The Transparency Fallacy
Part Two: How the SEC caused the flash crash.
September 20, 2010
Part two on how the SEC caused the flash crash….click here for Part one.
There is a lot of background to the storyline of this blog which I will attempt to fill in as best I can as I go along. The SEC lobbied Congress in 1975 to allow it to grant the National Market System (NMS) the authority to operate, which it did. Wunsch contends that its foundation was based on an inherent, but wholly untested theory by both academics and practitioners, that transparency is good. It was supported by the belief that increased transparency leads to better trading efficiency through lower trading costs, improved price discovery, more beneficial exchange organization and enhanced capital formation.
The first target of NMS was block trading because politicians thought it was a world reserved for the big guys and the little guys (retail) would always be the loser. Wunsch cogently contends that this is not the case and in fact the reverse is true. Block trading is not necessarily transparent and therefore it qualifies as a “dark pool”, at least in the minds of politicians. As such they feel it ran counter to the Exchange Act goals of “transparency, fairness and efficiency”.
The NMS is attempting, by curtailing block trading and upstairs trading through forcing all trades onto public screens showing all order flow, to create one gigantic “lit” market. I suppose this is a noble cause indeed, if the underlying assumptions are correct. Wunsch reasons they are not by pointing to the unintended consequences of the policies:
“By reining in dark pools, the proposed rules would hasten the ongoing transformation of the lit market into what is effectively becoming a giant, highly fragmented dark pool, characterized primarily by algorithmically shredded institutional blocks and high frequency market making.”
This is accomplished Wunsch contends by algorithmic order shredding, whereby an order is disassembled into hundreds, perhaps thousands of tiny orders executed in a multiplicity of dispersed venues. Their real purpose is to obfuscate not create transparency as none of the mini-trades mean anything individually and even less so in aggregate simply because of the volume and speed by which they are executed. If anyone thinks the public (read small investor) is any better informed under this regime, think again.
To me this is a hugely compelling point. I have always known that if you want to hide something, one can do so by providing too much information under the guise of being totally transparent.
But the meat of Wunsch’s assertion lies in the nature of the market structure itself. He learned with his own the exchange, the AZX, that the only way to accommodate full transparency was through what is known as a “call market”. Defined, a call market or single price auction is one where buyers and sellers meet at discrete points in time and reveal their order book to one another and determine a clearing price through auction. Even then many conditions must be satisfied to make it work.
The market structure we have is known as a continuous market which means that order flow can arrive anytime. If buyers and sellers cannot be matched, specialists or market makers provide temporary liquidity to ensure an orderly market.
The problem is that transparency is a non-starter in a continuous market, either as a trading strategy or market structure. This is not hard to figure out. Being the first discloser, that is the transparent one, simply invites the competition to pick you off. You will always be at a disadvantage. Consequently larger traders will do what they have to obscure the size of their order. No matter what regulations are instituted to promote transparency in a continuous market environment, large traders will find a way to obscure their order flow. What is important are the unintended consequences of these regulations.
More on that in the next installment.