High Frequency Trading and ‘Market Rigging’
My interview and debate on CNBC about High Frequency Trading.
By my colleague and friend Mike Earlywine @MEWINO, senior trader and options expert:
As you may have heard Michael Lewis has a new book out called Flash boys. It is about High Frequency trading,(HFT) and it is creating quite the fire storm in the financial media and among the various market participants.
Michael Lewis has been in the press promoting his book by saying that the market is rigged. Surprisingly, for how easy as it is to vilify wall street, there has been some push back. Part of the problem is that HFT means different things to different people. It is often confused with computer based trading or algorithmic trading. Often it is spoken about in conspiratorial tones that make is sound illegal or something out of a bad Hollywood movie. But his claim that the market Is rigged has galvanized many people to defend what is right about our market. Either way, It is a complicated topic and I hope this summary helps.
In the first part I use the Open letter from Charles Schwab to opine on what I think the real concerns are, and in the second part I give an example of HFT in its truest and simplest form
The controversy –
Like many I think the current market structure is flawed and rife with unintended consequences but I am hesitant to vilify the firms that take advantage of the fragmented market that has evolved over the past 10 years.
This letter from Charles Schwab really sets out in detail what a lot the controversy is actually about.
* My comments on the letter are in inverted commas. http://www.aboutschwab.com/press/issues/
- Advantaged treatment: Growing numbers of complex order types afford preferential treatment to professional traders’ orders, most notably to jump ahead of retail limit orders.
- Unequal access to information: Exchanges allow high-frequency traders to purchase faster data feeds with detailed information about market trading activity and the specific trading of various types of market participants. This further tilts the playing field against the individual investor, who is already at an informational disadvantage by virtue of the slower Consolidated Data Stream that brokers are required by rule to purchase or, even worse, the 15- to 20-minute-delayed quote feed they have public access to.
Orders that jump ahead? What are these order types? I am still working with limit and market orders?!? There are no special order types just for HFT, but there are many SEC approved order types that are only used by the HFT type traders. It can cost upwards of $50mil to put the infrastructure in place that would make some of these order types useful.
Is this what people mean when they say HFT guys can see an orders coming? Are they monitoring the high-speed feed and then transacting in front of it against what are about to be stale quotes? YES that is exactly what they are doing. The SEC is aware of and allows exchanges to sell this different feeds. After consolidating the ticker plants the high speed feeds are only 1.5milliseconds faster than the regular, but that is enough for these guys to pick off stale quotes. (this is why co-location is so important. Every millisecond counts when your stealing fractions of a penny).
- Inappropriate use of information: Professionals are mining the detailed data feeds made available to them by the exchanges to sniff out and front-run large institutions (mutual funds and pension funds), which more often than not are investing and trading on behalf of individual investors.
Can’t fault firms for taking advantage of all the information they are buying… but just what are they buying? How detailed and what data points are in there. I can sniff out big order just watching the tape so I’m not sure how hard it would be to do if I was getting special data points. But whatever it is, it is not illegal or even surprising.
- Added systems burdens, costs and distortions of rapid-fire quote activity: Ephemeral quotes, also called “quote stuffing,” that are cancelled and reposted in milliseconds distort the tape and present risk to the resiliency and integrity of critical market data and trading infrastructure. The tremendous added costs associated with the expanded capacity and bandwidth necessary to support this added data traffic is ultimately borne in part by individual investors.
Posted shares don’t accurately reflect what can be truly transacted – HFT have a very low risk tolerance so they fade any move. They don’t stand still, they only transact when their model says they can get the offset. I am the same way, I only transact when I think it benefits me, but I think in 5 and 10 cents increments. HFT math is done in fractions of a penny and includes rebates – my math leads to finding other intuitions with different opinions or a different urgency on timing. Their math leads to small trades with little valuation component – rather it is based on their ability to close out the trade at a profit or flat.
I am constantly trying explain how I can struggle to buy 100k shares of a stock that has traded 1mil on the day.. but HFT can have that kind of effect, both through fading and because their activity can move a stock to a price level where the institutions don’t want to transact. For example, it is not uncommon to see a stock move multiple percentage points on HFT like activity, but when I come in to sell at that price there really is no contra side (there was no real price discovery, it was instead a temporary price inflation due to mechanical HFT strategies.)
This is the part that drives me crazy – I think it is probably market manipulation -They try to overwhelm the system in an effort to push the market to certain levels. BUT the worst part of this gets little attention. By quote stuffing they are excluding participation by other investors. It is no longer about finding the right price or taking advantage of what you consider mispricing it is more about protecting turf and bending the rules to protect their access to liquidity. The original rules of the NYSE included a rule that held an order up for a specific time so traders could match and bid or offer. It was just 1min and allowed anyone to participate in the trade. It was there to make sure the biggest and fastest didn’t monopolize the exchange…they had it right and we have lost something in our quest for instant execution.
An Example and some further comments on this point:
Basic HFT example– a simplistic look at HFT trader strategy – This is an example of what they do, but it’s not what is causing the controversy
- Exchange A pay a few basis points if you take liquidity – business model promotes activity
Exchange B pays a few basis points for posting trades – business model incentives providing liquidity
My super-fast computer sees that Exchange A has 100 ABC offered at $20
HFT – step one – buy the 100 from exchange A get paid fractions of a penny on rebate
HFT – step two – offer 100 shares of ABC on exchange B at the same price or a higher price depending on my strategy and or risk tolerance
HFT – step three – hopefully someone buys those shares and I get paid again because exchange B pays for liquidity
HFT – step four – repeat thousands of times a day in hundreds of different stocks
NEED for SPEED
- Once I open a position I need to get in the front of the book to post my closing position to reduce my risk exposure
- No free lunch I am still exposed to the market and could lose money
- My models might have all kinds of stats on likely hood of execution but I still need to be first to market to get paid
- I am competing not so much against traditional institutions but against other HFT players!
- I have to compete to buy or sell the opening position and I have to complete to close it too
- Being late can expose me to market risk that my strategy is not designed to manage