An appeaser is one who feeds a crocodile, hoping it will eat him last.
- Winston Churchill
Senator Chuck Schumer has warned the SEC that, if the Commission does not act to halt the new “flash orders”, he will introduce legislation to ban the practice. The New York Times obligingly ran a front-page story (23 July, “Stock Traders Find Speed Pays, In Milliseconds”) and followed up with stories about Senator Schumer’s assault.
Flash trading takes to a new level the algorithm-driven model known as “High Frequency / Low Latency” trading. Traders with the most powerful computers and the most sophisticated algorithms – “algos” in trader-ese – capture significant advantage by identifying patterns of buying and selling literally as they emerge, and in many cases before trades are even printed.
Free markets are predicated on the notion that those who are smarter, faster and more diligent than the rest also get to make more money, even at the expense of the rest. No one compels us to trade stocks, and we do so with eyes open to the risks. Including especially the risk of trading against someone smarter than ourselves.
But the flash order double-dips the advantage already enjoyed by the smart guys. First, the market venue where you enter your trade attempts to fill your order by sweeping available inside bids or offers – preferencing its own members – then they flash the unfilled portion to their biggest customers. Only then does it get routed out to the broad market. We always knew that money talks. Now we learn that it also front runs your order.
The Times reports that on July 15, trading in the shares of Broadcom (BRCM) surged. The Times story indicates that buy orders in Broadcom were flashed to the Star Wars crowd for 30 milliseconds. This 0.03 of a second was enough for the algos to determine out not only the direction of interest, but the upper and lower price limits, and to scale their orders accordingly. The Times reports “the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.”
A profit of $7,800 on transactions valued at $1.4 million may not seem like a lot of money, especially when factored over all the High Frequency / Low Latency guys in the flash realm. It is a return of 0.0056, or a little over one-half of one percent of the total amount that changed hands.
Multiply that by the billions of shares that trade in the markets every day, factor in the news stories, rumors or just plain market momentum that drives trading swells, and you see this can add up.
As a random example, for trade date 30 June of this year, NYSE Group daily dollar volume was reported as $45.6 billion. One-half of one percent of numbers of that magnitude – $228 million – adds up quickly. How quickly? The Times article cites a report indicating the high frequency traders as a group took in $21 billion in profits in 2008.
At the time of this writing, the SEC is looking at flash orders and it looks like the kibosh will soon be applied.
Buried in the Times story, almost as a throwaway, is the following:
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 exchanges, in an attempt to attract business, pay incentive fees to traders who execute on their facilities. Everyone in the business acknowledges this practice. It even has crept into trader-ese, where they call it “incenting.” For those of you who have forgotten, this practice – Payment For Order Flow – is how Bernie Madoff built his business. It worked for him, and it has certainly worked for the exchanges. NYSE average daily volume is up some 164% since 2005, even as other exchanges and trading venues have proliferated. By some estimates the Star Wars guys account for over half of all trading volume on all exchanges.
This is touted as being good for everybody. Markets need depth. All other things being equal, the more volume on an exchange, the more robust that market should be. But by paying for order flow the exchanges induce firms to place orders in trading venues, regardless of the quality of execution. Exchanges are supposed to offer depth, liquidity, transparency, and protection of customer orders. Firms should trade based on the robustness of that venue – not on the basis of who pays them for their business. By “incenting”, exchanges create a false impression of market activity – the activity is real; what is false is the underlying reason for that activity.
When this type of activity occurs in individual securities, it is called Painting the Tape. Traders buy and sell the same securities repeatedly, artificially pumping the trading volume in order to create public interest in a security. When individuals do it, it is a criminal activity. When an exchange does it, it is called promoting liquidity and market depth. Now, even incentive fees are not enough to hold onto the Star Wars traders, but they need an early peek into the order book to top it off. The bigger they are, the more clout they have, and the more the exchanges have to offer them to stay. Some traders even have algos that calculate maximum loss scenarios, then enter losing orders as long as the incentive fee will be more than the loss on the trades themselves.
In a reversal that should take no one by surprise, the NASDAQ Stock market, which introduced Flash Orders on 3 June, now characterizes these types of orders as “order types that do not support price formation” (Reuters, 28 July, “Nasdaq Backs Ban On “Flash” Trading: Schumer”). For the lay person: we tried to give an excess unfair advantage to our biggest players, because try as we might, we couldn’t incent them enough, but too many people figured it out too quickly.
So it looks as though the flash order will end up as a flash in the pan. This looks like the regulators once again giving away the store, then making a big fuss about taking back a little, while still leaving the big boys free rein to dominate the marketplace.
The Star Wars world of high frequency trading is here to stay. Anyone doubting this need only look at the Wall Street Journal report (WSJ, 31 July, “NYSE’s Fast-Trade Hub Rises Up In New Jersey”). The NYSE is creating a 400,000 square foot mega trading starship at a secret (we’re not making this up) location in Mahwah, NJ, to house Star Wars traders. The physical proximity to the NYSE trading floor, we are told, will make a difference in time of order transmissions, as traders are now executing not in milliseconds – thousandths of a second – but in microseconds – millionths of a second.
Winston Churchill once observed that no government in history has ever gone to the vast logistical trouble and financial expense of a broad military mobilization without subsequently going to war. Once the armies are massed on the border, too much money has been spent – and too much political capital – to ask that they stand down.
The NYSE is betting on the future of Star Wars, and it looks a safe bet – though whether the NYSE’s Starship Frequency will be the fleet’s flagship is anybody’s guess. The article says the NYSE hopes to attract certain established players in the high frequency world. “Worries about high-frequency trading aren’t focused on” Goldman or hedge fund Citadel. No surprise there. Indeed, the only thing the NYSE is worried about is whether Goldman and citadel will actually book aboard their starship, or if they will be off on someone else’s DeathStar. Count on the NYSE to offer free rent – otherwise known as “soft dollars” – as another way to “incent” the big boys, at the risk of undermining the integrity of the marketplace.
As Senator Schumer leads the charge, the flash order may look like a dead issue. But have no fear: the Empire will strike back.