High Frequency Trading Glitsch

Over the past week everyone seems to have jumped on the HFT bandwagon: people who know nothing about the issue, as well as tested industry veterans, all of a sudden are chiming in, with some, like quant legend Paul Wilmott debating the potential dangers of HFT, while others such as respected bloggers including Eric Falkenstein and John Hempton saying it is too much noise over nothing. Both sides of the debate are respected, as, if nothing else, it forces further clarity on this most secretive topic.

While long-time Zero Hedge readers have known our position on the issue since early April, the basis of our perspective has always been a (very relevant) question. Which is why it is useful to hear those who are directly involved in not only the HFT market, and not only were instrumental in developing the HFT architecture, but have worked for the largest HFT option trading desk in the US, that of Citadel (and likely were sitting one desk away from the likes of Misha Malyshev, made infamous by his involvement in the Aleynikov-GS scandal). We present to you Michael Durbin, who tips his cards in a piece by Reuters' Matt Goldstein who broke the Aleynikov scandal.

Durbin says it’s reasonable to wonder whether Wall Street’s unfettered embrace of algorithmic automated trading could be setting the stage for a future meltdown.

“You have multiple HFT trading firms and sometimes their agendas are complementary and sometimes they’re not,” explains Durbin, director of HFT research with Blue Capital Group, a small Chicago-based options trading firm.

“There could be a time where these HFT programs unintentionally collaborate and you have a two- or three-minute period where the markets are going crazy. Then other traders respond to it and it simply gets out of control.”

What Durbin’s talking about is the dreaded contagion effect, in which a bad trade or a rogue algorithm misfires — sparking copycat sell orders at other high frequency desks.

A little on Durbin's background:

Durbin certainly has the bona fides to speak to the potential risk. Before joining Blue Capital, he worked for two years at Citadel Investment Group, constructing the hedge fund’s high frequency trading desk for stock options — the largest in the business.

Of course, if Durbin is right and the regulators finally do something about the inherent risk, the revenue streams that would be cut would reach into the tens of billions of dollars. It is not surprising that so many lay and otherwise voices have sprung up in defense of HFT, some of which have an agenda, others which speak purely out of naivete.

Big players in the field like Goldman Sachs (GS), Citadel Investment Group, Getco and Interactive Brokers claim they’re mainly providing liquidity — making it easier for other traders, institutions and investors to get in and out of positions. The vast majority of high frequency traders would have you believe they are nothing more than service providers.

Yet it’s fair to question the necessity of the service that high frequency traders say they are providing. Much of the liquidity high frequency traders are adding to the mix is simply to match trades created by other high frequency traders.

Reread the last sentence carefully - it basically encapsulates the whole argument against HFT, and against B/Ds who use it and generate massive returns year over year: does anyone wonder why Medallion (which aside from being investigated by the SEC will likely be annihilated if Flash trading is banned) generates 50-80% returns year over year, while RIEF has gone from managing $27.8 billion to $5.4 billion in under 2 years. In principle this is like Goldman seeing the order flow on Sigma X, matching it in dark liquidity and offsetting the other side of the just executed trade on the NYSE without anyone else having a clue as to what drove the stock price materially up or down as there was nothing at all on Level 2 to suggest a supply/demand disbalance.

As this topic picks up much more steam, Zero Hedge would like to reinforce Goldstein's conclusion from his article.

That’s enough for me. It’s high time for the Securities and Exchange Commission, the Commodity Futures Trading Commission and overseas securities regulators to start working together now to assess the potential systemic risks posed by high frequency trading before a problem occurs.

Again, it’s premature for anyone to suggest that regulators either prohibit or severely restrict high frequency trading. But let’s be clear what we’re talking about here — this is mainly trading for trading’s sake. High frequency trading is simply another way for Wall Street firms and hedge fund to make money.

There’s nothing inherently wrong with profit-driven trading. But if high frequency trading isn’t critical to keeping the markets humming, there should be nothing stopping regulators from putting a review of this strategy at the top of their agendas.

We hope that this time, unlike the Flash case, the SEC won't wait until a senator actually reminds it to do its bloody job.

Comments

[Modesto:]

Isn't paying for a peek at the order flow before it hits the market (Nasdaq) simply front running? High bit traders will most likely have a black swan event, particularly since it is so hard to predict precisely what and when it will occur.

Jul 31 08:45 AM

[kotika98:]

"Much of the liquidity high frequency traders are adding to the mix is simply to match trades created by other high frequency traders."

This is pure silliness - it may or may not be true but how would anyone know? Its not like anyone has an overall birds-eye view of the markets who could tell.

Jul 31 08:45 AM

[john s. gordon:]

mr. murphy (who worked for lockheed aircraft in 1948) would say that anything that can possibly go wrong, will.
> jack

Jul 31 08:51 AM

[Doh!:]

Doh! - While we're at it, could we please stop those noisy auctioneers? I simply can't keep up with them!! I would like to take a minute or two to think about that Michael Jackson fingerless glove before I make an offer!!!

That's why it's called TRADING - If you can't keep up - find a new game!

Stop whining!!!!

Jul 31 09:15 AM

[Moon Kil Woong:]

LOL 2 minutes to anyone is the time a HFT can generate a good 250,000 trades hiding any trace of what it is actually doing until they execute it on the heads of someone that's not a computer playing fake I buy 100 shares at 1 cent higher and then you buy them back at 1 cent higher in a Hal2000 handshake.

The simple fact is dark pools and off exchange trading is dealing real trades and HFT is clearing them so that there is 0 real price transparency. This system effectively makes the exchanges a derivative. Thus my derivative is now a derivative of a derivative with no insight on the value some hedge fund gave to buy a given stock which was consumed by GS before it hit the floor. In fact, perhaps it never hit the floor but was used to clear a long that they helf for a hour before. We will never know besides the fact I'm sure they pocketed a nice spread on the synthetic differential they executed among HFT prices between 1PM and 2 PM. If you think they could have taken a loss on this you must be joking.

Jul 31 09:43 AM

[upfornow:]

The money that is being skimmed off the stock market is not productive investing and is coming out ordinary investors pockets. When does the ordinary investor stop buying because the game is crooked or when do retired people insist that managers of their pension fund start suing to recover losses. upfornow

Jul 31 09:52 AM

[debtacid:]

HFT has turned the market in to a Saturday morning cartoon. We need to get our gold and silver back from these fools

Jul 31 10:15 AM

[ObjectiveFu...:]

Toto, I don't think we're underneath the buttonwood tree anymore.

The only "open outcry" is shorts getting mangled....

Jul 31 11:41 AM

[Doh!:]

waaahhh... sob sob - try Monopoly. I doubt Warren Buffet is HF Trading because he is an INVESTOR and he probably could not care less who is making money trading Coke (a Cola) 250,000 times a day, so long as the company's fundamentals stay strong, because the market will reward him in p/e.

If your MOM's retirement is being day traded, you have bigger things to worry about than who is making .013 on which side of a 26$ share trade.

Investing is about BUY and HOLD not trying to play BSD day trader.

If you like slow moving markets, try South America where pension funds and others (like PE firms that help fuel growth in smaller firms) DO NOT PARTICIPATE simply because there is no liquidity in the markets.

Jul 31 11:49 AM

[Doh!:]

BTW, We can't compete with Toyota's robots when it comes to making cars either. Damn the machines! Time for a blacksmith renaissance! Think of the savings in petro dollars if we did away with cars! I know a few horse traders (and granola crunchers) who would be very happy indeed.

In fact, if we got rid of our dependence on foreign oil, we could eliminate nuclear arms and there would be world peace. Hmmmm...

Jul 31 11:57 AM

[whidbey:]

Yes it is a moon shot, but we need innovation and new technology that even the inventors find thrilling for its unpredictability. Who knows? They may discover the lost algorithm which could turn this into our salvation. Dangerous? yes, but worth the price!

Stop the bitching and start living, the spirit that built America was one of doing the impossible. For example, we must believe that the SEC gives a damned and understands sufficiently to respond sometime after GS gives them permission to proceed.

Jul 31 03:48 PM

[Brian McM:]

Was there world peace during the Middle Ages which were bereft of cars and nuclear arms? Ever hear of The Crusades? Hannibal? Genghis Khan?...Hmmmm, back at you. Don't be so naive.


On Jul 31 11:57 AM Doh! wrote:

> BTW, We can't compete with Toyota's robots when it comes to making
> cars either. Damn the machines! Time for a blacksmith renaissance!
> Think of the savings in petro dollars if we did away with cars! I
> know a few horse traders (and granola crunchers) who would be very
> happy indeed.
>
> In fact, if we got rid of our dependence on foreign oil, we could
> eliminate nuclear arms and there would be world peace. Hmmmm...

Jul 31 05:23 PM

[Doh!:]

It was sarcasm. Apparently lost.


On Jul 31 05:23 PM Brian McM wrote:

> Was there world peace during the Middle Ages which were bereft of
> cars and nuclear arms? Ever hear of The Crusades? Hannibal? Genghis
> Khan?...Hmmmm, back at you. Don't be so naive.

Jul 31 08:25 PM

[untrusting ...:]

Moon,
Good comments. As per my previous posting, trading for tradings sake provides nothing of value to the overall market. The role of providing liquidity and guaranteed buy/sales is the role of the market maker and has been for many decades. Thus the arguements of all these HFT, dark pool entities, algo traders, etc, and the like are just bogus excuses for them to develop as many ways as possible to skim the markets of tens of billions in profits.

In fact there is absolutely zero justification for 1-second, 1-day, or even 1-week trading of securities. The capital markets were designed and intented to be forums for raising debt and equity capital for business operational purposes. The investors or lenders were to be compensated for providing debt/equity. None of these basic capital market functions has anything to do with instantaneous trading.

So in effect these big players have effectively turned the captial markets into one giant casino whereby they attempt to use every conceivable advantage into a cash generating machine for themselves. And with virtually no transparency of any kind and with the complicity of the exchanges themselves.

Since ST/instantaneous trading is basically counter productive to the basic purposes of the captial markets, the easiest way to deal with it not to ban it or even regulate it, but simply to tax it to the point whereby it is essentially unprofitable to undertake it. If something is essentially non-productive, then develop disincentives to do it. My suggestion is a 95% tax on any profits of any security held for less than 1 week. That will put a real quick end to this nonsense of massive instantaneous trading that is capturing the market.


On Jul 31 09:43 AM Moon Kil Woong wrote:

> LOL 2 minutes to anyone is the time a HFT can generate a good 250,000
> trades hiding any trace of what it is actually doing until they execute
> it on the heads of someone that's not a computer playing fake I buy
> 100 shares at 1 cent higher and then you buy them back at 1 cent
> higher in a Hal2000 handshake.
>
> The simple fact is dark pools and off exchange trading is dealing
> real trades and HFT is clearing them so that there is 0 real price
> transparency. This system effectively makes the exchanges a derivative.
> Thus my derivative is now a derivative of a derivative with no insight
> on the value some hedge fund gave to buy a given stock which was
> consumed by GS before it hit the floor. In fact, perhaps it never
> hit the floor but was used to clear a long that they helf for a hour
> before. We will never know besides the fact I'm sure they pocketed
> a nice spread on the synthetic differential they executed among HFT
> prices between 1PM and 2 PM. If you think they could have taken a
> loss on this you must be joking.

Jul 31 08:59 PM

[salvacion ...:]

In our business sometime we gain sometimes got loss but this is the reality in business market .

Aug 01 04:15 AM

[Trey Jarmond:]

You know the HFT boxes an work in the downward direction just as they can in an upward correction. That simply means we get stronger moves than people anticipate. so everyone is saying S&P drop to 950. well, with HFT in effect, I suspect it can hit 910-925 in a correction. Which in itself would be about 8% which is healthy for the markets

Aug 02 08:34 AM

[Youri Carma:]

It's a totaly rigged sytem if 70% volume is done by 2% of the dealers/computers it means that the other 30% is led by what the 2% does. This sytem only benifits the ones in this business and it's all ver exciting with this new counter flash software also but bottemline speaking the economy is skimmed from money what otherwise would be in the real economical sytem. I think it has become more of a computersimulation with the computer throughing the ball up for others to play with for a while. Onethical, very costly for taxpayers and economy cause this is no open price discovery anymore, it'e rigged gaming simulation and should be forbiden immediately.

Aug 03 12:13 AM

[S3:]

The truth about high frequency trading-

www.s3.com/news2009-07...

Aug 04 12:16 PM

[Doh!:]

Nice!

Would love to see any empirical evidence that shows a negative correlation between hft and p/e in any S&P stock over time.

Trading ain't investing folks :)

Doh!


On Aug 04 12:16 PM S3 wrote:

> The truth about high frequency trading-
>
> www.s3.com/news2009-07...

Aug 09 07:47 PM

[Doh!:]

www.businessinsider.co...


On Aug 09 07:47 PM Doh! wrote:

> Nice!
>
> Would love to see any empirical evidence that shows a negative correlation
> between hft and p/e in any S&P stock over time.
>
> Trading ain't investing folks :)
>
> Doh!

Aug 09 07:59 PM