude innovative order types,

freedom to choose fee models Latency differential goes away, but

ATSs can still compete in other ways

Example: dark pools in Canada currentlyall have specific niches

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Analogy:Distribution ofMaterial Information

When a company issues material information:

its stock is halted,

the news is diseminated, investors and traders are given time to digest the

news,

the market re-opens

What if price discovery is consideredmaterial?

Apply the same model on shorter timescales

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Analogy: Requiringsynchronization

Entrepreneurs can create new productsthat work with AC current

Product must be able to plug into theexisting electrical grid and consume 60 Hz

AC

Innovations must work within the existingstructure: what if we required tradingvenues to synchronize?

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Issues

Need to apply the model to alljurisdictions and asset classes

Requires co-ordination between venues

Requires new approach to matchingengines need to be changed

There will surely be some unintendedconsequences

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Conclusion

A new approach to trading: abandoncontinuous trading for a series of call auctions

Primary goal is to restore confidence to theparticipants that the market serves: NaturalInvestors, Corporations

Continue to allow competition of venues and

intermediaries (HFT) Avoid transaction tax, technology arms race,

minimum resting times, data explosion

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Questions?