No. of Recommendations: 36
"...The die is cast. The old order is gone forever...."----- Edward McCormick

Dear Swashbuckling Fools:

Begin Sojourn:

First mate James Skrym was wearing his Sunday best. He waited patiently while two smartly dressed deckhands bolted the pulpit to the quarterdeck, but the frenetic motion of his Captain, John Bartholomew Roberts, drew his attention away. Skrym had seen this before. It was as if Roberts was in a trance. With unceasing compulsion Roberts tugged at his lacy shirt cuffs, straightened the waistcoat, smoothed down the velvet outer coat, straightened the cravat, fluffed the wig, set and reset the tricorner, fluffed its feathers, buffed each shoe against the opposite leg. Roberts caught Skrym gawping. With a hint of embarrassment, he clasped his hands behind his back and gave Skrym an approving nod. Skrym rapped the gavel on the pulpit. "Orrrderrr, gentlemen... pleeeasse, orrrderrr!" In a moment only gull caws and gentle waves could be heard. "I shall read the minutes of the last meeting."

While the assembled crew listened intently, Roberts studied them. He saw faces weathered by salt, wind and sun. Faces scarred by saber slashes and pock marked by illness. Faces with crooked noses, swollen jaws, missing teeth, missing ears. "Quite a fearsome lot", he thought. But today, their appearance was far more demure. For on every 'meeting day', in a unified token of respect, they dressed as well as their captain: scrubbed clean, hair tied, proper coats, waistcoats, frilled shirts, cravats, proper breeches, stockings, buckled shoes and of course each man topped himself with a dandy tricorner. Warm African breezes mixed wafts of bay leaf perfume with salty sea air. Roberts was visibly proud. But emotional display was rather out of character for him. Without exception he was unblinking and icy eyed. For Black Bart Roberts was a merciless, cold blooded, ruthless, teetotal Baptist pirate captain who through diligent application of his villainous traits as well as virtuous ones, had made himself the most successful pirate, ever, in the history of the New World.

When Roberts finished his scrutiny he glanced over at the leather bound, gold gilded ledger on the pulpit. There was no need to ever open it. He had memorized every entry. Nearly 470 "prizes" with a detailed accounting of captured or ransomed cargoes. He knew each name of the combined crews of his five ship flotilla and each man's prize share. He kept a mental accounting of all armaments and provisions stowed on the three large warships, the Fortune, the Good Fortune, and his flagship the Royal Fortune. He constantly kept at the ready his two small and fast brigs, the Ranger and the Little Ranger, used to overtake and board victims,

Black Bart Roberts wasn't simply a pirate. Black Bart Roberts was the captain of a well-organized, international pirate enterprise spanning from the west coast of Africa, to as far north as New England and as far south as Brazil.

When Skrym finished, he turned the pulpit over to Roberts.

"Gentlemen! As noted in the minutes, we had agreed to consider a proposal to invest a portion of our holdings towards merchant financing. By doing so our money will not sit idle. Each man will receive a share of regular client payments. Now, our articles require that we put the proposal to a vote. Questions or comments?"

A flurry of question rose above a bassy murmur: "What of local usury laws?” for one. "How many bribes must be paid, and to whom?" was another. But the last caused a rustle of nervous agreement: "What of the legal risk when offering a bribe to the King's magistrate?"

Roberts was quick to answer. "We needn’t offer bribes nor break laws! Gentlemen, we shall charge a combined rate! This shall be the legal rate plus the premium for the attached insurance policy amortized over the life of the loan." Roberts waited as the mutter of discussion continued again. It all stopped short by a single question toned with innocent curiosity: "What insurance policy, sir?"

With slightest hint of a smile Roberts replied, "My good man! I have the utmost confidence that we are well able to insure our clients against losses due to piracy!"

Like a sudden wind in sails, there was a swirl of approving applause and calls of "Hear! Hear!"

He raised his voice above the applause. "Thus we safely navigate the narrow straights of laws, the shallow shoals of bribery and are deaf to the gallows’ siren song! Other questions?"

When no further questions arose, Roberts stepped back and Skrym stepped up. With quill and ledger at the ready Skrym snapped, “Show of hands! In favor!?" Skrym counted raised hands. "Opposed!?" Again he counted. "I record 105 yeas, 21 nays. This proposal is adopted."

Providence was waiting in the wind, however. A split instant before anyone could react to Skrym's count a shout came from the crow's nest: "Sails on the horizon!" Confident in his run of success Roberts rubbed his hands together. "Good! Good! A blundering fool! If she carries coin, we can pay the fleet!" He leaned forward towards Skrym. "Close the meeting. Let them relax. Extra rations of rum. But not you! Take Ranger and get that lubber! Log the prize in the ledger."

It is 5 February, 1722 and Black Bart Roberts' dream of expanding into financing will go unrealized. For the sighted sail is actually that of the British warship, Swallow. It will lure Skrym to his doom, then return to destroy Roberts' flotilla and by so doing, put to an end "the Golden Age of Piracy" in the New World.

End Sojourn

Retail investors are well acquainted with trading risks on Equity Sea. We've beached on earnings disappointments, been dead in the water in market doldrums, shunned safe harbors and sailed through market storms.

Recently the retail investor holds fast to their capital. What has caused these confident captains run aground on Treasury Islands? Why does 0.X% mark the spot on so many monthly statements?

For a while, imagine we can see through the eyes of a great seabird, the Equity Sea Albatross. We take to the sky, gain altitude and leave land behind. We glide along until we sight a small flotilla of five ships.

Let’s dive in low and weave between them to see who they are. We swoop past the stern of the first and read the archboard. It’s the "Phantom Index"!

Amazingly, our most trusted indices, the DOW, the S&P 500, the NASDAQ 100, and others have become mere skeletons of their former selves. Recently, these indices have been based on as little as 30% of total trading volume on any given day! Markets have become so fragmented, with sub exchanges and dozens of HFT managed dark pools, that only a small portion of daily statistics float to the surface. The data we receive may be timely but are leagues from complete!

We bank sharply, and come about past the stern of the next ship. She’s a sleek, fast schooner. Her name? "Arbitrage"!

Imagine if you were able see the best bid/ask just a bit ahead of anyone else. What an advantage! Place a buy order just 0.0001 cent above the best bid. Place a sell order 0.0001 cent below the best ask. Now, when the next market sell order arrives, you have the best bid, and get it. When the next market buy order arrives, you’ve the lowest ask, thus you sell it and pocket the spread. This is a slow motion description of Latency Arbitrage. Do it a few million times a day and pretty soon you’re talking real money!

We bank and come about again past the stern of two ships sailing side by side. The first is the "SOR" and the second is the "Dark Pool".

An experienced retail investor uses limit orders. However, limit orders might now be more of a hinderence than a help. Recently, brokers channel market orders through Smart Order Routers. The SOR sends the orders through HFT owned Dark Pools. So any, if not every, potential match to your limit order is intercepted in the dark pool at a tiny 0.0001 cent improvement over your order. The broker will get free execution for itself and a fill for their client. The HFT will capture the spread and a fill for their client. And you? Well you get to wonder why it’s taking so long to fill your order!

HFT equipment is designed to squeeze out every millisecond of delay. An HFT will subscribe to private data feeds and collocate their equipment close to the exchange servers. More speed means more profit, which brings us to the last ship in this flotilla. Again we bank and come about, but it’s gone! It was there a moment ago! There’s a reason for this. The ship we seek is a ghost ship. It’ll appear from nowhere, for no reason. It will wreck your trade and disappear. She’s the phantom that goes by the name "C Glitch".

An HFT algorithm is like a superfast powerboat. When skimming over the water’s surface at 200 mph, the slightest wrong ripple will destabilize, flip, crash and smash it to pieces in just seconds. Algorithms have the potential to do the same thing. They played a key role in the Flashcrash, the Knight Capital debacle and the BATS IPO failure. However, there’re a few others you might not have heard about:

The Equity Sea has become rife with privateers. Perhaps we need regulation? Not so fast! You see, these privateers are legitimized by Letters of Regulation.

Reg NMS requires that orders be routed to the market with the best price:

Now combine Reg NMS with Reg ATS, which opens the sea lanes to Dark Pools:

Lastly is the loophole. Rule 612 prohibits sub-penny quotes, but ignores sub-penny trading:

Add the three together and you have the perfect platform for High Frequency Trading.

Regulations have inadvertently scuttled a stable market system which assured participants of an orderly and liquid market. METAR has discussed HFT many times. Unfortunately, by focusing on HFT, we are being short sighted. Automated trading in and of itself is not the problem.

The albatross turns back towards land. Below us is the wide expanse of the Equity Sea. This ocean of liquidity itself is a danger that we can see, but do not perceive.

The ”for profit exchange” industry is growing rapidly. For example, ICE recently purchased NYSE-Euronext. Both are for profit exchanges. Both have sub-exchanges and dark pools. Ice plans to IPO “parts” of NYSE-Euronext. Here are the components of NYSE-Euronext trading venues:

And of ICE:

We are sure to see more IPOs, mergers and spinoffs. I would not be surprised to hear of a “For Profit Exchange” ETF in the near future! Consider this list of major global exchanges:

Click on any of those exchanges. Look for the summary box on the right side of the page. Note the related subsidiaries, sub-exchanges, dark pools, alliances and composite indicies for most of those major exchanges. The potential for further fragmentation is impressive, isn’t it?

What is desperately lacking is governance of this trading venue build out. And it is needed quickly. Further, regulations alone are not enough. 21st century market governance will have to be as technology sophisticated as the market which they monitor. Also keep in mind that many of these for profit exchanges not only trade across asset markets, but also across borders. Imagine the complexity and systemic risk of cross border arbitrages on cross asset trading taking into account latency over long distances! Governance might actually need a multinational agency.

As evidenced by HFT trading in US markets, we are clearly moving in that direction. At the twilight of 2012, we should resolve ourselves to better understand our own broker’s venues. What are average order execution times? Is auto-routing quicker than direct routing? What are the direct routing choices? We can neither see a millisecond difference nor a sub penny increment. But if enough savvy small investors make it a point to use the best possible routing, it will become noticed. After all, we are constantly being reminded about the lack of investor confidence and of the billions of sidelined capital.

At the dedication of its new building in 1921, New York Curb Exchange Commissioner Edward McCormick correctly perceived the sea change taking place in his time. So too it is in our time. The die has been tossed. There’s no going back. With government as dysfunctional as it is here and abroad, high frequency privateers will continue to profit from our trade routes unchecked for years to come. The best that we can do right now is learn how to make our small trades as efficient as possible to educate ourselves as much as we can to avoid the risks of trading in this changing sea.

Your anchored Fool,


The High Frequency Traders who broke the story and authors of ”Broken Markets”:

For more detail on ‘Dark Pools’, I refer the reader METAR’s very own yodaorange:

In all fairness, here’s evidence refuting a direct link between HFT and volatility. It isn’t a complete repudiation but it is a counter point:

Lastly, if you’ve made it down this far, I’d like to wish each and every one a very happy and healthy New Year and may you navigate all of your 2013 challenges with success!-------FM
Print the post Back To Top
No. of Recommendations: 9

Thank you for posting this combination of entertainment and hair raising fear.

I think you have hit the mark very well (pun intended). The success of the individual retail investor exchanges is of little consequence to the exchanges. They make money based on the number of trades and the HFT'ers are their bread and butter (and, of course, they have no incentive to restrain them).

It is far easier today to trade across borders. We see the security industry in NYC blackmailing the authorities by saying that their move to London if they don't get things their way. In London, they blackmail the authorities with the risk that they will move to NYC. In fact, if a move were to take place, it would likely be to neither of these locations.

The "physical" location of an exchange is simply where their office is located. This location attracts the HFT data centers which collocate (and provide much of the exchanges revenue - not only through trading, but through IT location rental costs. If the exchange were to move, it would need good data connections, cheap (or at least reliable) electricity and the agreement of its customer base to accept the new location of their data processing equipment. Throw a dart at a map and you can pick the continent of your choice.

Can governments retaliate? Sure - if an exchange was disenfranchised from being authorized to trade US shares, for example, that could be a body blow. Could that happen? Well, I met a Swiss banker last summer whose bank had been potentially fatal damaged by being prohibited from using the SWIFT international bank wire system (whose data center is located in the US) because they had been sheltering US tax cheats (this is a different, but equally interesting activity where the US imposes its domestic laws on a foreign government's banks).

Anyway, as long as the exchanges bring tax revenue into the US (or UK) coffers, there is no political incentive to change things. The threat of leaving is only semi-serious because the exchange would risk its ability to trade effectively. The fact that the individual investor is not only at a disadvantage, but subject to being gored is of no particular interest to the majority of Americans for the same reason that they are unconcerned with whether the income tax system is fair as long as they are not adversely affected with higher taxes.

In short, you are right in your assessment and no one is going to make things better (though downhill is always a possibility).

Wishing you and your family as well as all of the readers of METAR and their families a coming year of excellent health, happiness, prosperity and the free time to enjoy them.

Print the post Back To Top
No. of Recommendations: 4
FM, a terrific post -- cinematic and informative. We may need to rename ourselves as LMETAR Literate Macro Economic Trends and Risks.

21st century market governance will have to be as technology sophisticated as the market which they monitor

My key issue.

david fb
Print the post Back To Top
No. of Recommendations: 0
FastMike, thank you for this wonderfully informative post. I think it's the best you have ever written. (Didn't I say that last time?)

Now my head is spinning. This is so scary.

What's a small investor to do?

Print the post Back To Top
No. of Recommendations: 0
"...What's a small investor to do?..."

Dear Wendy et. al.,

Well that's an easy one to answer! Play the M&A guessing game, for one. And second, determine which for-profit-exchange is 'best in class'.

After all, if you can't beat 'em join 'em.

Your jolly Fool
Print the post Back To Top
No. of Recommendations: 0
For Black Bart Roberts was a merciless, cold blooded, ruthless, teetotal Baptist pirate captain who through diligent application of his villainous traits as well as virtuous ones, had made himself the most successful pirate, ever, in the history of the New World.

In addition to providing insight into why execution of my small limit orders sometimes seems strangely delayed, you have given me the cultural/historical reference for why Robin, the cursed Baronet, referred to himself as a "Bad Bart" during his confession to the villagers in Gilbert & Sullivan's "Ruddigore" (or "The Witch's Curse).

In G&S's 19th Century England, no doubt, Black Bart ("Bad Bart") apparently was an icon, of sorts.

Somehow, I doubt that the perpetrators of stock market piracy (via latency arbitrage) will be sufficiently well-known to future opera-goers as to provide the subject of a humorous chorus.

Print the post Back To Top
No. of Recommendations: 2
"...providing insight into why execution of my small limit orders sometimes seems strangely delayed..."

Dear hound:

Black Bart also gets a cameo mention in R.L. Stevenson’s ”Treasure Island”. It seems that people were literally traumatized! They were real bad dudes!

Let me mention a quick personal experience. I had been wishing to get into FOREX trading for years. Then my discount broker acquired a fabulous trading platform. Best of all, it had a ‘mirror image’ practice platform. I learned enough about FOREX to realize that it was heavily dependent on ‘technical analysis’ and indeed, it responded extraordinarily well to technical moves.

I had price channels nailed. And I mean n-a-i-l-e-d, nailed.

In practice, I nailed trade after trade after trade.

Then I moved to real time. I got mangled. But I observed something that I didn’t understand until relatively recently. I’ll bet you noticed the same thing. My real time chart marks the price of my limit order. (So did the ‘trading ladder’). I set up everything the same way. And, again I nailed the channel…. But….. time after time after time ……… after time, the candlestick “touched” my price but never enough to execute. I mean like dozens of times. When the trade finally did execute….. whack….. the pair I had just went long on fell like a stone.

Then I thought: “AH! FOREX is just too complicated for me. And this is what I convinced myself of after racking up nearly a million “practice dollars”. DUH!

I was suspicious, but figured, “well who would care about my dinky little trade?” Well, shiver me timbers! Somebody did care! If an institution trades blocks though an HFT, well the HFT will break it up in small trades into small pieces, the size of the trades that you and I make. That’s why you probably seen that “unusual” chart activity. That block order was sitting in that pool, waiting for the SOR to pass orders through that would have matched your but betters it by a itsy bitsy 0.0001 cent and as soon as a match for your order passed through it got gobbled up! And it was gobbled up because Reg NMS says that the best offer gets the trade, even if it’s only 0.0001 cent!!!!!

That wasn’t the end of it! Many institutions don’t want to get scalped by HFTs. So they jump through hoops to avoid being pick off by an HFT. While researching “Bart”, I uncovered several University Research papers which were trying to develop “counter measures” to be used by institutions to identify HFT. I mean like mind numbing probabilistic calculations used to determine HFT activity.

Hound, there’s a real war going on the Equity Sea, between block traders and HFTs!!!!! We’re just collateral damage!!!

Two things: first, I only skimmed the surface. Yoda has posted some real good stuff on HFTs and Dark pools. It would be nice if he would repost the links. I posted one of his links in the post script notes. Second is a recent publication call “Broken Markets” by Saluzzi and Arnuk (I’ve no personal interest except to alert METAR to this great expose).

As for my stock trading platform? It's outrageously GREAT! Unfortunately HFT makes it usless. Markets have changed like you simply couldn’t imagine.

Your battening down Fool,
Print the post Back To Top