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THOMAS PETERFFY, AN ARCHITECT of the modern securities market, is concerned the markets he helped create are at a dangerous turning point.
Peterffy is so concerned that he is changing the operations of his Interactive Brokers Group (ticker: IBKR) business, and is speaking out in unusually direct language for a Wall Street chieftain. Since the May 6 flash crash, when an aberration in S&P 500 futures trading pushed the Dow Jones Industrial Average down 1,000 points in about 20 minutes, Peterffy has directed his trading firm, Timber Hill, to stop making markets in 50 exchange-traded funds. Timber Hill is one of the world's most influential market-making firms, and its actions are closely watched by competitors.
Peterffy said in an e-mail that Timber Hill's next step, should market conditions merit, will be to gradually widen quoted prices, and cut the size of trading commitments. Many market makers use Timber Hill's prices and liquidity—the number of stocks or options market makers are willing to buy or sell—to refine prices. If Timber Hill steps away, others are likely to follow, and investors will find many options prices worse than market conditions may merit.
Peterffy's actions and contemplations reflect a growing discomfort with Byzantine modern markets. Technology, initially a democratizing force that improved prices, has been weaponized by some firms to create powerful trading advantages.
"Technology, market structure and new products have evolved more quickly than our capacity to understand or control them," Peterffy said in a recent speech to the World Federation of Exchanges in Paris. In his business, that's tantamount to Steve Jobs or Bill Gates confessing concern that computers harm attention spans and turn people into instant-gratification junkies.
Like Jobs and Gates, Peterffy defined and created an entire industry. He was one of the first traders to use computers to price options. His early success gave birth to Timber Hill, and then Interactive Brokers, an online brokerage service that lets investors inexpensively trade stocks, bonds, futures, currencies and other securities on 80 markets all over the world. "I must confess to you," Peterffy said during his speech, "that I was an ardent proponent of bringing technology to trading and brokerage. Unfortunately, I only saw the good sides."
While technology has certainly improved markets, increased competition and improved prices, it has also created an unwieldy environment in which no one—not even the somnolent Securities and Exchange Commission—knows exactly what's happening because trading is fragmented.
Peterffy opposes brokerage firms' "internalizing" customer orders rather than executing them at exchanges. Of course, his traders tend to dominate exchange trading, and his ideas would likely increase his firm's earnings power, but his ideas, if enacted, might make the markets safer.
Peterffy told the exchange chiefs that he favors stopping the proliferation of exchanges and clearing firms, which are little understood to most investors. In these post-financial crisis days, clearing firms are sprouting to handle the back-office financing of many different financial products and investors. Peterffy wonders–as did others during the worst of the crisis—what happens if the losses of a failed investor exceed a clearinghouse's resources. In that event, Petterfy warns of a domino effect. His solution is to encourage trading to occur in more centralized places, in more liquid markets where it is possible to see what is happening.
Petterffy, who started, then abandoned, the Boston Options Exchange, favors exchange consolidation.
Peterffy's speech, posted on Interactive Brokers' Website, should be required reading for securities regulators and Congress. He was present at the creation, and he can give policy makers real-world ideas about how to better order the universe.
Skew indicates whether the options market expects a stock-market advance or decline. It measures the difference between the implied volatility of puts and calls that are 10% out of the money and expire in three months. Higher readings are bearish.
Comments: steve.sears@barrons.com
http://twitter.com/smsearsBarrons
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