Wall Street is stupid: BATS IPO edition

In general, stock exchanges have a perverse business model: they sell out their clients (investors) to market makers.  They give special trading advantages to market makers, who then use those advantages to fleece investors.  Now one of these stock exchanges (BATS) wants investors to buy their stock.  I doubt that it is wise to buy stock from people whose business model is built on cheating you.

I’d be interested to see which institutional holders participate in the IPO.  It will be a who’s who list of clueless portfolio managers and those who enjoy the graft that investment banks send their way.  (If investor interest is strong, there may be some Jim Cramer types who immediately flip their IPO shares for an easy profit.  While this practice is not entirely kosher, any portfolio manager who does this is at least trying to make money; I would not classify them in the stupid category.  If these money managers care about their clients, they would flip these IPO shares in client accounts rather than their own personal accounts.)

8 thoughts on “Wall Street is stupid: BATS IPO edition

      • Sorry I didn’t elaborate, but I have so many issues with Flash Boys that I didn’t know where to start. Lewis could have told the story about how wall street outsiders, through smarts and technology, broke through the NYSE good ol’ boys club, but decided instead to vilify them. The old school NYSE specialist had special advantages that allowed them to take money e.g. holding up your order and filling them only when they were out of the money. Remember the specialist and Grasso scandals? How is that any different now? Now, like in a foot race, everyone starts at the same starting line, but some are faster than others through better preparation and training. For example, you can send an order to the exchange using the FIX protocol or a faster binary one. The binary and FIX ports cost the same; binary order entry is no secret, its spec is right next to the FIX one. So why would anyone use the FIX one? Because it’s easier to code to and because it’s a standard that can be used across exchanges. I could go on and on, but if you truly are interested, there’s a book Flash Boys:Not so Fast, that walk through the all the inaccuracies in the original book. But it’s written by a guy that used to work at a hft firm. Before Flash Boys came out, I was also skeptical of any literature sponsored by the industry it defended, but now I wonder, while they do have a bias, they are also the most knowledgeable about how it all works. And why would Michael Lewis lie to us? To sell books. Unfortunately, reality is not as sexy as the story he’s trying to sell. I’m sure you’ve been disgusted by some crap article about something you know, but do you wonder about everything else that’s printed? Michael Crichton has a good quote about this (the “Gell-Mann Amnesia effect” ). Though the US markets aren’t perfect, just know that they’re not “rigged” as some might have you believe.

      • So please tell me why institutional investors aren’t allowed to use sub-penny pricing?
        Why are there more order types than what investors need?
        And what’s with the payment for order flow kickbacks? (*Affects mainly retail and off-exchange trading.)

        Also, the interview with the BATS CEO and Brad Katsuyama did not go well for BATS. While I don’t always agree with Zero hedge, BATS’ CEO at the time had to retract his statements because he lied.

  1. Good questions. The critics like to portray HFT as a monolith, all doing the same activity, but there are very different firms that all happen to use technology to trade. They also like to conflate a lot market structure issues such as sub-penny pricing, rebates, dark pools, colocation, etc, which creates confusion.

    So there’s a SEC rule that “prohibits displaying, ranking, or accepting orders priced at more than two decimal places for stocks priced at or above $1.00.” The most common way to get a sub-penny execution is to send a midpoint order in a penny wide stock (will not be displayed), An institutional investor can send this order type if their broker provides it. Interactive Broker has the order type. Another issue that gets thrown in is internalization and wholesaling. When a broker’s customer sends a marketable order, instead of sending it to the exchange, the broker takes the other side of the trade. In order to do that, they give price improvement, usually $0.0001. No one but the broker has access to that order flow. If they don’t have the capability to internalize, they’ll sell the order flow to a wholesaler (many which are classified as HFT such as Citadel and KCG), which will do the same thing. The reason they’ll pay for the order flow is because retail traders usually don’t have short term alpha or are not working a large order that no one wants to get run over by. The quote at the exchange (probably belonging to a HFT firm), on the other hand, is at risk of getting picked off by an institutional algo, daytrader, and even another HFT firm without getting the benefit of trading with less toxic flow. I think the issue is with the brokers more so than HFT, since there’s a conflict of interest. It’s funny how Schwab bashes HFT while selling their order flow to UBS, Citadel, and KCG.

    The reason there are so many order types is Reg NMS, specifically the disallowing of locked markets. So a bid at Bats (buying @ $10) can’t be displayed if there’s an offer on NYSE at the same price (selling @ $10). Why doesn’t he just send the order to NYSE if he wants to buy at $10? Because there are exchange access fees. To remove liquidity (lifting the offer), it costs an extra $0.003 (effectively $10.003), but if someone sells to them on Bats, they get a rebate $0.0002 (effectively $9.998), a difference of $0.005, which is huge when the margins for hft are around $0.0005, but for investors, it’s too small to matter. Even though it’s economically different, the SEC decided that it was too confusing to include the fees in the quotes. To attract liquidity, the exchanges created an order type that never pays the access fee (post only). So instead of locking the market, what Bats does (and so does pretty much every exchange), is display the order a penny back $9.99, but works the order at $10 (meaning if someone sends a sell order to Bats at $9.99, they would get filled at $10). But if the NYSE sell order @ $10 leaves, now Bats is allowed to display the order at $10. Now depending on the instructions, your order can stay at $9.99 or slide to $10. Having the ability to slide and keep your queue position prevents excessive messaging. When they didn’t have the price sliding feature, before a new price level opened, people tried to sneak in by pinging the price level continually. These order types are just how the markets adapted to the regulations.

    As for the Bats president, he did misspeak. I don’t know if he lied or was just mistaken, but I wouldn’t judge Bats based on that. Unfortunately, no one got to ask Lewis and Katsuyama about the many inaccuracies in Flash Boys.

    I may not have changed your mind, but I hope at least I got you to question some of the things you’ve read. Instead of arguing in circles, any changes to the market structure should be a/b tested so we can really see the effects.

    Anyways, I need to get back to family and taxes. Yes, we have families and pay taxes too :).

    • Thanks for the comment.

      The midpoint pricing (A) doesn’t work and (B) conflates the issue. The SEC Rule on subpenny pricing is a stupid one that gives special advantages to certain market participants. It’s bullshit.

      The sliding order thing is BS. It lets certain market participants camp at the front of the line even though they don’t have the balls to display the price that they are actually willing to trade at.

      Anyways… I guess this is a subject that really annoys me even though it largely doesn’t matter. Transaction costs have come down a lot.

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