Speed and Market Efficiency: Competition Over Mandate?

An efficient market reflects the current price for a given amount of supply and demand. The four key aspects of the equation are price, order size, supply and demand, and time. In an efficient market, supply and demand should produce a price given the size traded, and the price should constantly reflect changes in the supply and demand for an asset at any point in time. Too many buyers and the price will go up; too many sellers and the price will go down.

When engaged, the trader (or a trading bot) must be constantly aware of supply and demand imbalances. If gauged incorrectly, the trader (or the machine) will either miss an opportunity or, conversely, leave a stale quote in the market long enough for someone else to take advantage of it. That is what trading is all about. That is why professional traders are professionals, and that is what differentiates the good trading algorithms from the not-so-good algos.

Turtle or the Hare?

When markets are slow, there is more opportunity to take advantage of stale quotes and inefficiently priced merchandise. When markets have significant latency or quoting is slow, then dealers need to widen their quotes because they cannot react fast enough to avoid being picked off. This provides the quick with an advantage, as timing and patience will allow participants to opportunistically pounce on mispriced products. It also makes the market less efficient, as prices don't represent the real market; rather, they represent the market plus a latency premium, or a "fudge factor," for not being able to discreetly and quickly manage the price you really want to pay.

Conversely, when markets are too fast, it becomes harder to react to changing quotes. It is like getting the Sunday circulars, seeing an ad and running out to the store, but by the time you get there, the price has changed. Not much fun.

When the speed of the price provider and the price taker are not in parity - when one party's technology isn't as sophisticated as another's - the market becomes inefficient and seemingly unfair. What are we to do?

If stores change prices too quickly, buyers can boycott, use a faster channel (phone/internet), or reprioritize service and convenience over price. With financial markets, we can mandate better market integration (which everyone is for), slower markets, a wider quote or faster technologies, or hold market professionals accountable and let competition run its course.

Competition Over Mandate?

Historically we have chosen competition over mandate. When small order execution system (SOES) bandits picked off the dealers, the dealers invested in new technology or went bust. When fragmentation made trading across heterogeneous markets difficult, firms invested in execution management platforms, algorithms, dark pools, smart order routing and transaction cost tools to help them analyze execution cost.

Now that high-frequency trading is causing firms to rethink their execution strategies, we can either step up to the competitive threats and invest in re-architecting our trading technology, or cry foul, slow the markets down and stop the very competition that makes our markets the most efficient in the world. My vote is to invest.

While some traders and firms can invest directly, however, many use low-touch brokers for market access. Hold your brokers and dealers accountable. Force them to ensure that your executions are fair, and if they're not, vote with your order flow. If some brokerage firms can't compete, too bad; they should find another job or join the ranks of the unemployed.

Some complain this tips the balance to larger firms. I say, think again - larger firms have larger overhead. Competition doesn't favor the large; it favors the nimble and creative. And isn't that who we want managing our order flow anyway?