Broken Markets: How High-Frequency Trading and Predatory Practices Are Destroying Confidence and Your Portfolio, by Sal Arnuk and Joseph Saluzzi, FT Press, 2012
This insider look at the evolution of high-frequency trading (HFT) from its start as "scalping" in the Chicago commodity trading pits well over a decade ago is chilling, even to the most intrepid retail investor like me. It provides vital advice for institutional portfolio managers and individual investors on how to stay abreast of the current arms race by HFT traders and the over 50 electronic exchanges they use.
Broken Markets' authors Sal Arnuk and Joseph Saluzzi are co-founders of Themis Trading, LLC, an independent agency brokerage firm that trades equities for institutional money managers and hedge funds. After decade-long careers at Instinet, the pioneer electronic platform where they headed trading in equities, they saw the coming storm in the electronic takeover of stock markets and left in 2002 to found Themis Trading. Their birds' eye view of the changes electronic trading was creating in the structure of equity markets provided them the foresight to publicly predict the May 2010 Flash Crash. Vilified by the HFT industry, Arnuk and Saluzzi sounded the alarm first to the SEC and wrote technical papers in financial journals. Later, they participated in a campaign of public media interviews.
Joseph Saluzzi's appearance on CBS's 60 Minutes in 2010 finally opened up the kimono on HFT. As if the investing public had not been terrified enough at the Wall Street meltdown and the resulting global fallout in their portfolios, the authors' revelations on HFT amplified the mass exit by retail investors from publicly traded equities. Investigative journalist Matt Taibbi's exposes of Wall Street's foibles, frauds and unpunished criminality in Rolling Stone magazine, along with bloggers Tyler Durden's ZeroHedge and Yves Smith's Naked Capitalism, continued to scoop the mainstream financial media, . We learn from Broken Markets that even Arthur Levitt, the respected former Chair of the SEC, now advises two of the biggest HFT firms -- GETCO and Goldman Sachs (p. 85).
Arnuk and Saluzzi were able to dig deeper, putting themselves and their company in the firing line to reveal the extent of HFT's predatory practices and its collusion with the for-profit new exchanges and dark pools where most trades today are executed. They report in-depth on how NYSE, NASDAQ and other exchanges sell co-location sites next to their huge electronic trading machines to shave off milliseconds in trading advantages to HFT operators. They point out the fallacies of the conventional indices endlessly followed in conventional media: Dow Jones, S&P, NASDAQ, Russell 2000, etc. For example, they write, the Dow Jones Industrial Average of 30 industrials now covers, on average, just 27% of the daily trading volume in these equities.
Arnuk and Saluzzi describe machinations between HFT players and the new electronic exchanges where some 70% of all trades are executed. They explain how these practices evolved as the formerly staid non-profit NYSE went public and for-profit, along with NASDAQ. They also show how the SEC promoted these changes in their misguided focus on reducing commissions, liquidity and "efficiency." Deregulation and computer technology were the means, and stock market volumes skyrocketed. HFT "scalpers" became the dominant force they are today, all their deals with exchanges offering "rebates" to attract their huge order flows. HFT traders justify this by claiming they provide liquidity, but as I have frequently argued, this is "faux liquidity" which disappears when needed. Unlike the "old specialists," HFT firms have no obligation to stay in the game and provide real liquidity as responsible market-makers.
In our Ethical Markets Media initiative Transforming Finance, we pointed out that the platforms and infrastructure used by HFT firms: the internet, satellites, communications networks, were largely funded by taxpayers and thus, represent public assets. Therefore, HFT firms are clearly mis-using this public infrastructure and severely taxing the resources of the SEC and the Commodities Future Trading Commission, which still have not fully explained the May 2010 Flash Crash due to lack of expertise, information, staff and funding. Clearly, they and the public are out-gunned in this epic battle with today's financial markets. As a science policy wonk from 1974 to 1980, I advised the US National Science Foundation, the National Academy of Engineering and the Office of Technology Assessment (OTA), which produced the first study of the harmful effects likely from computerized Wall Street, Electronic Bulls and Bears after being shut down by Republicans led by House Speaker Newt Gingrich in 1996.
Additionally, the authors describe the current computerized arms race of the algos now competing on "latency arbitrage" (e.g., speed). Recent reports show $300 million invested by HFT trader Hibernia Atlantic for undersea cable across the Atlantic between its New York and London servers. This is an illustration of the profits that can be skimmed by HFT in what is best described as front-running of customers' orders -- typically a punishable offense.
For those portfolio managers responsible for institutional funds, I can do no better than to list some of the authors' key advice on how to protect your assets and those of pension beneficiaries and other institutional portfolio owners and trustees.:
• Know your router: Ask what is the detailed preference of your smart order router (SOR) service? Is it just the cheapest trading destination that is likely filled with HFT traders sifting out order information? Protect yourself by requesting the removal of destinations in collusion with HFT traders from your SOR. It may cost a little more per share in commissions, but your trades will be better executed.
• Learn whether your SOR sends "actionable indications of interest" (IOIs) to dark pools, which may give other market participants the ability to take a "free look" at your order flow.
• Ask your broker for a daily report detailing where your executions occurred, to ensure avoiding "toxic pools" where your information is "leaked" to others.
If you are a retail investor fleeing from corrupt public markets, like me, here's the authors' advice for you:
• Ask your broker if you can direct your orders to a particular exchange (to avoid HFT snooping).
• Never use a market order! These are "picked off" by HFT traders. The May 2010 Flash Crash was the ultimate example of why not to use market orders.
• Find out where your broker plans to execute your order. SEC Rule 606 requires brokers to make public reports quarterly on their routing of non-directed orders in National Market System (NMS) securities.
• Ask where your order was executed as required under Rule 606.
On page 145, the authors show a revealing map of the circuitous routes a buy-side order takes with a SOR "algo," wandering through computers at dozens of exchanges. As Arnuk pointed out at a November 2011 industry meeting, "Yes, you may pay very low commissions, but you've given up control and placed the economics of your routing decisions in the hands of your broker." For example, the authors describe Direct Edge ROUC, which offers a "cost effective" routing strategy, including revealing the long journey your order will make, gaining traders "rebates" from the various exchanges along the way.
I have not included more details about Broken Markets because readers should buy this book and see for themselves what the authors predicted. As market participants, we need to understand that systemic reforms are needed, as well as what we must do to restore confidence in the markets. The restoration of investor confidence is key - without it, no market can function.