CODA Markets has been pounding a steady beat for on-demand auctions since launching CODA Block, a 30-second block auction program in 2017. With a new study from ViableMkts of the auction system, data shows CODA Block generally did not create adverse market moves when initiating an auction. Don Ross, CEO of CODA Markets’ parent PDQ Enterprises, spoke with JLN’s Jim Kharouf about the study and his view on auctions throughout the trading day.
Q: You have been a proponent of auctions in securities and feature an auction mechanism on your CODA Markets platform. Why such a big fan?
The biggest problem in the market today is that there is no way for an individual or institution who desires more size to figure out where the market is for the size they want to trade without hurting themselves. There’s hasn’t been a way to do it until CODA Block and that’s our goal.
And what does it mean to “hurt yourself?” There are basically two ways. One is, I didn’t get the trade done and the market moved away from me. They call that information leakage. But when you initiate an auction, there is no evidence that it has an impact on the movement in the market.
The other is that I need to get some size done. I don’t want it to be that I only trade when the market is going to move against me. That is called adverse selection. Those are the two things we are measuring for in this report, and it’s pretty clear there isn’t leakage or adverse selection.
Not only does the market not move when you initiate an auction and don’t trade, but it doesn’t move when you do initiate an auction and do trade. That is what we’re seeing.
Q: Is that because the price is reflected on the tape but not necessarily the size?
What we’re doing is providing fills that are four times the size available at the displayed NBBO quote. But when we do that trade, it doesn’t necessarily affect the quote. It is possible in a second order effect. But in the data, it really doesn’t affect the quote.
Q: Why don’t more venues do auctions if they are such a good idea?
Just because it’s a good idea doesn’t mean it will happen overnight. Going back 150 years, the New York Stock Exchange actually held an auction for every single trade. The only reason they stopped was because they didn’t have the technology to run an auction for every trade. When the economy was expanding, and there were so many stocks to get through, traders couldn’t handle all the auctions. So they left the orders with brokers who specialized in each stock and that’s how the specialist system was formed, and how the limit order book system was born.
In the first phase of the electronification of the first market, they simply automated the specialist model. For me, in the past 10 years, we’ve had a competing model. Change takes time. Now the technology is here.
Q: So who are the interests you are battling with?
Every trading venue with decent market share in the current paradigm prefers not to change. It doesn’t really matter, though, because those trading venues don’t decide where the trading is going to happen. It is the actual participants.
One of the challenges for us is that the portfolio manager isn’t necessarily the one making the trading decisions. And the individual trader, who is making the trading decisions, is not necessarily incentivized to improve fund performance. He is incentivized to not embarrass himself (by making a bad trade or error).
Many in the industry use a ubiquitous benchmark for execution quality. So you may want to trade a lot of size but you don’t believe it can be done all at once. So you do a bunch of small trades and find the average price over a period of time. It is an easy to understand benchmark but it is fundamentally flawed because you don’t know what the value is going to be until after you trade. So it is impossible to separate the impact of your trade from what the market was going to do. So any quality execution benchmark has to be known before the trade starts. And that’s why we are looking at “what was the midpoint now and what would it be in the future?”
And invariably, you front run yourself. And these orders are creating market impact because they are bought in increments that affect the market’s perception of demand.
So even though we see growing levels of frustration from the buyside and their ability to find liquidity, it’s just hard for people to try something new. That’s why it is so important for us to be able to prove the auction works and get the data out there.
Q: How’s it going since you launched CODA Block in February 2017?
By May 2017, CODA Block went from trading about twice a week to almost every day. We were really pleased with our performance. Our hit rate goal for Q4 was 4 percent and we reached 10 percent. In Q1 2018, it was up to 11 percent. Our hit rate in small caps in Q1 was 14 percent, which means 14 percent of the time an auction is initiated, small caps are getting traded with an average of four times the displayed size. **(The “hit rate” is the percent of auctions that result in a trade.)
It’s not just 14 percent of the auctions but it’s 46 percent of the small cap symbols, which initiate an auction, get a trade. It is a new way of participating electronically.
I’m pretty fired up right now. Also I’m fired up because a few weeks ago the SEC Trading and Markets Division, led by Director Brett Redfearn, held a roundtable on the topic of thinly traded securities. And the topic of auctions came up with great frequency. Nearly everyone said “Gosh, it sure makes sense that an auction would be the kind of cure for this problem. Too bad it’s not available in the U.S.” The NYSE’s Stacey Cunningham laid testament to that and said the NYSE thought about doing an auction in the middle of the day – and that they do them at the open and the close. She said their read, based on member feedback, was that they wouldn’t use it because there would be a concern about leaking information in the middle of the day. So they gave up. Many focused on post-MIFiD II and the periodic options they have over there. But the panel said that it works in Europe but doesn’t work here in the US.
Well, it does work here and I have the evidence. We want to let Director Redfearn know that his job is done already. He doesn’t want a rule-based approach. Well, we got it.
Q: What’s next for bringing in more participants?
A: The focus has been on the algorithmic side generally. We want to make sure we have this critical mass and initiators. Now we’re starting to make our presence known to the buy side.
Greenwich Associates put out an electronics report about on-demand auctions. A vast majority have heard about it, and they are in our pipeline, but they want to see a little more. So take this report, and take it to the next step.
We have good relationships with all the brokers. So when a new client wants to try and use CODA Block, their broker needs to enable access. But I get the sense we actually have some alignment with the brokers. Their clients are frustrated and they want to provide new and interesting ways to access liquidity.
Q: You’ve also written about the concept of transparency in the securities markets – basically, that it does not exist. Can you explain?
On its face, transparency is a great sounding word. But when it comes to price discovery and aggregating supply and demand, my demand is valuable information. Therefore, you cannot expect me to give it to you without some sort of consideration. So if you think that displayed quotes are telling you where the supply and demand really is you’re fooling yourself. You are in denial.
Another way to put it is, displayed liquidity is always the most expensive because the providers of that liquidity have to take into account the value of the information they are giving away for free. So they make the price a little worse than it would be, or they won’t show you all their size, because that is giving up too much information.
And with auctions, because it is a dark order book, when you put in your most aggressive price and size, you are not giving any information away. But you are improving your competitive position in the auction. And so it is possible for people to put in more and more aggressive prices that actually result in larger trading and less volatility. You are clearing the whole market instead of doing it in the piecemeal way.
Q: Playing devil’s advocate – if you are a big institution and you have to trade the market in smaller sizes over a longer period of time, doesn’t that sort of democratize the market in some way? In other words, doesn’t that give more participants more chances to interact with the market and create a healthier ecosystem?
A: Diversity of opinion in a market is critical. I don’t think, though, that it should be the optimization criteria of the institution with 500,000 shares to do. That institution is managing money for a pension fund and their job is to get the best price for its clients, not spread the wealth around to as many participants as possible.
The problem with getting as many people as possible involved with the trade in the typical way they do, is what I mentioned before. You are front-running yourself. When you take 500,000 shares and turn them into 5,000 or 100 share trades, you are front running yourself.
So here is what is not democratic about the 500,000 share trader. Who is going to be the counterparty to those trades? It is either the dealers in the dark pools or the high frequency traders on the exchanges. In order to be on the other side, you have to be competitive in this speed arms race. And that is a smaller and smaller number of firms, with a bigger and bigger barrier to entry.
The auction process lowers the barriers to entry because you don’t have to be competitive in the speed arms race to have an opportunity to trade with every natural liquidity provider. And I’d say the auction is more competitive because anybody with a little bit of market data and access can calibrate price signal for Apple.