“It is the hot new thing on Wall Street,” according to The Times’s Charles Duhigg, “a way for a handful of traders to master the stock market, peek at investors’ orders and, critics say, even subtly manipulate share prices. It is called high-frequency trading — and it is suddenly one of the most talked-about and mysterious forces in the markets.”
The big trading houses are using new algorithms and superfast computers to spot trends before other investors can even blink.
Well, given the ambiguities of what’s occurred on a doorstep in Cambridge, Mass., and in the halls of Congress this week, it’s nice to have a clear villain back in our sights. But is it fair to say the wizards of Wall Street (Goldman Sachs, this means you) are picking our pockets, or are they really the smartest guys in the room after all?
Let’s start with Duhigg’s explanation of how it works:
As new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds.
High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.
High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.
Karl Denniger at the Market Ticker writes that Duhigg has “blown the cover off the dark art” but thinks that the traders’ computer speed isn’t most important advantage they have. Rather, he says, the “algos,” rather than providing liquidity as they are supposed to, intentionally probe “the market with tiny orders that were immediately canceled in a scheme to gain an illegal view into the other side’s willingness to pay.” He explains:
Let’s say that there is a buyer willing to buy 100,000 shares of BRCM with a limit price of $26.40. That is, the buyer will accept any price up to $26.40.
But the market at this particular moment in time is at $26.10, or thirty cents lower.
So the computers, having detected via their “flash orders” (which ought to be illegal) that there is a desire for Broadcom shares, start to issue tiny (typically 100 share lots) “immediate or cancel” orders - IOCs - to sell at $26.20. If that order is “eaten” the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40. When it tries $26.45 it gets no bite and the order is immediately canceled.
Now the flush of supply comes at, big coincidence, $26.39, and the claim is made that the market has become “more efficient.”
Nonsense; there was no “real seller” at any of these prices! This pattern of offering was intended to do one and only one thing - manipulate the market by discovering what is supposed to be a hidden piece of information - the other side’s limit price!
With normal order queues and flows the person with the limit order would see the offer at $26.20 and might drop his limit. But the computers are so fast that unless you own one of the same speed you have no chance to do this - your order is immediately “raped” at the full limit price … as the fill price is in fact 30 cents a share away from where the market actually is.
A couple of years ago if you entered a limit order for $26.40 with the market at $26.10 odds are excellent that most of your order would have filled down near where the market was when you entered the order - $26.10. Today, odds are excellent that most of your order will fill at $26.39, and the HFT firms will claim this is an “efficient market.” The truth is that you got screwed for 29 cents per share which was quite literally stolen by the HFT firms that probed your book before you could detect the activity, determined your maximum price, and then sold to you as close to your maximum price as was possible.
Even if such trading isn’t illegal or inherently vile, Brett Steenbarger of TraderFeed notes, it certainly makes life hard for day-traders and others with slower access to data.
Because the high-speed algos are buying and selling quickly as a rule, their effects on the markets longer-term are unclear. A stock may still travel from point A to point B, but the computers will affect the path from A to B. This may help explain why traders I work with who are more selective in their intraday trades and who tend to hold for longer intraday swings on average have been doing better than very active daytraders.
When up to half of all stock market volume consists of these algorithmic trades, one has to wonder about the edge of very active traders. Interestingly, those that are successful may be trading new patterns that have emerged since the onslaught of the high-frequency computers. My hunch is that these new patterns would involve a keen reading of order flow, catching the shift in the bidding/offering and the location (bid/offer) of transactions in real time.
While we can expect the rest of the MSM to get in a tizzy after Duhigg’s article, the blogosphere has been smelling a rat for some time. Two weeks ago, Tyler Durden’s Zero Hedge blog posted a white paper by Sal L. Arnuk and Joseph Saluzzi of the brokerage Themis Trading that clearly spelled out some big concerns about the “HFTs.”
1. HFTs provide low quality liquidity.
In the old days, when NYSE specialists or NASDAQ market makers added liquidity, they were required to maintain a fair and orderly market, and to post a quote that was part of the National Best Bid and Offer a minimum percentage of time. HFTs have no such requirements. They have no minimum shares to provide nor do they have a minimum quote time. And they could turn off their liquidity at any time. When an HFT computer spots a real order, the HFT is not likely to go against it and take the other side. The institution is then faced with a very tough stock to trade.
2. HFT volume can generate false trading signals.
This can cause other investors to buy at a higher price, or sell at a lower price, than they would otherwise. A spike in HFT volume can cause an institutional algorithm order based on a percentage of volume to be too aggressive. A spike can attract momentum investors, further exaggerating price moves. Seeing such a spike, options traders can start to build positions, which, in turn, can attract risk arbitrage traders who believe there’s potential news that could affect the stock.
3. HFT computer servers are faster than other trading systems.
Because most HFT servers are co-located at exchanges, they can beat out institutional or retail orders, causing them to pay more or sell for less than they should have for a stock.
As if that weren’t worrisome enough — the pair also raise some “what if” problems that HFTs could confront us with down the line.
1. What if a regulation like the uptick rule were enacted?
Volumes could implode and stocks that appeared highly liquid could become extremely difficult to trade with wide spreads and no depth in the quote.
2. What if a “rogue” algorithm entered the market?
Many HFTs are hedge funds that enter their orders into the market through a “sponsored access” arrangement with a broker. Many of these arrangements do not have any pre-trade risk controls since these clients demand the fastest speed. Due to the fully electronic nature of the equity markets today, one keypunch error could wreak havoc. Nothing would be able to stop a market destroying order once the button was pressed.
Durden himself has been sounding the warning for a while, likening the rest of us to Vegas suckers:
As the market keeps going up day in and day out, regardless of the deteriorating economic conditions, it is just these HFT’s that determine the overall market direction, usually without fundamental or technical reason. And based on a few lines of code, retail investors get suckered into a rising market that has nothing to do with green shoots or some Chinese firms buying a few hundred extra Intel servers: HFTs are merely perpetuating the same ponzi market mythology last seen in the Madoff case, but on a massively larger scale. When it all blows up, the question is whether the SEC will go after the perpetrators of this pyramid with the same zeal that it pursued Madoff himself. We think not …
It is imperative that Wall Street firms shed much more light into this astronomically profitable yet highly misunderstood and under the radar concept. In the absence of more information, the likelihood that Wall Street firms who dominate order flow and have material unfair advantages over virtually everyone else, should be isolated from trading up to the point where they provide sufficient information to make the market a fair and equal playing field for all investors. Until that moment, investing, trading and speculating is doomed to have the same outcome for the majority of market participants as playing roulette with 35 instances of 00, a much lower fun coefficient and no ability to be comped for your room in light of significant trading losses.
So, while the econobloggers follow the story with eagle eyes and fact-filled brains, the political and MSM bloggers seem content to vent:
Joel Achenbach writes that Duhigg’s story has his “hackles in a knot that may take the rest of the day to unravel. It’s an echo of Jon Stewart’s line about the market investors operate in and the ‘real’ market operated by, and for the benefit of, the Wall Street insiders. Remind me why this is legal?”
“And here I always thought that fixed income trading was where all the money was,” writes Kevin Drum at Mother Jones. “HFT has turned into an arms race, but it’s an arms race that only the elite are allowed to play. You and I just get to foot the bill, a tenth of a cent at a time. Sound familiar?”
Bmaz at Emptywheel assumes Goldman will pay out “mega-billions in bonuses” to those “who took us down the economic sinkhole to start with … the cliche is to say our economy is built on a house of cards. Not sure that is right anymore; a house of cards would at least have, you know, cards. Heck air may be too substantive, we are down to Goldman Sachs’ electrons and vapor.”
One bonus of the high-frequency trading controversy is that it keeps alive one of the more curious stories of the summer: that of Sergey Aleynikov, the former Goldman computer programmer who prosecutors say “stole proprietary, ‘black box’ computer programs that Goldman uses to make lucrative, rapid-fire trades in the financial markets.”
Aleynikov has his defenders. Matthew Goldstein of Reuters, who broke the story, is not one of them — saying the programmer is “not the Wall Street folk hero that some Goldman Sachs conspiracy theorists are making him out to be” — yet he admits that the case sheds light on a much more vital issue.
This strange Wall Street crime story isn’t just about one man’s guilt or innocence. The case should also serve as an alarm for securities regulators to start taking a close look at so-called high frequency trading and the impact that this speed-of-light trading strategy is having on the markets.
After all, if a computer code is valuable enough for someone to steal, and critical enough for a Wall Street firm to go to federal authorities to protect, one would think that regulators would want to know why it is so important.
Yet regulators largely have stood by and allowed this secretive corner of the quantitative trading world to grow ever bigger, without mustering up much of a protest.
Computer-driven trading, where complex buy and sell orders are completed in fractions of a second, now account for 73 percent of all daily stock trades in the United States, according to the Tabb Group, a financial services research firm
Econoblogger Rick Bookstaber, however, isn’t convinced there’s a link between the programming pirate and HFT:
I even wonder if the code really was for a high frequency trading operation. Prosecutors want to paint the most extreme picture possible. So if you listen to them, you will come away thinking the code not only made untold millions for the firm, but if put in the wrong hands it could destroy the Western world. And the person accused of the theft, Sergey Aleynikov, would have had an interest in exaggerating the value of his work to potential future employers – at least before he was apprehended. Granted it might have been valuable for a high frequency shop, but it is more likely is that this code was one component of a broader trading operation, a way to efficiently execute trades, to add value to other systems. We do know, for example, that Goldman – like others – has substantial infrastructure for automated trade execution algorithms as a part of its market making and brokerage business.
In fact, Bookstaber doubts that there’s much of a story here at all.
I doubt that Goldman is making much of its money from high frequency trading. For one thing, high frequency trading does not have a lot of capacity. For another, why bother with high frequency trading, an area where there are relatively low barriers to entry and where you have no particular comparative advantage, when you have a screaming money-making franchise that is close to unassailable? …
More interesting than what this alleged code theft might tell us about how Goldman made money is that it highlights that we have no clue how the firm really did make money. And, more to the point, that the regulators have no clue.
Imagine if early into the current crisis the New York Fed’s Division of Bank Supervision had performed a routine analysis to see where the banks’ profits were coming from. That question would have led to the burgeoning structured products markets. The next questions would have been – or at least should have been – whether those profits came from cutting corners in terms of risk or compliance. Or, whether the scent of yet larger profits might lead to future corner cutting. I gather that such an exercise never took place. (I also wonder why there hasn’t been more finger pointing toward the Division of Bank Supervision, but that is a different matter).
Well, we missed on that one. But maybe it is worth learning from the past and begin asking those questions of the banks as part of the supervisory process. Banks have plenty of ways to make money through questionable means and through imprudent risk taking. Come to think of it, if we ever get to the point of having hedge fund regulation, maybe the regulators should ask the same sorts of questions there, too.
Rich Miller of the Data Center Knowledge seems less concerned about how high-frequency trading will affect small investors or the economy than about how the MSM drawing attention to it might affect tech workers.
The story describes high-speed trading as a “mysterious force in the markets” with the power to “subtly manipulate share prices” that allows well-equipped firms to “reap billions at everyone else’s expense.”
That last bit is couched with “detractors contend,” but is consistent with the broader tone of the article, which depicts high-frequency trading as a tool giving well-heeled insiders an unfair advantage over the broader market. Surprisingly, there’s no perspective from firms that conduct low latency trading seeking to defend their interest in the practice. It’s not clear whether these hedge funds and banks refused to participate in the article, or their contributions simply didn’t fit the Times’ narrative. The story was written by a reporter who has covered health care and banking issues, rather than technology.
Proponents of low latency trading argue that this activity provides liquidity to execute trades that would otherwise not be possible, making the market more efficient, a point that was largely missing from the Times’ article …
Does this debate matter to the data center industry? Low latency trading has become a big business for a number of players in the data center space … The New York Times article is likely to focus more scrutiny on the practice.
Will this be accompanied by a chilling effect on spending by trading firms, which would affect demand for colocation space and connectivity? It’s too early to say, but it bears monitoring going forward.
Is that as close as we’ll get to a defense of high-frequency trades? Where is Lucas Van Praag, Goldman’s perpetually indignant spokesman, when we need him? Oddly, the highest-profile attack on the Times article so far popped up in an unlikely spot: Josh Marshall’s muckraking TPM Cafe. John Hempton, an Australian financial analyst, takes direct aim at Duhigg’s piece and those who have used it to bash Goldman et al.
I’m unclear as to what in the article, other than possibly Donaldson’s quote, Hempton feels was mindless or factually incorrect. But as for his final claim — if it was a distraction, it was one that took an important debate occurring mostly among a handful of Tyler Durden’s commenters and pushed it to the forefront of the blogosphere’s collective consciousness. Sounds like a good way to get to “know what is happening” this time around.Given almost nobody knows how to make $22 billion per annum trading and jealousy is a common trait, conspiracy theories abound. The current conspiracy theory is that this money comes from front-running clients in the market with very rapid trading. The New York Times recently promoted this view.
The idea is that by knowing client orders you can extract profits. Computers fleece clients by forcing clients to pay more when they buy and to receive less when they sell. And it is clear this happens …
That said – these profits can’t add up to sufficient to explain Goldman’s trading profit. Interactive Brokers is (by far) the most electronic and lowest cost broking platform in the world.We use it extensively as do many others. Interactive Brokers has a 12 percent market share in option market making globally and probably a 10 percent share in all market making. Trading revenue was about 220 million. Moreover in the conference call the CEO/Founder (Thomas Peterffy) thought the influx of competition in the area had reduced market maker margins very substantially.
Anyway if 10 percent of global stock volume provides 220 million dollars revenue per quarter then there is no way that a substantial proportion of Goldman’s trading profit can come from high frequency trading. The numbers do not work.
When the New York Times quotes William Donaldson (a former CEO of the New York Stock Exchange) as that high frequency trading “is where all the money is getting made” they are quoting bunk – and they should know it.
This is a plea. Can we have a dispassionate and accurate view of where the (vast) trading profits of Wall Street in general (and Goldman Sachs in particular) come from? The last big boom in trading profits was followed by a bust which came at huge social costs. [Look what happened to Lehman.]
We cannot understand the risks “Wall Street” is taking and hence the economic downside if it all turns pear shaped, and the appropriate regulatory structure, unless we know what is happening.
Mindless articles such as the recent New York Times one – grossly inconsistent with facts are less than helpful. They are distracting.
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