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Market Fragmentation Shows High-Frequency Hazard

The May 6 crash shows how the fragmentation of U.S. stock trading across 50 venues dominated by computerized traders is hurting investors, executives from Invesco Ltd. and TD Ameritrade Holding Corp. said.

Regulations for market makers should be improved and better coordination among exchanges mandated, said Kevin Cronin, director of global equity trading at Invesco, and Chris Nagy, managing director of order routing sales and strategy at TD Ameritrade. They spoke at a meeting of the Commodity Futures Trading Commission and Securities and Exchange Commission.

U.S. regulators are exploring ways to avoid a repeat of the May 6 selloff, which erased $862 billion in equity value in about 20 minutes before the market rebounded. Cronin and Nagy said the plunge highlighted a deteriorating environment for investors where efforts to increase competition have left traditional buyers and sellers more vulnerable to predatory tactics by high-frequency traders.

“We have no incentives to post large amounts of liquidity,” Cronin, whose firm oversees $560 billion, said at the meeting in Washington yesterday. “We’re not sure what the value of a quote is.”

Mutual funds and asset managers often avoid exchanges because of concern about the strategies of some high-frequency trading firms, who may submit and alter quotations thousands of times a second, Cronin said. Atlanta-based Invesco believes some of those strategies may include manipulative activity, he said.

Execution Speed

The current structure is “too focused on the speed of execution over all other factors,” said Cronin, who considers high-frequency firms that make markets electronically an important source of liquidity. “Speed and price discovery have an inverse relationship and this dynamic needs to be better understood.” To elude traders seeking to profit from knowledge they glean about market-moving orders sent to exchanges, institutions use dark pools, or private venues that don’t display orders publicly, Cronin said.

The SEC under Chairman Mary Schapiro is trying to protect investors in an increasingly fragmented U.S. stock market while maintaining liquidity on venues dominated by firms that profit from computerized trading. Chicago-based Getco LLC, the high- frequency firm founded a decade ago, purchased rights in February to handle floor trading in 350 New York Stock Exchange securities as a so-called designated market maker. NYSE Euronext in New York owns the Big Board.

Liquidity Providers

Getco and other automated traders also provide liquidity on electronic systems run by companies such as Nasdaq OMX Group Inc. and Kansas City-based Bats Global Markets, through computer-driven strategies that can generate hundreds of buy and sell orders in fractions of a second. High-frequency traders make up more than 60 percent of U.S. stock volume, according to research firm Tabb Group LLC in New York.

Invesco and Omaha, Nebraska-based TD Ameritrade want obligations set by exchanges for market makers to be more stringent. They say firms should provide bids and offers for more shares to counter the decrease on exchanges in the average trade size, which has fallen to fewer than 300 shares. The decline has caused firms like Invesco, Fidelity Investments and T. Rowe Price Group Inc. to trade blocks of stock piecemeal over time to avoid moving the price.

‘Dispersed Structure’

“The dispersed structure of U.S. markets and the market’s increased dependence on liquidity providers” that aren’t required to publish two-sided quotes -- bids to buy and offers to sell -- helped cause the May 6 plunge, said Nagy of TD Ameritrade. The market includes “many players that use their liquidity opportunistically,” buying or selling when it suits them and standing aside when they don’t want to trade, he said.

U.S. Senator Charles Schumer, responding to concerns that high-frequency traders abandoned markets during the May 6 crash, said more financial firms should face a legal obligation to buy or sell shares. The Democrat from New York echoed a proposal submitted to the SEC last month by Getco and two other automated trading firms in suggesting tougher requirements on all venues.

Exchanges have been using new circuit breakers that temporarily halt trading across markets when a stock declines 10 percent in 5 minutes. The curbs were a sensible initial reaction although they “do little to address the underlying cause of the problem,” Nagy said. He added that better solutions may be measures limiting the price at which stocks can trade and giving market makers incentives to continue submitting quotes and to “post size,” or orders for a larger number of shares.

Circuit Breakers

Schapiro said that while “circuit breakers were the thing we could do fast and put in place,” the agency is considering alternatives or changes. Investors and brokers have criticized circuit breakers for halting stocks such as Citigroup Inc. on June 29 because of small, erroneous trades that were later canceled.

Schapiro the SEC may consider requiring orders to have a “minimum life” on exchanges before they can be canceled. Market makers could be exempted, she said. The agency may examine “limitations placed on the way trading is done today and some of those limitations might not apply to market makers,” to encourage them to display larger orders, she said.

Disrupted Trading

When trading is disrupted, “market-maker obligations will accomplish nothing,” said Michael Mendelson, principal at AQR Capital Management, the Greenwich, Connecticut-based hedge fund. The role of market making is “not to buy stock at the wrong price when the market is crashing,” he said. AQR doesn’t engage in high-frequency trading since it holds most positions for months, he said.

Added Noel Archard, the head of U.S. products at BlackRock Inc., “Market makers are there to help with the orderly flow of traffic in markets but they need orderly markets to operate in.”

While rule changes are needed, the “evaporation of limit- order books” on exchanges may have inadvertently benefited market participants on May 6 by prompting them to stop trading, shortening the selloff, Mendelson said. Limit-order books are an electronic record of buy and sell requests awaiting execution at a venue. The volume of available orders plunged during the crash as liquidity providers receiving erratic data removed their quotes, worsening the decline.

Dislocated Prices

A system should be developed to “better inform those participants of the live aggregate supply of liquidity,” Mendelson said. AQR stopped trading equities that afternoon and “avoided trading at dislocated prices,” he said.

The SEC has said it may change the use of market orders as part of its response to the May 6 plunge. Many sell requests that executed at prices as low as 1 cent were stop-loss orders used to protect against declines in stocks that converted into instructions to sell shares at any available price. These orders are used mostly by individuals.

“Invesco recommends that exchanges and broker-dealers only accept market orders that have collars on them,” limiting the price at which they can execute, Cronin said. Market orders should be rejected if they’re 3 percent away from the stock’s last sale price, he said. Similar treatment should also apply to stop-loss orders, he added.

Nagy of TD Ameritrade, whose clients have about $323 billion in brokerage accounts with the firm, said market orders shouldn’t be eliminated or curtailed. Prohibiting individual investors from using them would be an “adverse, misguided and unnecessary overreaction,” Nagy said. TD Ameritrade averaged 413,000 client trades a day in June, according to the firm.

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