JP Morgan: High Frequency Trading a Form of Parasitic Market Making

When JP Morgan (JPM) discusses high frequency trading, people listen. When the head of JP Morgan's algorithmic product desk Carl Carries says that high frequency trading is merely a form of parastic market making, people should run for the hills (not in the least due to JP Morgan's proficiency in transforming theory to practice especially as it pertains to various daily trading patterns in the SPY).

The print that a Dark Pool leaves in its wake does not signal an aggressive buyer or seller as would a sweep, so the information leakage is reduced accordingly. Reduction of information leakage minimizes adverse price movement created by predators like high frequency traders who feast upon the signals of others.

And a few more questions to add to the ever increasing roster of queries for the NYSE (Mr. Pellecchia- maybe the time has come to provide at least some answers?): some dark pools have banned use of third party algorithms in accessing them in order to prevent harm to their institutional clients. Why is this good for dark pools, but not NYSE?

Trader Magazine reports Pipeline Trading banned third party algo's from accessing its dark pool:

Algorithm Switching Engine was introduced in October 2007, six months after Pipeline Trading banned third-party algorithms from accessing its own electronic block trading market.... Pipeline claims to be more effective than competitors in finding block matches because of its 50,000-share average execution size; large block orders are executed automatically without the possibility of sniffing out institutional interest with a small probing order.

Trader Magazine reports that ITG has banned third party algo's from accessing its dark pool POSIT:

Investment Technology Group, for the second time, has banned broker-dealers from accessing its POSIT crossing system via algorithms.... ITG chief executive and president Robert Gasser told analysts on the day of the decision that 'third-party dark aggregation has not been beneficial to our institutional POSIT constituency.'... Heckman told Traders Magazine that some brokers offering customers algorithmic access to POSIT appeared to give preference to their own or other liquidity through the algos. He said that adversely impacted the order flow POSIT received.

hat tip Richard

Comments

[apppro:]

Anything this confusing can't be good. I'n not a 'transparency' nut, but I am also "Not Smarter Then a Fifth Grader" and want my markets to reflect that.

Jul 12 07:33 AM

[dguest:]

it's clear the NYSE was increasingly marginalized over the last few years as alternative sources of liquidity became available, especially those that stood away from the sometimes specious influence of a specialist. as a result the exchange jumped into bed with super high frequency algorithmic traders - renaissance and goldman representing only the most high profile examples - as a way to make up for lost order flow, generate revenues, and attempt to portray that the floor is still relevant in today's modern trading age.

Jul 12 09:34 AM

[nukldrager:]

Let's just give them all the freakin money and be done with it lol

Jul 12 12:05 PM

[Lawrence Kl...:]

It is wise, for those with eyes, to seek different skies.

Jul 12 12:09 PM

[hooligan:]

sometimes one wonders whether our forefathers had the right of it in having single capacity trading. Brokers could only introduce deals to price makers (who had no other access to transactions). Here we have miniscule volumes affecting collosal market caps. The solution is either to revert back (with better technology) hence marginalising those who have no interest in the market other than to "bully it". Completely contra to efficient markets I know, but how about this as an alternative. Let the next price = the weighted average of previous market cap and deal cap, either when the bid is given or the offer is paid. At least use this as a price discovery principle. Might even work for TBS (toxic backed securities) too.

Jul 12 12:16 PM

[Moon Kil Woong:]

Good article. I'm glad someone else is uncovering what market makers already know, there are people who are very efficient at deciphering time and block trades to find out individual market orders and then using the information against those placing legitimate orders (for GS its simpler determining it since if they placed it they probably know and if they didn't it's free game ergo incentive to trade through them if you want to make a short term bet and don't want a tiger chasing after you from the rear).

This is a tried and true method of getting an edge that not just GS but all major brokerages do. The reason they don't prevent this is because it benefits the insiders who write the rules.

Inefficiency and a failure in the system to prevent order disclosure is a fundamental neccesity to enable such transactions. The current trading system is more rife with ways to take advantage of trades than 3rd world country's automated trading systems. Of course on thr NYSE having individual people and firms screaming orders only makes it that much more easy to tell where things are coming from. Gee, they all love people who place trades for discount brokers I'm sure. Pathetic.

And US equity market is under seige by overseas exchanges precisely because clients prefer a market where GS and other people can't run roughshod over them. Sadly, US citizen's find it very hard to grade GDR's or other instruments in other exchanges. I'm glad GS' woes came to light. I hope this encourages people to demand some change in how the exchanges operate and how people can disseminate your trades.

Jul 12 12:21 PM

[mplaut:]

The following paper discusses these trading strategies and comes to a conclusion similar to what Tyler Durden has been driving at (if I understand it properly). This is a very clearly written paper.

www.themistrading.com/...

The bottom line:

5. High frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.

Jul 12 12:25 PM

[basehitz:]

In this week's Barron's, Alan Abelson wrote;
"The hubbub over high-frequency trading grew in intensity and virulence when a slightly befuddled prosecutor told the court, in arguing to keep Mr. Aleynikov in the hoosegow rather than allowing him to make bail, the Goldman code in the wrong hands could lead to "unfair manipulation" of markets. We couldn't help being amused by how ravenously the malapropism was seized upon by hordes of cybernauts, unable to resist the obvious, as suggesting that in Goldman's hands it was used for "fair manipulation."
We'd be remiss in not crediting Tyler Durden and his feisty Zero Hedge blog for early coverage of the Aleynikov affair and helping to make the dog days of summer a tad less doggy."

Kudos TD.

Jul 12 01:31 PM

[John McLeod:]

mplaut,

Terrific dig :-)

I've got 3 paras of that that wonderful analysis spattered over the front page of our site.

... and Tyler, thanks for two great posts in one Sunday morning. Hope Sergey's code survived.

Jul 12 01:44 PM

[Hazel Hende...:]

Thanks for this article, helping explain another bunch of reasons not to trust Wall St.

Jul 12 01:47 PM

[Alan Young:]

BIngo! Excellent find. This makes everything clear--even to a "5th grader."


On Jul 12 12:25 PM mplaut wrote:

> The following paper discusses these trading strategies and comes
> to a conclusion similar to what Tyler Durden has been driving at
> (if I understand it properly). This is a very clearly written paper.
>
> www.themistrading.com/...
>

Jul 12 02:34 PM

[TinyTim:]

Great article, comments and links.

This is way more than I wanted to know about the market makers and scares the crap out of me. If they have colocated computers humping in back rooms to scim 1/4 penny and a 1 second rule makes or breaks the biz, why can't these guys go out and write a better open source computer operating system instead?
Imagine if we turned em loose on eBay.

Jul 12 08:41 PM

[Scalpulator:]

Lets be a little careful before pointing the finger at high frequency liquidity providers - If they are not providing a more sane price to the marketplace someone will step in and smash them. Firms like JPM, GS and friends are the ones with the real buying power might to move markets in the direction of choice while most proprietary traders cannot come close to their level of market bullying.

It is true that HF traders will increase microvolatility however this is typically unbiased in direction and has little if any negative effect on retail buyers of smaller size. I am not convinced that the above linked article by Arnuk even makes a strong case that there is any cost passed on to retail traders due to HF trading. Keep in mind the old NYSE specialists routinely front-ran order flow and had quite a generous timeframe to fill orders. A collection of independent liquidity providers is far preferable from a market efficiency and fairness point of view.

The true reason that HF trading pisses off GS and JPM is that these new boys are taking liquidity rebates away from the old boys market maker club. Exercise some healthy skepticism before pointing fingers at the HF traders please.

Jul 12 10:43 PM

[Wizler:]

damn there goes my plan for an exchange/dark pool arbitrage algo

Jul 13 08:57 AM