Good Morning. With the stock market currently doing a fine imitation of a Mexican jumping bean (the S&P's close has changed colors each and every day for the past fourteen straight days), it is safe to say that major indices are currently entrenched in a consolidation phase. And since the meat of the earnings parade doesn't arrive for another week or so, it is a decent bet that the current sideways, back and forth action might continue for a while. As such, I'd like to expend my pixels on a rather controversial subject this morning: HFT.
I had the distinct pleasure of being a panelist on a roundtable discussion Sunday evening on the subject of high frequency trading (aka HFT). The gang at Benzinga and Marketfy host periodic live discussions with various experts in their field, which are purely educational in nature and free to all attendees. And before I go any further I want publicly applaud Kyle Bazzy, Jason Raznick, and the rest of the crew for their efforts in this regard. Too many websites are very long on hype and extremely short on substance. The energized folks at Benzinga/Marketfy are employing the opposite approach and putting their readers, visitors, and customers first. To which, I'd like to say, "Bravo, well done."
I know what you're thinking - what the heck was I doing on a roundtable discussion with experts in the HFT field? I may be considered a swell guy by some and my 26 years of money management experience may mean that I might know a little something about how the markets work, but I am by no means an expert on HFT. No, I was invited to join the fray and asked to bring a money manager's perspective to the subject. So, I joined Hiam Bodek, who is one of the primary players in Scott Patterson's "Dark Pools," an industry expert, and an outspoken critic of HFT, and Mani Majouri, the CIO of TradeWorx - an HFT outfit.
Given that we had both a pro and con view on this highly controversial subject, the discussion was surprisingly civil. Mr. Majouri first walked the group through an example of an HFT strategy and "dumbed it down" enough so that even I could understand what was going on. Mani informed us that the HFT game had become very competitive and the uber-fast trading outfits were now working much harder for their profits these days.
Yes, believe it or not, profits at HFT firms are down - and down hard. Via an SEC filing when the HFT's 800-pound gorilla GETCO was acquiring Knight Capital Group (you remember the "Knightmare" right - where Knight's trading algo had a little hiccup and managed to lose $10 a minute for about 45 minutes) it was disclosed that GETCO's profits had fallen 82% to just $24.6 million in the nine month period ending 9/30/12. Apparently profits had been $134.8 billion a year earlier. Poor babies.
Ivy Schmerken explained what is happening in a recent article for Advanced Trading. Ivy wrote, "With shrinking volumes and a steep drop in volatility over the past four years, high-frequency trading in U.S. equities has become a less-profitable business, forcing some firms to exit the market. HFT firms are still dominant buyers and sellers of U.S. equities, but their profits reportedly have slumped from nearly $5 billion four years ago to $1 billion last year. As a result of these trends, firms are diversifying their strategies and adjusting their computerized models to compete." Again, my heart goes out to these poor souls.
Since Mani Majouri's TadeWorx provides HFT services to investors of all kinds, I didn't really expect him to get into the more predatory practices such as "queue jumping" or "quote stuffing," or talk about the orders that allow the machines jump in front of your market order and extract a penny or two before filling your trade. But he made some decent points about HFT works.
On the other hand, Hiam Bodek didn't mince words during his turn at the microphone. He accused brokers today of using "dumb" orders that allow the HFT folks to play their games and told the audience that it was their mutual funds and pension managers that were ultimately footing the bill for the HFT profiteers. Hiam said that institutional investors who don't know how the plumbing of the exchanges work are simply asking to be abused. He suggested that all investors should contact their mutual fund companies to find out how they were dealing with order routing and HFT practices.
Hiam's major points against HFT include: (1) HFT plays by a different set of rules by using order types specifically designed to help them profit. (2) The big HFT firms have gotten in bed directly with the exchanges in order to create "guaranteed economics" for their trading. (3) The "liquidity" purportedly provided by HFT is only available when conditions are favorable and as such, HFT firms are NOT the "new market makers." And (4) Hiam said that REG NMS, which was intended to help investors is actually a major source of the problem as "locked markets" create a haven for HFT.
If you've kept pace with the HFT story over the years, you will likely agree that none of this is really new. However, both Hiam and Mani provided some insight that left me feeling hopeful by the end of the discussion. Hiam said that many of the predatory practices the once were rampant are beginning to diminish. He said the NASDAQ was taking the lead in improving the way orders are routed. Hiam even went so far as to tell me that the NASDAQ may be "completely clean" by now.
My takeaways from the discussion are that there is now (a) more competition among HFT players, (b) less profitability in the latency arbitrage and HFT game, (c) more disclosure on order types (i.e. these orders aren't just for a select few anymore), (d) more regulatory oversight (and also more understanding of both HFT and the exchange "plumbing" by the regulators), and (e) less predatory activity. And from where I sit, all of the above are positives.
You see, after the 'Crash of 87', there was a lot of furor about program trading. And for several months after the computer-driven event, the program traders created massive volatility. But as more and more players got into the program trading game, the profitability and effectiveness of these strategies began to wane. Thus, it is my hope that the same scenario will play out now with regard to HFT.
In fact, new rules went into effect just yesterday aimed at preventing the likes of the May 6, 2010 "flash crash" where the HFT gang yanked that so-called "liquidity" faster than you could blink. According to MarketWatch, "the new "limit up/limit down" rules will require trades of a group of liquid listed stocks be executed within a range tied to recent prices for that security. Later, all exchange-traded stocks will be subject to the rules ... The circuit breakers were designed to halt trading of a security during periods of uncertainty, so that market participants could assess the situation and provide liquidity."
However, both Hiam and Mani said Sunday evening that HFT isn't going away anytime soon and that if you want to avoid being taken advantage of, you need to work with people who understand the game. The message was kind of like, "If you can't fight 'em, join 'em."
If you'd like to watch a recording of the roundtable discussion ... Here's the link.
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Turning to This Morning ...
After a record run of flip-flopping back and forth between red days and green days (never before had the S&P gone 14 sessions without at least two days finishing in the same direction) it appears that the bulls have a shot at making it two in a row today. Despite new warnings out of North Korea and concerns about Slovenia being the next bailout nation in Europe, U.S. futures are following the European markets higher in the early going.
Here are the Pre-Market indicators we review each morning before the opening bell ...
Major Foreign Markets:
- Shanghai: +0.65%
- Hong Kong: +0.70%
- Japan: unch
- France: +0.63%
- Germany: +0.27%
- Italy: +1.27%
- Spain: +1.36%
- London: +0.36%
Crude Oil Futures: +$0.13 to $93.49
Gold: -$1.10 to $1571.40
Dollar: higher against the yen lower vs. euro and pound
10-Year Bond Yield: Currently trading at 1.755%
Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +4.53
- Dow Jones Industrial Average: +29
- NASDAQ Composite: +10.57
Thought For The Day ... "A clever person solves a problem. A wise person avoids it." - Albert Einstein
Positions in stocks mentioned: none