High Frequency Trading: Legally, It's Called Churn

Includes: BAC, C, CIT
by: Tyler Durden

Following up to the earlier post about Direct Edge's Enhanced Liquidity Provider program, it again makes sense to appreciate the practical aspects of high frequency trading. Joe Saluzzi provides a good example from yesterday's program trading bag:

The three HFT horsemen are C, BAC and CIT. These three stocks traded 860 million shares today which is 10% of all US Equity volume. Think about that: 3 stocks in a universe of over 5000 U.S. stocks represented 10% of the volume. How could this be? Look at the intraday chart of all three of these stocks and you will see a something in common: an early morning move followed by a flatline with a very tight range (around .05). Meanwhile, while these stocks were flatlining the market was heading higher. The S&P 500 gained around 10 points in the afternoon (or 1%) but these 3 stocks did not move. There was a constant bid to these stocks yet anytime they wanted to lift there seemed to be a constant offer just a few pennies higher. This is what HFT looks like. The HFT’s made a killing in these 3 names today – in addition to the .01-.02 spread, they collected about .005/share in liquidity rebates. Not a bad day for a supercomputer.

There is, on the surface, nothing with wrong with this... except that there is, and there is a legal name for it, which FINRA and the SEC use when they impose fines, bars and other nasty things - it is called churning. And what churning does, at least in this macro HFT context, is it creates the perception that the market is all good, trading with decent amounts of volume, when all that is happening is the HFT/SLP entities provide a shallow market on either side of the NBBO (which as the Traders Magazine article pointed out is a worthless concept in a world dominated by flash orders at the top hierarchical level), with little to no interaction by natural buyers or sellers (though if such appear, the algorithms, as the Direct Edge case demonstrated, can be easily taken advantage of by these same HFTs).

Furthermore, extrapolate a $0.0025/share rebate (or the $0.0032 that Direct Edge's Ultra Tier clients pay) and double that, as these were likely the same entities on both sides of the trade... and you quickly can see why mega churning in otherwise dead names like CIT suddenly become very, very profitable and can even mitigate marginal capital loss if such old-fashioned concepts like fundamental analysis were to kick in and reset the price to its true level.

After all, liquidity rebates plus spreads on 70% of all 8 billion shares daily adds up to a whole lot of money in one year. And surprisingly, those who keep paying this "70%" day in and day out are happy to tip the "liquidity providers" for keeping an orderly, efficient market.