Phantom indices

Posted by FT Alphaville on Jun 23 12:30. 3 comments | Share

Themis Trading — ever-alert for structural weaknesses in markets — have a new paper.

It’s about ‘phantom indices’ — or the idea that widely-followed indices such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq 100 don’t actually track all of the shares traded intraday. More…

Themis Trading — ever-alert for structural weaknesses in markets — have a new paper.

It’s about ‘phantom indices’ — or the idea that widely-followed indices such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq 100 don’t actually track all of the shares traded intraday. The discrepancy, Themis says, stems from the indices being calculated using only primary market data, in a world where a significant amount of trading has now moved off into non-primary spheres.

How much are the indices missing?

Themis says as much as 70 per cent of all shares traded on an intraday basis.

Here’s a bit more detail from Joe Saluzzi and Sal Arnuk:

US stocks are traded today on more than 50 market centers. according to TABB Group, stock exchanges trade 67% of overall volume. The biggest exchanges are NASDAQ (26% of total US stock exchange share), nySE (19%), NYSE Arca (19%), DirectEdge (14%) and BATS (12%). The balance of shares traded (about 33%) occurs in dark pools, electronic communication networks (ECNs) and broker internalized alternative trading systems.

As a result, many stocks are traded on exchanges other than where they have their primary listing. NYSE actually only trades 27% of the volume of NYSE-listed stocks and NASDAQ 29% of the volume of NASDAQ-listed stocks. Most major indexes, however, are calculated intraday using sales from only the primary exchange where the component stock is listed. Thus they do not incorporate the majority of shares traded. That means that these indexes are based on a little more than one out of every four shares traded.

Now, we’d love to know how much the non-primary market activity relies on the primary market for so-called ‘price discovery.’ In Europe, our understanding is that when primary exchanges fall down, while you’d imagine that the trading would continue on alternative platforms, it usually dies there too. However, since 2007 the US market has been governed by Regulation NMS, which basically requires traders to transact on the trading venue with the lowest price, rather than a platform with, say, quicker execution times or more reliability. Which means this might not be the case in the States.

Indeed, Themis point out that the phantom problem may well be a consequence of the somewhat-controversial Reg NMS. Before the rule, about 80 per cent of NYSE-listed stocks traded on the NYSE itself, with the majority of stocks on other indices like the DJIA and S&P doing the same. Reg NMS, helped fragment the equity markets so that just a third of NYSE-listed stocks now trade on the NYSE.

Anyway, the whole phantom index thing has very interesting implications for the indices themselves, but also the multitude of products which trade off them. Think, for example, of the multi-billion dollar SPDR S&P 500 ETF. It also makes you wonder who’s tracking (and profiting?) off the real intraday value of indices.

The discrepency between phantom index values and real trading could be pretty huge.

Witness, Themis says, the 2010 flash crash:

We also believe that during times of market stress, when the whole world is watching, jey indexes might reflect an even greater degree of inaccuracy. The conventional belief is that on May 6, 2010, the DJIA, under selling pressure due to a plethora of reasons, plunged nearly 1,000 points, and then recovered much of that loss within 20 or so minutes. Some speculate, however, that the DJIA actually fell 25% lower. On reason could be NYSE’s Liquidity Replenishment Points (LRPs). According to the NYSE, an LRP is: “A volatility control built into the Display Book to curb wide rice movements resulting from automatic executions and sweeps over a short period of time. When triggered, LRPs automatically convert the market temporarily to slow or Auction Market only mode, allowing specialists, floor brokers and customers to supplement liquidity and respond to the stock’s volatility. During the May 6th Flash Crash, many LRPs were activated. Most trades that were executed at extreme prices, sicj as $0.01 per share did not occur on the NYSE. For example, NYSE-listed Proctor & Gamble (PG) — a DJIA component — traded as low as $39.37 on non-primary exchanges. However, because LRPs were activated, the low of the day on the NYSE was only $56, or 43% higher. Any trades below $56 were not included in index calculations because they were traded off the primary exchange. In times of extreme volatility, NYSE LRPs will likely be activated, but non-primary exchanges may continue trading NYSE stocks. However, intraday trades from these non-primary exchanges will not be reflected in the indexes.

Which presumably, might provide plenty of opportunity for micro-second arbitrage.


By Tracy Alloway and Izabella Kaminska.

Related links:
Phantom indexes: major market indexes reflect only 30 per cent of trades interday – Themis Trading

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