High Frequency Trading vs. the Dead Specialist: Did We Get What We Wanted?

Boxing

Introductory Note: We don’t normally air our internal debates for public review, but in this case we do so for two reasons: 1) it illustrates how we encourage differing views to achieve consensus, which in turn strengthens our culture and service to clients, and 2) it sheds unique perspective on today’s hot topic of high frequency trading and “are the markets rigged”?

Our Chairman Emeritus Gene Hoots starts, our trader Charlie Bettinger rebuts, and Gene then responds. Despite their different views, we actually believe they share common ground… but we’ll let you get to the end before we offer our conclusion!

Gene Hoots, Chairman Emeritus, in response to the High Frequency Trading debate:

Personally, I am no more concerned about this than I was when the specialist stood on the floor and could see all the orders.

The specialists were supposed to “maintain an orderly market” in their assigned stocks.  But I never heard of a specialist who lost much money.  It always seemed to me like a sealed bid auction in which the auctioneer got to open the bids and then bid himself, if he wanted to.  The story, probably apocryphal, was that Meyer Lansky, the Mafia Don in New York, was given a tour of the floor of the NYSE.  Upon hearing the function of the specialist, he said, “I’m in the wrong business.”

I doubt this activity is costing us as much as we paid in the “good old days” when there was no fast trading, but commissions ran from $0.25-$0.50/share to trade and quotes were in 1/8ths  so that the bid/ask spread was a minimum of $0.125/share. (Note: trading costs have now fallen to less than $0.03 or $0.04 cents a share.)

Charlie Bettinger, our trader, countered:

After 10 plus years of working on the floor of the NYSE as a clerk and in the capacity of a Specialist, allow me to defend against the negative generalizations directed at the integrity and honesty with which my colleagues and I carried out our fiduciary duties.  Here are the types of things we did:

Provide Liquidity:  You say you never heard of Specialist losing money?  Who was it who bought stock when bad news came out about a company or sold stock when the news was good?  It was the Specialist providing price stability and liquidity when there was none to be found elsewhere whether he was getting crushed on the long or short side.  Watch a stock in today’s market when negative news comes out, the bid side looks like the Grand Canyon because the electronically controlled markets can’t get out of the way of the sell side fast enough.

Transparency: It was my fiduciary responsibility to provide accurate “color” or looks into the stocks in my panel as to how the book looked with regards to the depth of electronic bids and offers and who the other active brokers were in the security.  I saw several Specialists’ lose their badges for not doing so.  With regard to your auctioneer analogy, everyone got an accurate look at what was going on in a stock—it was the law—but what the Specialist didn’t know when they said, “take em” or “sold”, was whether or not a buyer or seller had a million more shares waiting to be sent down to the floor from the trade desk upstairs.

Error Management:  There were never mini crashes or flash crashes from erroneous electronic orders when the Specialists’ were there.  Countless times we caught bad market orders and prevented dramatic price fluctuations in securities by freezing the order, identifying the brokerage house behind the order, contacting them to verify and then more often than not canceling the bad orders.  We knew the brokers behind the order flow.  Try to find out who’s behind the other side of an order today and you’d have better luck finding Big Foot.

Stability:  I was proud to return to the floor to get the markets running again after the September 11 terrorist attacks.  That Monday we opened down 500 points right off the bat and our firm lost millions of dollars.  Those losses continued to mount for the remainder of the year as the country searched for stability; they were not simply wiped off the books but were reflected in our salaries and bonuses.  NASDAQ, the supreme electronic market, crashed numerous times before finally being able to stay open a day after we’d been running full on.  We went in every day while the smoldering remains of the World Trade Center building and the rows of armed national guardsmen reminded us of the possible danger of working in the building that symbolized the heart of American Capitalism.

I learned how to trade on the floor, I learned how to negotiate and haggle and how to manage people and responsibilities.  All these skills I use at Corner Cap to seek the best trade executions, haggle for the best fixed income deals, or negotiate terms for service contracts and commissions.  My capabilities on CornerCap’s trading desk is a direct result of the experience and skills I gained while working on the floor.

Certainly as in any business there are those who take unfair advantage of opportunities for their own financial gain and there were some on the floor that were guilty of this but they were found out and removed.  The vast majority of people I worked with were hardworking, honest folks busting their butts for their clients and colleagues just like the people here at Corner Cap.

Just as it would be unfair to compare and judge all money managers by Bernie Madoff, it is unfair to characterize the Specialist with a negative broad brushed stereotype due to a few bad apples.

Reply from Gene Hoots:

Good response, Charlie. There are always two sides to every story.  I wrote from the viewpoint of a customer who only has seen commissions and bid/ask spreads decline.  And as someone who sat far away from the floor of the NYSE and who repeated anecdotal stories.  You gave the front line, in the trenches version – unquestionably the more thoughtful and accurate.  

There is an opinion written in today’s WSJ, claiming that this whole mess has been created by well-intentioned rules from Washington that have led to unintended consequences.  And that if the market were left alone for people to choose, they might actually gravitate back to the NYSE floor specialist system.  Who knows?  In 1981, Dean LeBaron  was doing computerized trading at his firm Batterymarch.  He said then that there was no need to have humans involved in the process.

Now thirty plus years later, we have what he envisioned, and this system has its own flaws.

CONCLUSIONS?

Gene and Charlie actually aren’t that far apart in this debate. They both agree that the market was not transparent during the Specialist days, and that it is arguably less so today with electronic complexity. Ironically, electronic trading was designed to correct the lack of transparency in the specialist world—which has not occurred.

As Charlie says, the vast majority of specialists were ethical. As Gene says, the handful of specialists who were not could ruin the reputation of the group.

The reality is that, as is always true on Wall Street, most players ethically police themselves, but the system itself does not self-regulate well, which enables a few bad apples to gain at others’ expense.

This is why, as Gene, Charlie and all of us at CornerCap would agree, we need transparency and a level playing field (but not necessarily dense regulation!) for all participants—mainly to guard against those few who take advantage of its inevitable flaws.