It’s my baseline assumption when looking at markets, financial or otherwise, that when something involves no fraud or physical coercion it’s beneficial or innocuous. When you find something damaging to markets, it’s usually the result of some law (price controls, quotas, cartels). So I gave the benefit of the doubt to these opaque trading strategies that made money from speed. Surely, like other traders or market makers they were adding efficiency to the marketplace somehow.
Well, the day it became available for download I read Flash Boys cover to cover, and it makes a good case that some HFT is damaging to the markets, and that this drain on capital is the result of unnecessary regulations. The kind of HFT in question operates by being the first to see an order come to market on some exchange (by putting out tiny buy or sell orders on hundreds of stocks), then jumping ahead of that order (using fast connections and software) on other exchanges. In the case of some customer’s buy order, the HFT shop will snatch up all the lowest offers from the various exchanges, then then sell the stock a fraction of a second later to the customer at a slightly higher price than they would have paid, had the HFT not raced ahead of them.
Here’s a clip from Sunday’s excellent 60 Minutes piece on the book:
So far, this sounds shitty but fair the way Wall Street works. So, some firms’ trading systems are quicker than others – in the end it must lead to greater efficiency, right? Well, the first clue that something is not quite right is the astonishing regularity of HFT profits. Aside from a few accidents, most never lose money. That’s odd – most traders make money by assuming risk someone else would rather not. Say a stock is trading at 20.00 bid / 20.10 offer and a big mutual fund wants to sell a million shares. To dribble it out would run the risk of the stock falling in the meantime, so their policy is to dump the whole thing, even if it pushes down the price. A specialist buys the block at 19.85 and feeds it into the market over the course of an hour. Maybe the stock drops and he closes out at a loss – no worry, since over a number of such transactions he’ll be compensated in excess of the average loss. In effect, he is paid by eager sellers and buyers to take risks for them. With skill, he will come out on top in the long run, but he doesn’t come out black every day.
Some HFTs may come out black every minute, since they have a higher buyer in hand already every time they go long. They don’t enter a trade unless the exit is known – and it’s not as though they are finding something the end customer wouldn’t get anyway without them at a better price.
Regulation National Market System (Reg NMS)
After a 2004 SEC suit against a two dozen specialists on the NYSE for frontrunning, the commission implemented a new system meant to ensure that customers received the best available prices for their orders. In effect, it required that brokers accept the best quoted price, no matter how few shares were available at that price. This meant that a broker with a buy order for 5000 shares would have to first fill 100 shares on say the BATS exchange even if the full 5000 were available for just a penny more on other exchanges. By taking away brokers’ discretion, it opened the door for HFT shops to hold out best price bids and offers for 100 shares, using these as triggers to race to the best prices on other exchanges ahead of the brokers’ orders.
Reg NMS also set up an official quote system (he SIP) that surveyed the best prices available on the exchanges and published this for the use of brokers and their customers. Naturally, it is not the fastest system, so HFT shops’ own internal quotes from direct feeds are more accurate. This difference, combined with a system for detecting orders (courtesy of the same regulation) is a recipe for riskless profits.
Brokers are selling out customers.
Here’s where it gets far worse: nearly all US brokers have started selling order flow to HFTs. Lewis tells us that TD Ameritrade, for example, is paid hundreds of millions of dollars a year by Citadel (an HFT hedge fund with a brokerage license) for the right to execute customers’ orders. Retail brokers’ orders are the most valuable (sold for around $0.02 per share) because their investors are using the oldest quotes. Brokers can also be paid by exchanges to direct orders there, since the exchanges want volume and sell services to HFTs.
Please, not another regulation
Some politicos are already chomping at the bit to do something about HFT, but there is already a market solution: IEX, a new exchange set up specifically to eliminate any opportunity for front-running using deliberate delays that put all traders on the same footing. Goldman Sachs (which contrary to popular belief was never a top-tier player in HFT) has been an early adopter and supporter of the exchange, and just yesterday Interactive Brokers (a huge online brokerage catering to professionals) announced that it will add the ability for customers to direct trades to IEX.
Heavy-hitting customers would be crazy not to demand the same from all of their brokers, which is going to force other exchanges to become less friendly to HFTs. BATS announced this week that starting next January its matching engine will start using the fast direct feeds rather than the SIP, after its CEO lied about this on CNBC in a heated debate with the CEO of IEX.
The heyday of HFT is over.
Want another viewpoint? Here’s an informed negative review of the book on Amazon.
And here are some further possible weak points, courtesy of Meanderful:
The IEX guys sound like great lads but let’s start by looking at how to win on their platform. Their price is delayed fairly. OK. You are lucky enough know the price is going to be always delayed and thus stale at match point. The stale pricing is guaranteed by many miles of fibre in a shoebox. Great! Try to use all your inputs to deduce an impression of a better price in real time. Throw it at them. Send in limits or IOCs at your biased price and see if you land a trade in their time warp. Better information exists on the outside of the delayed world. Use it. It’s still a race. Slower exchanges are always problematic as the world knows better. IEX is no different. You can be played by better information or decisions. You don’t eliminate the speed race. Hmm, it’s not really much different to any other venue in that regard. There is always an arb in a world that has space and time as a feature.
In theory, there is no difference between theory and practice. Unfortunately, the real world does intervene on our clever ideas. It is wrong to think that there is not a continuum of probabilities and latency where views that seem absolute can’t be replaced by a bit of educated guesswork with a virtual latency gain. Things are just not as simple as Lewis makes out. Some people think bunching trades into chunky time slices may be the solution. Such time point based auctions are not the answer. Even if you traded with an auction to the minute there is still a game of maximising your information at the deadline with latency tricks. So even slowing down trading to minutes becomes a latency game. A stupidly inefficient one, but still latency sensitive. Unintended consequences abound. You really do have to be careful what you wish for.
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Obviously there remains a lot more to this story, and those of us outside the business are just starting to grasp some of what goes on after we click “execute order.”
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