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Interactive Broker CEO: “Crisis of trust” created by brokerage industry could lead to more Flash Crashes

Terrific story today by the Wall Street Journal about how U.S. pension fund managers are switching their portfolios out of stocks, back to levels not seen since the 1980s. Jim Browning writes that, in addition to the lost decade of returns in the stock market, the May 6th “flash crash,” when the Dow fell 700 points in eight minutes, further spooked some pension managers, heightening concerns that computers and high-frequency trading now control a rigged U.S. stock market.

Which brings us to Thomas Petterfy’s fantastic and blunt comments in testimony Oct. 11th, in which he calls out the brokerage industry for creating a “crisis of trust” that could lead to still other crashes:

“In the last 20 years came computers, electronic communications, electronic exchanges, dark pools, flash orders, multiple exchanges, alternative trading venues, direct access brokers, OTC derivatives, High Frequency Traders, MiFID in Europe, Reg. NMS in the U.S. — and what we have today is a complete mess.”

“It is not so much anymore that the public does not trust their brokers. They do not trust the markets, the exchanges, or the regulators either. And why should they, given our showing in the past few years?”

This from one of the biggest brokerage firms in the country. OUCH. Petterfy admits he wasn’t always a hater of market structure — but he has since changed his mind.

“I was an ardent proponent of bringing technology to trading and brokerage. Unfortunately, I only saw the good sides. I saw how electronic trading and recordkeeping could be used to force people to be more honest, to make the process more efficient, to lower transaction costs and to bring liquidity to the markets.”

“I did not see the forces of fragmentation and the opportunity for people to use technology to keep to the letter but avoid the spirit of the rules — creating the current crisis.”

Petterfy also predicts more flash crashes are in the offing, since most brokerage firms just suck up your and my orders and fill them in-house, rather than sending them to exhanges for a better price, a process known as “internalization”.

As the U.S. CFTC and SEC report indicated, “internalizers suck off all the customer orders, but when an imbalance develops they are unable to handle it and they throw the switch to route the orders back to the exchanges, which no longer have the liquidity to deal with it. Since the bulk of the volume is now being traded at prices relative to a displayed market that is no longer driven by real supply and demand, sudden imbalances of buy and sell orders will occur more and more often, giving our industry more and more … headaches.”

For his fix-it recommendations, including getting rid of “dark pools,” read his testimony to the World Federation of Exchanges in full here.

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