How MM's can influence the market

Discussion in 'Retail Brokers' started by Privateer, Mar 3, 2000.

  1. Hello to all Elitetrader fellows. I found this article about Knight/Trimark on RB recently. It's from a WSJ journalist. It gives some very interesting insight on MM's business and how it can affect all of us daytraders :

    For everyone interested in the MM system and how it works, and since I have owned NITE (boo, hiss) for a long time, and since NITE is the major manipulator of USTI stock - this is an interesting read from today's WSJ:

    By GREG IP
    Staff Reporter of THE WALL STREET JOURNAL

    When Inc. released good news early one morning in December, before the Nasdaq Stock Market opened, many online investors thought its stock would open higher. Kenneth Pasternak knew it would.

    Mr. Pasternak sat before a screen at Knight/Trimark Group Inc., a market maker whose job it is to execute trades. His screen showed that orders to buy Egghead exceeded orders to sell by 100,000 shares. Because it would be Knight's job to fill those orders, Mr. Pasternak quickly went to work, buying up 50,000 shares in informal trading before the market opened. When it did open -- with Egghead sharply higher -- he sold them to online buyers, nailing a quick $15,000 profit.

    Most online investors know little about Knight, but Knight knows a lot about them. In five years since its founding, Knight has ridden the online-trading explosion to become the country's largest market maker, executing a huge 21% of Nasdaq dealers' trading volume (and a third of the smallest issues), as well as 7% of volume in shares listed on the New York Stock Exchange.

    Seeing all those orders gives Knight what Mr. Pasternak, its chief executive, calls an "informational advantage": exclusive intelligence on which it can trade for its own profit. "We're smarter than the market in aggregate and we're able therefore to make a determination whether the stock will go up or down," he says.

    So even as Knight executes the trades of thousands of amateur day-traders, the firm is, in effect, a day-trader itself. Most of its nearly 400 traders are paid solely on the basis of profits they earn for the firm. As a day-trader, Knight is surely one of the most successful: It hasn't had a single losing day this year.

    Moreover, unlike most of the online brokerage firms it serves, Knight is very profitable. Its net income more than doubled to $168 million last year, and its stock is up sevenfold in the 20 months it has been public.

    All this success is a magnet for both admiration and criticism. "They've built a great firm in terms of automating processes and serving people," says Bill Burnham of venture-capital firm Softbank Capital Partners. But, he complains, the people at Knight are "taking information about retail customers' intentions to trade and using that information to improve their own proprietary trading profit, at the expense of their customers and of other participants in the market." Similar criticism is leveled at other market makers who fill orders from discount brokers' customers, such as Schwab Capital Markets, a unit of Charles Schwab Corp.

    Knight is hardly alone in trying to profit from the prices at which it trades with its customers. But Knight's end-customers aren't big institutions but mostly small investors, often not aware of the mechanics of order execution. Nor do they have any choice in the matter, because many major online brokers send all their orders in particular stocks to Knight or another such firm for execution, in return for payment.

    Brokers defend this practice by praising Knight's service. The firm has "very robust liquidity, their service and support have always been good, their speed of execution is right up there," says John Chapel, head of U.S. brokerage operations at broker TD Waterhouse Group Inc., which sends about half of its Nasdaq orders to Knight.

    As for Knight, it deserves no criticism, Mr. Pasternak says. He argues that Knight, by promising to buy when investors want to sell and to sell when investors want to buy, is giving them free and valuable access to its capital, plus instant execution of most orders at the best price posted in the country.

    Mr. Pasternak wasn't among the Wall Street chiefs debating the stock market's structure before the Senate Banking Committee earlier this week. But he had a lot to do with why they were there. His firm, more than any other, has thrived on the fragmentation of stock trading that most of the chiefs bemoaned. It has done so by, in effect, becoming the biggest fragment.

    It happened almost by accident. Mr. Pasternak studied to be a teacher but taught just one semester before quitting to join a market-maker firm. In 1995, he and a colleague, Walter Raquet, set up their own market maker, which evolved into Knight. They made more than a dozen discount brokers co-owners. The pitch was twofold: If the brokers sent the firm their orders for execution, they would benefit both indirectly by their ownership, and directly by the payments the firm made for their "order flow."

    The subsequent explosion in online trading would have been enough to make Knight a success. But something else crucial happened. Nasdaq market makers historically profited from the spread between the bid price at which they bought stocks from customers and the offer price at which they sold. But in 1997, a federal probe of dealers' practices resulted in new rules that squeezed these spreads. The squeeze was made tighter still when stocks began trading in sixteenths instead of eighths.

    With profitability collapsing, many dealers stopped making markets and sent their Nasdaq orders to "wholesalers" such as Knight or Schwab Capital Markets, which make markets in thousands of stocks for other brokers. Such firms, Mr. Pasternak told investors in the 1998 prospectus to Knight/Trimark's initial public offering, would no longer profit primarily on spreads. Rather, they would "take advantage of the profit opportunities represented by each trade."

    As Mr. Burnham puts it, "Nasdaq has been transformed from a market where people make money off spreads to one where people make money off information. When the market was so much more fragmented, it was hard to be right. But when you have 30% of the order flow, you can make some damn good guesses."

    Mr. Pasternak concurs. Computers automatically fill the vast majority of orders Knight is charged with executing, leaving most of its 393 traders free to try to take advantage of the information these orders reveal about the market.

    The trader ethic begins with Mr. Pasternak, who mixes the jargon of financial theory with the expletives of a trader. Seated in a vast trading room in a Jersey City, N.J., tower overlooking lower Manhattan, the 46-year-old CEO explains that Knight profits by combining many bits of information about market trends with calculated risks.

    Oracles and Eggheads

    One morning last summer, Oracle was trading at $34. What would happen if it fell a point? Mr. Pasternak opened his file of limit orders, those that can be executed only if the stock hits a price the customer specifies. There were 13,000 shares' worth of buy orders between $33 and $34, but orders to sell 2 1/2 times that many shares between $34 and $35. Knowing of this selling pressure, Mr. Pasternak would hesitate to buy Oracle, and he might even sell it short, betting on a decline.

    Or consider that Egghead morning, late in December, when the company put out the news that it ranked in the top 10 e-commerce sites. Faced with a 100,000-share imbalance of buy orders over sell orders, all of which Knight had to fill, Mr. Pasternak bought half that many Egghead shares in unofficial pre-opening trading, which takes place mostly among brokers and other institutions.

    That would take care of half of the buy orders, but now he still was obligated to sell 50,000 more shares to online investors. He didn't own them. So he decided to go short-selling the investors 50,000 Egghead shares that Knight had borrowed, to be replaced later after a hoped-for fall in the price.

    The move looked smart as the stock weakened slightly just after the opening. "I was informationally advantaged," Mr. Pasternak says.

    But then it turned dicey. A second wave of buyers sent Egghead shares climbing. Knight at one point had a paper loss of $250,000. But the stock slid sharply by the end of the day. Knight made a profit of $100,000.

    But what about small investors? Softbank's Mr. Burnham says that while buyers got Egghead stock at the opening price, as promised, perhaps that opening price would have been lower if not for Mr. Pasternak's heavy pre-opening buying. "Kenny wouldn't have bought those 50,000 shares if he didn't know they wanted to trade at the open," Mr. Burnham says. "He used their own information against them."

    Crossing the Market

    Knight promises to execute, at the day's opening price, the first 250,000 shares' worth of buy orders sent to it before the opening bell. But other traders say that before the opening, wholesalers -- and Knight in particular -- regularly use aggressive trading tactics to push a stock up or down to favor the positions they will have to take when they execute the orders. All the wholesaler "cares about is getting the stock up to a level where he can fill all his orders profitably," says Matthew Johnson, head of Nasdaq trading at Lehman Brothers. But "where it opens is not necessarily in the best interest of their customers."

    In normal markets, the highest bid (to buy) is just below the lowest offer (to sell). Yet it's not uncommon, traders say, for Knight to bid more for a stock than the lowest offer to sell it, and to offer to sell a stock for less than the highest bid to buy it -- an anomalous situation known as "locking" or "crossing" a market. This anomaly leaves the best-priced order unfilled. But it forces the market in the direction the firm wants it go. Nasdaq restricts crossing during the day but permits it before the opening.

    "It's not unusual to see the large wholesale firms leading the pack on some of these locked and crossed markets on most openings, and clearly Knight is the name that's pre-eminent," says Patrick Ryan, president of Ryan, Lee & Co., a small brokerage firm in Washington, D.C. Still, he says the problem results more from the behavior of Knight's end-customers than from Knight itself. If Knight is "sitting there with unsolicited orders from a group of gamblers -- who figure 'P.T. Barnum was right, if I pay $90, someone will pay $92' -- clearly it's buyer beware."

    Circling theglobe

    Consider the day went public, in November 1998. The new issue was priced at $9 a share. Small investors swamped dealers with orders to buy at the start of trading. Shortly before the opening, Nasdaq records show, underwriter Bear Stearns & Co. was offering to sell shares at $70. Yet shortly afterward, Knight bid $75 for them. Then Schwab Capital Markets bid $80. Bear lifted the price at which it offered to sell shares several times, finally to $90, but Knight and Schwab again bid even more than the offer price.

    The shares opened at $90, and within minutes, Knight executed purchase orders by selling more than 450,000 shares at $90, Nasdaq records show. The stock got as high as $97 that morning, but closed the day at $63.50. Many investors were shocked by how much they ended up paying.

    Schwab Capital Markets President Lon Gorman says there was an "irrationality" in the market that day, and he has since led an investor-education campaign "to make sure that never happens again." Speaking more generally of the criticism of wholesalers, he says: "The notion that there's something going on in the back room, that you get an execution that's inferior, is totally bogus."

    As for Knight, Mr. Pasternak says it loses money almost every morning because of its guarantee to fill orders at the opening price. That crazy morning, he notes, the buy orders that market makers had to fill at the opening bell exceeded all the shares in the IPO. Mr. Pasternak says he will occasionally place a bid higher than the offer "if I don't like how the market is pricing."

    Knight promises online brokerage firms that when it gets an order, it will automatically execute it at the best price anywhere, even if it's not Knight's quote. To execute buy orders, for example, the firm buys shares and keeps them briefly in inventory, risking a price decline before it gets rid of them.

    But Knight takes steps to limit its risk. For example, it chooses whom to trade with. Mr. Pasternak welcomes the "uninformed" orders of thousands of individual investors, because he is confident that, on average, Knight will be smarter than them. And just as a casino bars gamblers who consistently beat the house, Knight's systems watch for investors who consistently make money trading against the firm. For such a customer, Knight may restrict or suspend the promise to automatically execute all trades at the best price posted anywhere.

    Knight also occasionally suspends this promise during "fast markets." Suppose a mention on CNBC triggers a surge of buying or selling in a stock; Knight can suspend automatic execution after it has accumulated a long or short position of, say, 25,000 shares. Then it switches to manual execution and fills orders only against another customer or another dealer -- a slow process during which the stock may move a lot.

    Knight tells online brokers when it has restricted automatic execution, but the brokers typically don't notify investors. In a volatile market, an investor may not get his order executed for several minutes.

    Christopher Vu of Houston entered a market-price order for 10,000 shares of Books-A-Million with broker Brown & Co. one day in November 1998, with the stock at just over $29. Brown sent the order to Knight, but Knight didn't fill it -- that is, sell Mr. Vu the shares -- until six minutes later, some at $37 and the rest at $38.

    With the stock just below $40, Mr. Vu, who thought he had bought the 10,000 shares but wasn't sure, sent an order to sell them. Five minutes after receiving that order, Knight executed it -- at $33.50. Mr. Vu, who had expected a $9,500 profit, lost $4,500. "I was totally taken aback," he says, adding that he wasn't aware Brown didn't execute orders itself.

    While his order was awaiting execution, trades took place elsewhere at better prices, notes Mr. Vu's lawyer, Philip Aidikoff, in an arbitration against Brown. He argues that a broker that doesn't go to other venues -- having agreed to send orders to a single market maker -- may be breaching a fiduciary duty.

    Brown says Mr. Vu has no case, because Brown didn't do anything to slow the execution, and Knight's service wasn't in any way defective. A spokeswoman for Brown's parent company, Chase Manhattan Corp., adds that Knight is "consistently one of the best in terms of their execution speed." Mr. Pasternak says that he isn't familiar with this case, but that such incidents typically arise when automatic execution is suspended; he says he would like to find a way to notify investors when it is.

    Regulators and some Wall Street firms are increasingly wondering if dedicated order-flow arrangements are hurting the quality of the markets. Such deals enable a firm like Knight to "cordon off" a portion of the market that only it can see and trade with, says Ed Nicoll, CEO of Datek Online Holdings Corp. That means Knight's customers don't benefit from competitive bidding by other investors that might improve their price or force Knight to improve its price, he says.

    Mr. Nicoll's firm is a competitor to Knight through its Island ECN. Electronic communications networks, unlike market makers, merely display customer orders, against which other customers can trade directly. They don't pay brokers for dedicated order flow, and they don't make trading bets.

    Mr. Pasternak says ECNs don't provide what individual investors want and what Knight provides: certainty of execution, at the best price anyone is posting, and the rock-bottom commissions that payment for order flow helps make possible. "Put a button on everyone's computer," he suggests, "an ECN choice and market-maker choice -- and let the customers choose."

    Write to Greg Ip at

    Good Trading
  2. Very nice post !!!! Thanks to you.
    It just shows and confirms my bias
    AGAINST nasdaq and any of these CASINO
    firms who are the 'sock-puppets' of
    such market makers. There is no due
    dilligence of informing the MM practices
    and pitfalls of many nasdaq stocks.
    The selection of nasdaq stocks to trade is pivotal to success and it always
    hushed and we all so proud how ECN's
    are 'saving the world' of over the
    counter trading and maintaining a clean
    business. It's lightyears away from
    being even functional. NYSE is far the
    better place to trade !!!!!
  3. Scalper23


    Very informative. I day trade the Q's at Brown usually profitably until sometime last week when the orders were consistently being held and filled 5 to 10 cents away from the market. Now I think I understand what happened. I got tagged as someone who was beating the house.


    I do have one question? When was the article in Journal?

  4. Dustin


    That article is from early 2000. There was quite a fuss about it back then. I think Knight's practices have changed a bit since then. Here is a follow-up article from May 3rd, 2000:
    Nasdaq Looks to Protect Investors
    From Dealers' Pre-Opening Trades
    By GREG IP
    Staff Reporter of THE WALL STREET JOURNAL

    The Nasdaq Stock Market is considering new rules on how dealers trade before the market's regular opening, responding to concerns that such trading may sometimes hurt investors.

    The rules under consideration would require Nasdaq dealers to give customers the benefit of any prices that the dealers obtain by trading before the regular 9:30 a.m. EDT opening. Currently, that obligation doesn't ordinarily exist.

    The proposed rules, outlined in a memo from Nasdaq to its Quality of Markets Committee, appear to reflect a concern that dealers, by trading before the opening, may be taking advantage of their knowledge of investors' trading intentions, sometimes at investors' expense. For example, a dealer with many buy orders of a stock might snap up shares before the opening, then sell them at a higher price to investors at the opening.

    "Nasdaq staff have recently become aware of certain practices in the pre-market that it believes adversely impact public customers," says the memo to the committee, which is Nasdaq's top advisory committee on market-structure issues and is made up of brokerage and institutional traders.

    Some brokerage firms are using information about orders their customers want executed at the 9:30 opening to trade before the opening, then fill those "queued customer orders at the open, at prices significantly above the firm's pre-market purchase cost," the memo states.

    The memo, dated March 20, followed a page-one article in The Wall Street Journal several weeks earlier about Knight/Trimark Group Inc., Nasdaq's biggest dealer, or market maker. The firm, based in Jersey City, N.J., executes hundreds of thousands of orders a day sent to it by online and discount brokers. The article described, among other things, how Knight uses knowledge of its customers' order flow, including pre-opening orders, to aid its proprietary trading. But it also noted that Knight's brokerage customers praise the firm's service, speed and willingness to use its capital to quickly give investors the best price on a stock anywhere.

    Richard Ketchum, who is president of the National Association of Securities Dealers, which runs Nasdaq, said Tuesday: "We are seriously looking at the trading rules governing the opening. But I can't comment on anything in particular because there isn't a hard proposal at this moment."

    The memo made no mention of any particular firm. But people familiar with the committee's deliberations said the issue arose because of the attention focused on Knight, though other dealers often engage in similar activity.

    Kenneth Pasternak, Knight's chief executive officer, said he was unaware of the proposals, but bristled at the suggestion that his firm's activity comes at investors' expense. "We don't make any money off the pre-opening," he said, and in fact the firm, though highly profitable overall, regularly loses money at the opening by guaranteeing the opening price to all eligible orders. "We're trying to add value, not detract value." It's the customer, not Knight, that has the edge, he says. "The customer chooses when we trade, at what price we trade, at what [share amount] and at what time."

    The memo describes a hypothetical situation in which a market maker -- a dealer who quotes bid and offer prices at which he will trade with investors -- has received 500,000 more shares of buy than sell orders to be executed at the opening. Using this information, the market maker buys shares before the opening, placing bids at successively higher prices, sometimes at or above another market maker's offer price (an anomaly known as "locking" or "crossing" the market). "At times the member will lock/cross the market without trading, which raises concerns of manipulation," the memo says.

    It buys 500,000 shares at an average price of $21.50, then sells those shares to customers at an opening price of $23.0625 apiece, profiting from the difference. "Nasdaq believes such activity is not in the best interests of public investors or the quality of the Nasdaq market," the memo says.

    The memo makes two proposals. The first is to require that a market maker that holds both a customer's limit order (an order that can be executed only within specified price limits) and a same-priced in-house order for itself, fill the customer's order first. That obligation, known as the Manning rule, already exists after 9:30 a.m., but the memo proposes it begin at 8:30 a.m. The second proposal is that market makers give customers' market orders (which are to be executed at the best available price) the benefit of any prices it obtains trading before the opening.

    Mr. Pasternak says his firm already applies the Manning rule to all its customers' orders, but those orders generally aren't eligible for execution before the opening. If they were, Knight would extend Manning protection to them as well, he says. He added that a market maker is taking on risk when trading before the opening, since the price can move against it, and customers can cancel their orders before 9:30.

    "I'm in favor of adding best-execution practices" to whatever rules the industry agrees on, he says. He has also said his traders must trade at the quotes they show before the opening, even when Nasdaq rules don't require it.

    The proposals face many practical obstacles, persons familiar with them acknowledge, such as how to divvy up a dealer's pre-opening in-house trades among an unrelated set of customer orders, and what to do if the dealer's pre-opening price is worse than the opening price.

    "Two totally different market dynamics" are at play before and after the opening, notes one person. Indeed, preopening trading is part of how Nasdaq's competing market makers and trading systems known as ECNs determine the right opening level for a stock. Nasdaq's plate is also full overhauling its routing and executing systems and preparing for decimal prices. But the memo notes that the Securities and Exchange Commission is placing greater scrutiny on Nasdaq's opening, where volumes are rising.

    Nasdaq's opening has long been criticized as sometimes being chaotic, but market participants differ on how to change it.

    One approach is to publicly display all market makers' limit orders. Because they show how many shares investors intend to buy or sell at given levels, limit-order files can provide market makers and stock-exchange specialists with valuable information on market trends. Thursday, the SEC is scheduled to host an industry round table on the subject.

    Mr. Pasternak says he supports the idea. "There is no justification for the age-old practice of market professionals walling off access to important market information," he told a subcommittee of the Senate banking committee last week. "It is neither fair to individual investors, nor healthy for the marketplace." Mr. Pasternak says limit-order information is not "central" to the firm's trading, and he would be happy to provide his firm's limit-order and opening-order information to a third-party information vendor.

  5. gh1


    Interesting articles indeed. Not really sure that it effects my trading in the least -- but interesting none the less.

    I do have a question though -- can somebody explain to me just exactly how someone can get "tagged" as consistanly beating the house? Do you really think that your brokers are giving the MM's your information, or that they, the MM's, have a way of identifying which individual is placing orders, and tracking their P&L? And then selectively slowing down your executions just to screw you?

    That seems to be slightly paranoid, and a bit far fetched to me. But if that type of practice could be proved -- well now, there is a great story! But, that MM's make money on spreads, fast markets, IPO's, and order imbalances -- hardly news.

  6. Scalper23


    I used to make that same arguement with fellow traders who claimed they were getting "screwed" by the MM. I felt instead of the MM being nasty it was probably a fast market or the traders didn't look at the size of the bid or ask. However, that was before I started trading 50 times a day in the same issue. I have been doing that for the last 2 months and I think I can tell when something has changed.

    I know that my fills for the last couple of days have been 5 to 30 cents aways from the Amex bid if I was shorting or the Amex offer if I was buying. According to Brown the MM is supposed to honor the posted Amex price.

    Granted it may be that it is a function of the current market or that my quotes have suddenly become stale after 2 months of not being so, but I don't actually believe either explanation. It seems logical to me that Knight has a system to identify traders that are eating their lunch and the above article lends support for that theory.

    I'll let you know if subsequent trading indicates otherwise.
  7. Baron

    Baron ET Founder


    If your broker doesn't execute your trades directly, but instead sells your orders to NITE, then surely NITE is receiving information about you such as your account number that it can link with your order and use for tracking purposes.

    However, if you are with a firm that doesn't sell order flow such as a direct-access broker, I doubt there's any information that NITE has access to that would identify you directly, especially if you execute the majority of your trades anonymously through ECNs.

    As a general comment, here's my two cents on that article:
    There is a root problem here that is causing most of the problems for traders and therefore giving NITE and similar firms advantages. The problem is that the rules for extended hours trading are radically different from primary market rules. Currently, a firm like NITE can post any quote they want causing the market to lock or cross. And on top of that, they don't have to honor any quotes that they post during extended hours, which is absolutely absurd. If firms are allowed to post quotes during extended hours trading, they need to be obligated to receive executions against those quotes...period.

    I mean, is it really too much to ask of NASDAQ that they structure their extended marketplace like a real market and not like a 21st century saloon with no accountability or legitimate participants?