What Should Be Done About High Frequency Trading?
July 29th, 2009 | 
Author: A recent New York Times article has led to a good deal of discussion about High Frequency Trading (HFT). According to the Times:
Powerful computers, some housed right next to the machines that drive marketplaces like the New York Stock Exchange, enable high-frequency traders to transmit millions of orders at lightning speed and, their detractors contend, reap billions at everyone else’s expense.
These systems are so fast they can outsmart or outrun other investors, humans and computers alike. And after growing in the shadows for years, they are generating lots of talk.
Nearly everyone on Wall Street is wondering how hedge funds and large banks like Goldman Sachs are making so much money so soon after the financial system nearly collapsed. High-frequency trading is one answer.
The article goes on to further explain how HFT works:
Yet high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. The Securities and Exchange Commission says it is examining certain aspects of the strategy.
“This is where all the money is getting made,” said William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.”
For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea.
But 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.
The Times article has spurred a flurry of blog articles on the subject, most being highly critical of the practice. In fact, some bloggers have been warning of the evils of HFT prior to the Times expose’. A week before the Times article, Tyler Durden, on his blog Zero Hedge likened HFT to a ponzi scheme that is responsible for the recent market rally:
And 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.
Critics claim that violates front-running rules, manipulate markets, and create profits for firms like Goldman Sachs at the expense of individual investors. Goldman Sachs, in particular, has been singled out as the biggest villain in this controversy, and many believe that HFT is the primary source of Goldman’s record profits. However, financial analyst John Hempton of TPM Café states:
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.
HFT supporters claim that the practice provides market liquidity. In a Bloomberg.com story, Goldman Sachs spokesman Ed Canaday stated:
“Goldman Sachs believes high-frequency trading should have an accompanying obligation to provide liquidity, and be subject to appropriate regulatory oversight,” Canaday said.
Traders including David Lutz say automated brokerages boost liquidity, increasing the likelihood that buyers and sellers will agree on a price. Competition has driven bids and offers for some of the most widely held stocks, including Microsoft Corp., Citigroup Inc. and General Electric Co., to 1 cent in the U.S., according to data compiled by Bloomberg.
“When high-frequency traders are in the stocks I’m trying to execute, it helps me find the best execution,” said Lutz, a managing director of equity trading at Stifel Nicolaus & Co. in Baltimore. “It’s completely benign to me.”
One of the most controversial aspects of HFT is the practice known as “flash orders” has come under the scrutiny of NY Senator Charles Schumer:
High-speed trading in the U.S. stock market may face its biggest threat after Senator Charles Schumer proposed prohibiting so-called flash orders.
Schumer, the third-ranking Senate Democrat, urged the Securities and Exchange Commission to ban the practice in which some equity exchanges hold orders to buy and sell shares for a split second before publishing them on competing platforms. Nasdaq OMX Group Inc., Bats Global Markets and Direct Edge Holdings LLC, which handle more than two-thirds of the shares traded in the U.S., offer flash orders to their customers.
Schumer’s July 24 letter raises the stakes in a debate over whether computer-driven trading by hedge funds and Wall Street firms gives them an unfair advantage over other investors. While flash trades make up less than 4 percent of U.S. stock volume, they’ve drawn criticism from the Securities Industry and Financial Markets Association, Wall Street’s main lobbying group, and New York-based NYSE Euronext.
As is typical in these kinds of debates, the truth most likely lies somewhere in between the opposing viewpoints. I do not believe that HFT is driving the current market rally, but I believe there are enough questions about the practice to justify the SEC investigation of high frequency trading. Let’s get all of the facts before taking action.
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Themis Trading has a nice paper on how HFT’s can make money. According to Themis, there are a variety of strategies – but they are centered around identifying algorithms (e.g., VWAP algos) and targeting them for liquidity rebates and haircuts.
http://www.themistrading.com/article_files/0000/0348/Toxic_Equity_Trading_on_Wall_Street_12-17-08.pdf
It is interesting to think about the available pool of money. For example, according to BATS (batstrading.com), about 10 billion shares traded today. Figure an average rebate of 2/10 cent per share, and this means that there was roughly 20 million dollars in rebates paid today. Or roughly 5 billion a year is available in rebates from exchanges for providing liquidity.
That’s just the liquidity rebate strategies, of course — it doesn’t account for haircuts. There the possible available pool is much larger.
Thank you for your intelligent comment on Financial Services Issues.com