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Chris Martenson: Welcome to this Peak Prosperity podcast, I am your host Chris Martenson. Today we’re going to talk about markets, equity markets, bond markets and commodity markets. And today they all share one thing in common, they are utterly broken. At least they are if you think markets should be fair and level playing fields where prices are determined by the collective actions of thousands, if not millions of market participants who are carefully weighing and sorting through the same information as they make their decisions. However if your intent is not to have a level playing field and your intent is to rig the markets either for gain or policy purposes, then these markets aren’t broken, they’ve never been better. Discussing these markets with us today is a man we first interviewed on this subject back in 2011, long before the book Flash Boys by Michael Lewis came out and shined some additional light on this much needed subject.

Joe Saluzzi is partner, co-founder and co-head of Equity Trading of Trading LLC, a leading independent agency brokerage firm that trades equities for institutional money managers and hedge funds. Now, Joe is one of the foremost experts on algorithmic trading, often referred to as high frequency trading or HFT, and the dangerous risks it has introduced into our financial markets. Along with Sal Arnuk, he is author of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio (paperback). Hey welcome back Joe it’s great to have you back on again.

Joe Saluzzi: Chris thanks for having me, it’s been a while, I appreciate it.

Chris Martenson: So Joe after all the attention of the excesses of HFT, after all these years what, if anything has been done by the regulators to right the wrongs and give us back our markets?

Joe Saluzzi: They haven’t done too much. They’ve done some what we call Band Aid fixes after the flash crash of 2010 they put through the limit up, limit down circuit breakers which will basically prevent a stock from moving more than 5 or 10% in a matter of minutes, which is a good thing, don’t get me wrong. I think it’s prudent and they should have done that a while ago. And they got rid of something called a single stock, a stub quote but those are kind of cosmetic changes. They haven’t really addressed the bigger issues which we consider fragmentations, all the excess exchanges, all the market structure issues that have led to this type of trading that is changing. The market has certainly changed over the last 15 to 20 years. You don’t have those fundamental investors that’s setting price kind of like you mentioned earlier; you have more — it’s an algorithmic race, you’ve got spoofing, you’ve got all sorts of stuff going on now setting price. So I think they still need to address the market structured areas that we’ve talked about many times and the SEC just came up with something called the market structure advisory committee after, you know five years, after the flash crash—that will meeting for the first time next month to discuss certain market structure issues, but we’ll see if anything comes out of that.

Chris Martenson: Do you know who is going to be sitting on that?

Joe Saluzzi: Yeah actually we do and it’s actually a large group, much larger than we thought it would be. There’s 17 members on the group, we were actually — we were proposed to be in it. Unfortunately we didn’t make the final cut. I think there were some vetos to our nomination and that doesn’t surprise us at all. Many of the members are what we consider status quo industry types who want to leave things just the way they are and are basically making money and what we call them arms merchants, some of the exchanges and so on who have a vested interest in leaving things just the way they are. But then there are also some others who are out there and they’re going to ask some good questions. Unfortunately we think they’re in the minority of the 17.

Chris Martenson: Well yeah let’s keep an eye on that but I have to tell you after all these years of seeing the glacial pace at which the SEC has decided to move—and the CFTC on these things—it’s clear to me that technology is still winning this race and many of the things that they talk about which should be to me obviously and patently illegal, like spoofing or throwing quotes in there that you have no intention of filling. Those still happen to my eye all the time, I follow the guys at Nanex, I look at their market liquidity structures. It’s obvious there’s shenanigans going on all the time.

Joe Saluzzi: Yeah and I think what’s happened is the markets have evolved and the markets have certainly obviously embraced computerization and technology and all which things have been — some things have been very good for the markets and brought down cost. But regulators don’t seem to have evolved. They don’t seem to have caught up with time and they don’t necessarily have the eyes and ears out there to monitor things on a micro second or nano second level. Just as an example they have proposed putting together, the SEC has proposed putting together a consolidated audit trail. This came about after the flash crash as well, back in 2010. And we’re five years into this and they’re still out for bid waiting for someone to bid on the project and it’s nowhere near completion. And even when it does get completed, it’s still not going to be an all encompassing view. They won’t be able to see futures because the CFTC monitors that group; so it will be an incomplete set. It will be better than what they have now, which is called Midas, which is basically a bunch of a direct data feeds that are supplied by the exchanges. And Midas by the way was built by high frequency traders named Trade Works that still gets paid by the SEC over a couple million dollars a year for this thing. So it makes you wonder are they properly equipped to monitor it. And when you see cases like spoofing pop up and you’re like “How could they have missed it”? As you mentioned Eric Hunsader from Nanex, he sees this stuff all the time and he tweets it. I mean if I was a regulator I would just follow Eric and I’d say — there’s an example right there, I don’t have to do the work, I’ll just follow Eric, he’s doing the work.

Chris Martenson: Yeah just put Eric on your payroll for a couple of days, throw him a few bones and see what he comes up with. It’s —

Joe Saluzzi: He would do it very cheaply because he wants efficient fair markets as well.

Chris Martenson: Absolutely. So let’s talk about markets for a bit. You mentioned the flash crash, that event on May 6, 2010 where markets really plummeted; originally blamed on a fat finger trade by a trader out of the Midwest, out of Reed and Waddell. Today big news, I’m sure you’ve been swamped with calls around this. The SEC has decided no, no it was some guy operating out of a small bungalow in London. Tell us what your thoughts are on this?

Joe Saluzzi: It’s truly amazing. I don’t know how they come up with this stuff. But the case actually brings up so many more questions than answers but let’s go back to what you just said. Originally they all blamed a mutual fund trader out of Kansas City for basically entering an order for his own clients. So they’re blaming someone who actually turns out to be the victim. And they were the victim because there was a spoofer—this fellow by the name of Sarao trading out of the UK who they now have — they have all the documents. He was 20-29% of the orders in the e mini futures contract for the three hours prior to the flash crash. This guy was enormous for one guy coming out of an apartment with a software package that was modified by one of his vendors. So it makes you scratch your head and say “Wait a second, how could they not have seen this” and why did it take them so many years? And let’s be real, do we honestly think that there’s only one person in the world running the same strategy that this guy was doing? I can’t imagine it was one guy but I do think that he certainly exacerbated the move on that day because if he was that significant amount of orders he certainly had something going on but it wasn’t the cause of the flash crash.

The flash crash was caused by a poor market structure that went out of control and actually when the CFTC and the SEC did put out a report five months after the crash they noted that it was — they called it hot potato trading. Where basically market makers are flipping back and forth and once their inventory positions got exhausted or their risk levels got too high they were shutting down. And many of them were quoted afterwards saying that we just stopped trading and exited the market. That’s why you had a flash crash because it was a void in liquidity, which makes you think well where are the obligations? What is a market maker today? Do they have any obligations to supply real liquidity or can they enter and exit like this guy in the UK and pretend to be adding liquidity when in fact he was spoofing. So the case is troubling, it’s troubling for so many reasons. I mean it’s — where was his broker? Why weren’t they looking at it? Where was the CME where all the trades were being done? Why didn’t they come after him although they did but then they seemed to do nothing five years ago and then finally where was the CFTC? So who is watching the shop here and to me it’s very troubling.

Chris Martenson: You know this whole idea of market structure is really important to me because again following the work at Nanex by Eric Hunsader is — shows that this volume it comes and goes at the blink of an eye and so I had Bart Chilton on this show recently, formally the CFTC commissioner there, now out in private world, and he said that he thought recent reports had proven to him that HFT programs and the like were good for investors because they brought down prices, which I agree with, and provide liquidity to the markets. I disagree with that one. Where do you stand on HFT and liquidity?

Joe Saluzzi: Well liquidity and volume what are they? They’re different types of things but let’s differentiate amongst HFT. HFT is a hard thing to define. I was actually on a CFTC sub committee where we were trying to — my task was to define HFT and in the end we didn’t — they came up with a definition that I actually dissented to; I didn’t think it was a good definition because it didn’t have an inventory component in it, which at the end of the day most of these HFT’s are flat or relatively flat when maybe it’s one instrument versus another. But the bottom line is there are different types, right? There’s electronic market making which for the most part is a good thing in the sense that there’s no other market makers now a days. The traditionals left, so someone has got to make a market and these electronic market makers do quote two sided spreads although the quantities are much, much smaller than you would expect a real market maker to commit. But let’s just assume for a minute that that’s benign and that’s good for the market and that’s what Bart’s talking about. Well if Bart’s defending that I don’t think I would take an issue with that.

But now let’s talk more about the predatory and some of the momentum ignition and things like spoofing like we were just talking about and more of the proprietary trading HFC that’s out there just looking to take off an order or front run demand and supply. And I use the term very carefully when I say front run. Not front running an order because that’s illegal, if I had an order from a client and I traded ahead of this myself, that’s illegal and I go to jail. What they do is they basically — they take a look at the order book and they say “Okay where’s the buyers and where’s the sellers”? Once they think that there’s more buyers than sellers I’m going to try to front run that based on the technological advantage that I have due to my co-location ability or my microwave networks or whatever it is. So they front run demand and they front run supply. It’s not fundamental based trading at all, they don’t care what they’re trading; they’re just getting ahead and they’re trying to sell it to you or flip it back before you even know it. So that’s not helping anybody; that’s not adding to the price discovery process. That’s just scalping in an automated fashion, which is very hard to detect or very hard to monitor for the regulators.

So Bart, in the past Bart Chilton has said that there’s white hats and black hats of HFT. Okay and I’ll agree with that but what I don’t hear from Bart is tell me more about these black hats? Who are they, what are they doing? What have you seen them do? Can we go after them? Let’s find out some details because if there really are you need to start spilling the beans and as a guy who represents the industry I would think he would know.

Chris Martenson: Well absolutely. I found that a little shocking at the time because certainly I’ve seen and read enough to understand that there are black hats out there and so here’s an area perhaps that sort of brings this out to light a little bit for me; so and let’s talk about this idea of providing liquidity. I think that we need to reverse that word providing. I think this should be called sucking liquidity. There’s a firm out there that recently was describing the results of their trading and in this HFT universe and over an entire six year span they reported that they had somehow lost money on one day. Every other single day they were pulling in on average one and a half to two million dollars a day from whatever it is that they were doing. And publically the CEO came out and said explained this by saying, “Well we win more than we lose”, right?

Okay so let’s do some math. If there’s even ½% chance of losing, one-half of 1% chance of losing on any given day then the odds of that happening, of that company turning in one trading loss day out of six years is over one out of 58,000. So the odds, if we decide to say there’s a 50/50 chance of real trading involves risk you can’t even — my Excel is incapable of calculating the odds on a 50/50 chance because a get a div zero error in there and there’s probably not enough atoms in the universe to actually make the denominator of the one out of X statement of probability. So is what this company is doing, it’s not really trading then is it? Because it seems to be risk free.

Joe Saluzzi: Well I think what he’s saying is that there are losing trades, right? But what they appear to have is a risk management system that is able to minimize those losses quickly and then on the buy side or on the winning side maybe they’re letting the winners run a little bit more, I’m not sure. But and I think also one of the parts that he left out was a scratch trade, the ones that he didn’t make or lose money, what percentage was that? So it appears that it’s more — it’s a law of large numbers, that’s what they’re trying to explain where they’re trading millions and millions of times a day and they’ve built this model. And the model also by the way is not just equities and it’s not just futures, it’s multi-asset and it’s kind of interesting. Multiple books of currency bonds, futures, options, all different instruments where I would imagine that there’s some big interface which tells them where their risk exposure is at all times amongst these instruments, which somehow produces money. You know it does scare me that obviously in the days of technology and software and hardware there could be failures at any point in the system and what would happen if part of that Rube Goldberg machine all of a sudden collapses and the marble doesn’t get to the end where it’s supposed to go? I don’t know, that’s what happened to Knight Capital and they lost 440 million dollars on one day.

Chris Martenson: Yeah and before they figured out where the electricity plug was to this thing just yanked out of a wall.

Joe Saluzzi: Pull the plug quick.

Chris Martenson: Right so an important point came up which is that these companies who are in this space, they’re not just — they’re not really focused on any one particular asset; they might be in options, futures, across indexes, ETF’s, individual shares, trades. They’re kind of — they have tentacles in all kinds of things and their system would involve being positioned in one arena or asset compared to another, let’s make it tangible. Let’s say I want it to be long oil futures but I thought that at some point I was going to reverse that and go short, it wouldn’t hurt to have some puts on USO, the oil ETF. It wouldn’t hurt to have some individual puts on individual energy companies, etc. and so forth. Like you’re saying they might have more of a complete map across a set of related assets when they’re running strategy.

Joe Saluzzi: Yeah I think so and I think the goal is to be as close to neutral when it comes to risk as possible. You may be long the oil, like you said long the oil and maybe short the ETF or whatever it may be and you’re trying to minimize that and it may actually require them holding positions over night as long as they are hedged into neutral. Now really they’re obviously not investors like you know, Warren Buffet or you know some long term investor and they don’t necessarily care about the long term health of the company. But what I would like to see is if they are truly market makers I would like to see more obligations on these market makers. Right now there really isn’t much of an obligation to quote an equity.

I mean you can be within 8% of the market and you’re considered a market maker; so that’s nothing. And I think actually there are a couple of these larger electronic market makers who have actually argued for more obligations. And they said, “You know what? I don’t have a problem putting in a larger obligation”. So what’s happening is there’s kind of a divergence going on amongst the larger HFT’s and then the smaller ones who are more kind of what we would consider parasitic that are just kind of playing the game and then kind of hovering around. If you’re going to come in and you’re going to make a larger market and you want to be — I don’t have a problem if they want to get compensated obviously by earning a spread, well then they deserve it if they’re going to supply an obligation to the market. We need a market maker. Unfortunately the traditional ones have gone and so there is a void out there when times like the flash crash happen you hope that there’s a market maker there to hold it and you know as the old saying goes until calmer heads prevail, but right now there’s a bit of a void there. So we’ll see. That is an argument that’s going out there whether market makers should have more obligations.

Chris Martenson: Well that would certainly I think go a long way as well as putting maybe some latency on the trades as well; so you have to hold something for I don’t know, let’s pick something ridiculous, 200 milliseconds.

Joe Saluzzi: That’s ridiculous, way too long. [Laughter]

Chris Martenson: All right. Well let’s talk about correlations then because today it seems to me, this is my observation, I’m out here in the cheap seats remember. But it seems to me that you can explain a lot of what happens in both US stocks and global commodities if you simply follow the United States dollar index against the Japanese Yen, that correlation explains a lot of other things. The correlations are really high. So what it appears to me is that we now have global strategies that are being traded where I’m not sure fundamentals really come into play, or at least I have a hard time myself fundamentally explaining why a change in the value of the Yen should really radically alter the price of gold in London. How do we begin to understand this?

Joe Saluzzi: Yeah and I think what we were talking about before with the multi-asset strategies that tends to explain it a little where when a currency starts to move then I better get short equities whatever it may be. It does scare me in that I am wondering are prices now — you know what happened to the price discover mechanism? Is it really being set by fundamental investors who have looked at the company and look at long term aspects or is it now being set whether it’s on Fed policy or some algorithm that’s tied to one currency pair versus the other. And then where are we going? Are we getting into some bubbles in certain areas because no one is really looking at valuations, all they care about is “Okay I made money today and I start fresh tomorrow because every night I go home flat and I start the game all over again”. That’s a scary thought. That’s a scary thought that these multi assets are now playing into each other and like you said the correlation is so tight that when one market sneezes they all catch a cold really, really quickly.

Chris Martenson: It’s true and that is my concern. I’m having a hard time quantifying it but the idea is that it feels like we’re just in a large speculative environment where the relative movements of these asset classes is what’s important, not the absolute underlying value.

Joe Saluzzi: Yeah well I think we have to blame central bank intervention, how can we not? It’s all around the world. They’re setting interest rates at a ridiculous — at a ridiculous thing — quantitative easing is distorting all sorts of prices of assets, the amount of supply on a lot of these bonds is going down, it’s almost zero. So how do you price things anymore when you have such a giant manipulator out there?

Chris Martenson: Well let’s talk about that manipulator real quick because here’s some other slight sources of concern for me. We learned in 2013 that I think 13 out of 60 central banks were buying equities, right? Switzerland, Israel, obviously Bank of Japan, so we knew that. And we knew that the CME introduced a central bank incentive program; so this is — the CME is where futures and options are being traded on equities, commodities and other things. So how do we — we know that these central banks are not just manipulating things, or influencing, whatever word you want to use by driving the price of money down and flooding the world with liquidity. But they are actively — active enough in the CME that they have their own preferred buyer program and now we know that the New York Fed is moving a staff office out there to be closer to that action too. How do we interpret — how do you interpret those moves?

Joe Saluzzi: I mean I shake my head. Incentive programs just in of themselves really—a lot of times the CME and some of these exchanges put them out there to stimulate a new product. So say new hog futures contract comes up, or whatever it is, and they want to get some activity in it, and they’ll stimulate a market maker to quote a two sided market by giving them an incentive program. Somehow these incentive programs don’t tend to go away; they’re always there. Once they’re there they continue to get paid and that’s how you distort asset pricing when you’re starting to give all these rebates and whatnot. For central banks, I don’t know — I don’t know what the Fed is doing — I don’t know what they’re buying. Apparently the Bank of Japan is a little more active I guess when it comes to ETFs and a little bit more transparent about what they’re buying, but sure these are assets that they’re buying not based on fundamentals or based on what they like. They’re buying it because they’re trying to get some — some of the money they’ve created and they’re trying to juice the markets. It’s so — I shake my head like everybody else — guys like us who think this is ludicrous and that they’re distorting market prices. There are others out there which think that these are part of market forces and if the central bank is coming in to buy stocks, well that’s a source of demand; therefore the assets should be going higher and the market is being priced appropriately. I think that’s ludicrous. I think by printing money and stimulating asset prices is basically just a distortion and eventually it will come crash to the real price; so I don’t know. I don’t think it’s — it’s certainly a key driver in what’s going on out there but I really don’t know what to make of these guys or how long they’ll continue doing it.

Chris Martenson: Well yeah I’m sure you saw that Wall Street Journal article about the Bank of Japan's ETF buying activities and they had bought a lot and they preferentially would step in and buy on the days when the market was down, you know to like 79% of their trades were, if the market was down they were in there buying. So that feels supportive obviously and I don’t think it’s illogical for somebody to look at that and say “Maybe I should buy this too”. But where I do depart from the script is when the Wall Street Journal today announced the Nikkei had broken 20,000 and they listed a variety of reasons why that might have happened including improved corporate profitability. All this stuff they didn’t mention central bank buying.

Joe Saluzzi: Forget that part, heh?

Chris Martenson: How’d you miss that one, you just did an article on it?

Joe Saluzzi: It is — basically what it is is the biggest buy back in the world, right? Talk about corporate buy backs it’s obviously another way of distorting asset prices. But what central banks are doing is the largest buy back in the world, it’s crazy. They're doing it with borrowed money they don't even have.

Chris Martenson: Why didn’t we think of this before, it seems so simple.

Joe Saluzzi: I think there was a guy named Ponzi that thought of it a few years back.

Chris Martenson: Well so let’s imagine for a moment that you’re writing a financial thriller, okay? And in this masterpiece of fiction, Joe, let’s imagine that a variety of centralized powers, they’re interested in stocks going higher for a set of policy reasons maybe and they want to communicate economic vigor so they use higher stock prices as their signaling mechanism perhaps. You’re a central bank and you want to create the so called wealth effect and you want to drive equities higher. Hypothetically in this work of fiction if you did want to gun markets higher, defend breakdowns, critical sport levels all that, describe how that might be done and whether these computer algorithms would make that job easier?

Joe Saluzzi: Well that’s an excellent question and it would be done — you can be very sloppy. I trade — my job for a living is to trade for institutional clients, that’s how we get paid here. I need to go in and out of stocks quickly and efficiently and trying to leave as little footprints as possible so that no one can kind of find out that my institutional guys are either buying or selling. If I leave big footprints, guess what happens? They come like a parasite they jump on top and they will drive that asset up or knock that stock down really quickly and then there are certain algos that some people use certain algorithms that will just continue to chase the price whether it’s up or down. Obviously what I’m doing here is I’m going to be a little more discreet. If I think someone is trying to goose a stock, I’m not going to chase them, I’m going to wait. We’re going to be more strategic, but let’s just say I was somebody who really wanted that stock price to go higher. I could be very sloppy in how I wanted to buy the 10,000 shares of stock that I needed to buy on the day and guess what? The parasites will jump all over me and they will drive that price up even higher; so it is a very interesting point where I think — I don’t know if I’ve ever tweeted this out but QE plus HFT equals real dangerous stuff. It is dangerous; there is that parasitic effect that doesn’t care what it’s buying or selling and then if you’ve got somebody else out there saying “Well I really don’t care, I’m going to be sloppy. I’m going to go out there and just goose it up because I want that price higher”. Yeah, I wonder — I wonder what would happen. I can tell you for a fact that if you’re not careful and you’re trying to execute a large percentage of a stock, say 10 to 20% in a single day, you will drive that stock up very, very quickly. It doesn’t take much. All it takes is — for instance, say the stock is $10.10 bid offered at 10.15. If I go out there and I place a $.12 bid for 1,000 shares out loud on an exchange, that stock is off the races assuming there’s no natural seller out there. Let’s assume no one is hanging around in the dark or whatever. Next thing you know it will be $.13 bid, offered at 16 and then it will be $.15 bid offered at 20, $.20 bid offered at $.25 and then maybe 500 shares is traded. And now a sloppy algo will come in and buy the $.25 stock. What happens? 1,000 shares traded and the stock is up $.30 because you were sloppy, right? So you have to be careful.

Chris Martenson: Careful or perhaps that’s — that weakness is also a strength. This is my hypothetical thing—if you wanted to goose a market it seems easy to me today potentially with all these piranha’s in the water waiting for blood. In fact, you would want to be sloppy, do something really dumb like throw 200 million dollars at market into one corner and you’ll get an outsized sort of response to that I would bet.

Joe Saluzzi: Yeah you can even take the argument, a little side step to corporate buy backs. Corporate buy backs have very strict rules what they have to follow. They can’t cross the spread, they can only be a certain percentage of volume, they can’t trade in the beginning of the day, the end of the day… But let’s just say while it’s running these corporate buy backs normally are put into what they call 10B18 algos, which are pretty stupid in my opinion. They just go out there and they just mechanically go about it. Well they’re fairly easy to spot by