*** COPYRIGHT - ALL RIGHTS RESERVED *** "BEYOND ORDER FLOW: SPECULATIVE FORCES AND FINANCIAL INSTRUMENT PRICING" rev. 0.23 Recently I came accross the work of Professr Richard Lyons, Haas School of Business, U.C. Berkeley and his collegues' work on currency price action ("New Micro Exchange Rate Economics"; http://faculty.haas.berkeley.edu/lyons/), and studdied it with great interest. I was grateful to discover rich acedemic research covering a field I had been analyzing myself for some time. His reports are rigorous, empirical, insightful, and indeed quite valuable. I say valuable because I consider there to be a pressing need for greater public scrutiny of financial markets, including the currency market. Academic efforts like this form one important prong of such scrutiny. I characterize his research as one small, but important, step in what will invariably be a longer "work-in-progress." Metaphorically, the work can be viewed as a flashlight illuminating a small part of a rather large, dark space. The sometimes frustrating aspect of investigative work like this is that finding the answer to one question often generates numerous subsequent questions as a result. For example, Prof. Lyosn has discovered that order flow is more valuable than traditional macro-economic variables in predicting price direction in the spot market. The next logical, and to my mind, more analytically-ellusive question is: what are the determinants of that order flow? Not macro-economics - Lyons's own research confirms this. What then, are the true factors that influence speculative market participants (spot buyers and sellers of actual currency attempting to profit from predictions of future price direction) to place their orders? My respectful assertion - and this gets to why I'm writing - is that a substantial amount of spot order flow is placed in a competative manner by larger participants (in terms of trading capital, or buying power) to manipulate price action via that flow with a view to ultimately forcing the contra-party to the trade (who is less capitalized) to exit their trade at a loss, and pocket the profit. If this is true, then a substantial amount of price action itself (necessarily, as the new research has proven) is the result of competative speculative forces. Precisely how much, particularly in relation to the powerful macro-economic variables, is a research topic. This seems unremarkable to me in light of my personal experience trading and analyzing financial markets, including the spot, but it may surprise academics or a public schooled in searching traditional macro-economic principles as the sole source of a causal relationship with price action. Of course this scenario - of competative speculative forces manipulating price action to profit at the expense of other such forces - is only possible (or rather, profitable) if there exists an imbalance, an advantage available to only some speculative forces and not others to realize profit. The imbalances that I am currently aware of take two forms: informational and transactional. Informational imbalances entail some speculative forces enjoying access to restricted information that empowers them to accurately predict the extent to which their manipulative order flow will drive spot price action to their benefit. Lack of access to this information seriously disadvantages the ignorant (or restricted) particpant vis-a-vis his more enlightened and well-capitalized contra. I have experience trading numerous financial markets, and have maintaned a keen interest in analyzing these markets from a theoretical/philosophical perspective throughout. I began trading the spot currency market only recently, and was intrigued (I won't say surprised) to observe that imbalances are evident in this market in addition to the other markets in which I have participated. My observations of the spot market coincided with my discovery of the new research; that's why I got excited enough to write. The insight derived from the research of Lyons et. al. was only possible because they were granted special access to otherwise-restricted data sets by certain (few) of the large, institutional particpants in the spot market. They were provided a very brief glimpse of the orders constantly flowing through these opaque institutional channels. This information was largely inaccessible by non-intra-bank participants when the research was conducted in 1995, and this informational imbalance remains largely intact today. I believe that the overall competative imbalance, as between a select few institutional particpants and the larger public, is even greater in the spot market than in the equities markets. That is because in the equities markets non-institutional participants at least have access to order flow information - to volume - via a mandatory, consolidated, publicly-available tape. All equities trades, including their size, time, and the identity of their transactional sub-market, must be reported to the tape. This consolidated reporting is one important, informational aspect of a true "National Market System". Lyons et. al. had limited access to a similar "tape" during their research into spot market order flow. Of overriding significance, however, is the fact that in the spot market, non-intra-bank participants do not normally have access to such volume information. Of course, knowledge of volume is crucially important to competative speculation in any market because it empowers trading participants to recognize valid opportunities from the price action. Traditionally it has been the better-capitalized, institutional participants who have benefitted from informational imbalance (or any other imbalance) at the expense of the much more numerous, but far less-capitalized non-institutional participants. The new research poignantly highlighted the woeful lack of spot currency order flow "data sets" publicly disseminated and available for research or speculation. There is another instance of imbalance - in this case transactional - explaining price action in a financial market, and I would appreciate any feedback as to my analytical framework with respect to this scenario. I believe that a collaberative approach to exploring this phenomenon (imbalance between competative speculative forces as a driver of price action) by interested observers is necessary to effectively advance valuable public knowledge. Although informational imbalance is largely redressed in the equities (and some other) markets due to the afformentioned consolidated reporting, nevertheless, a transactional imbalance exists there. This advantage enables insitutional participants to successfully compete in speculative order flow manipulation vis-a-vis non-institutional participants. Informational parity does not guarantee transactional parity; knowledge of an instrument's price action does not gurantee access to all of the sub-markets in which it trades, even though the trades flowing from those markets are transparently reported. In other words, knowledge of volume is only valuable to the non-institutional participant if it can transact with that volume. The tape is only a tape, it's not a market. Participants who have knowledge of particular sub-markets but who are nevertheless denied actual trading access to those markets will be forced to trade in other sub-markets to which they do have access, and likely experience profit-erosion as a result. The disdvantage experienced by the restricted participant is positively correlated to the volume quantum they cannot access in these "hidden markets". By "hidden markets" I mean markets in which order flow and/or access to that flow is hidden from investors and small traders (i.e. the larger public). CONTINUED NEXT POST
*** COPYRIGHT - ALL RIGHTS RESERVED *** Currently the trading of a huge volume of equities occurs in these hidden markets, whose existence we know of solely because of the tape reporting provisions of the National Market System, which reveal transactions that have occured in pipelines that are publicy inaccessible. The overall "market" for many equities, including those listed on the NASDAQ, the NYSE, and the London Stock Exchage, is actually composed of numerous "sub-markets", the largest of which are hidden. Within these "black-boxes" only large institutions can trade. I discovered this recently (approximately two years ago) when I stumbled across Liquidnet Inc.'s website (www.liquidnet.com), and began investigating this phenomenon in tandem with my equities trading. Other examples of gatekeepers for hidden markets include POSIT, Pipeline, and others I've forgotten. Significantly for transactionally-disadvantaged participants, and interested observers such as academics and policy-makers, in this case there is also a present attempt by a public regulatory body - the SEC - to redress the transactional imbalance via a policy of mandated access to order flow previosuly limited to institutional participants. The SEC is now attempting to stengthen the National Market System via Regulation NMS, which just became law in April, 2005 and will take effect later this year. The National Market System was originally created by Congress in 1932 via the Securities and Exchange Act and its subsequents (noteably 1975) to address the fraudulent practises then extant in financial markets. Mandated reporting of all relevant trade information, including volume, was one important prong of this original effort. Creation of an updated, universal "tape" put the old-school bucket shops (contemporaneously described by Edwin Lefevre) out of business. Unfortunately, the appearance of consolidated trade reporting was only a temporary victory towards the creation of a true NMS in the financial markets. Institutional participants responded to losing the informational advantage they and their bucket shop agents previsously enjoyed by replacing it with a transactional advantage. This advantage was made possible by the fact that, while it made significant progress in redressing much (but not all) informational imbalance, the NMS as originally-created did not require participants to honor (trade at) their publically-quoted prices. The regulatory framework was, and still largely is, silent with respect to mandated universal access to instrument trading. A fascinating (and isolated) historical example of a regulatory attempt to strengthen the NMS via redressing transactional imbalance - and one that was successful, though only temporarily - came in 1988, when the NASD mandated market-wide participation in its Small Order Execution System (SOES) transactional pipeline (or sub-market). This was concrete progress towards a NMS, and likely only garnered sufficient political support from regulators because of the public outcry following the crash of 1987 (which I believe was manipulatively caused by institutional participants in those markets as a way to exploit and profit from the absence of a mandatory trade execution regulatory scheme at the time). In creating the SOES sub-market, the NASD required particpants who quote in that sub-market to transact at their quoted price, thereby increasing public transparency in that sub-market and imbuing it with greater "NMS-like qualities". Institutional participants realized significant profit-erosion at the hands of investors and small traders, and responded quickly by moving an ever-increasing amount of their volume to the afformentioned hidden markets. This eventually rendered SOES and the other, "second-generation" NMS regulations ineffective. The popularity of hidden markets amongst institutional participants has increased dramatically in just the last few years, evidenced by the explosion in volume transacted in them. The CEO of the NASDAQ himself recently resigned his post to create a new hidden market. The result has been a larger-than-ever transactional imbalance between market participants. Regulation NMS is the current, ground-breaking attempt to redress this source of transactional imbalance. In theory it will create the first true National Market System by requiring participants to transact at the best quoted bids and offers as between ALL sub-markets which trade the relevant instruments. In other words, before any two participants can trade, they must confirm the non-existence of more competatively-priced quotes eminating from all other sub-markets; transactions must occur at the most competatively-quoted prices. Of course, mere passage of Regulation NMS is not a certain indicator of what its real-world efficacy will be in redressing overall competative imbalance in markets falling under its scope. It is likely that, based on their past responses, institutional participants will actively search to restore the competative advantage they previsously enjoyed. One option for them is to amend the regulatory framework with the help of powerful political allies. An example of such is already evident under the provisions of Regulation NMS itself: Liquidnet Inc., probably the largest hidden equities market currently in existence, has been exempted from application of the regulation's strengthened trade-through rule. Or the institutions may look to novel activities - outside Regulation NMS's scope and presently unregulated - to restore their advantage. A historical example was the accelerated transfer of order flow from public pipelines (including SOES) to hidden markets, as previosuly discussed. In any event, Regulation NMS is at least a significant theoretical step towards a true NMS, and based on the substantial, though temporary, actual effect of past efforts to equalize volume access, I predict that the new regulation will cause significant re-shuffling of order flow volume in favor of the public. With respect to the spot currency market, the fact that both informational AND transactional imbalances exist as betwen Intra-bank and non-Intra-bank participants indicates the elevated risk assumed by the latter in competing with the former in this market. Indeed, most currency transactions even occur outside the regulatory scope of a public exchange. At present many (though not all) of the online currency "brokers" are actually proxy agents for Inter-bank dealers who induce trading by non-institutional participants, and then take the other side of those trades with a view to competatively manipulating price action via order flow in a zero-sum fashion. These "brokers" might arguably be viewed as the "new-school" equivalents of the "old-school" bucket shops so decried by Lefevre. From a normative perspective, of course, non-central bank efforts to profit from manipulative order flow in the spot market can simply be viewed as an extension of the long-standing, arguably unethical practice of those same banks to induce the public to conduct currency exchanges at rates that diverge widely from rates available in other, publically-inaccessible sub-markets (markets in which the banks themselves conduct most of their own exchanges). While investigative effort to uncover and expose imbalance in the financial markets, including the recent work on Micro Exchange Rate Economics, is a crucial first step, it raises the more fundamental question of whether such imbalances require equitable redress on policy grounds, and if so via what means. Metaphorically, the research has uncovered a rabbit hole. It's in the public interest to determine how deep the rabbit hole really goes...and possibly to fill it in. Thank you for your time. Any comments would be greatly appreciated.