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T2's Whitney Tilson On Toxic Trading
Excerpts from Whitney Tilson's client email:
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1) STOP THE PRESSES! This "toxic equity trading" appears to be MUCH bigger than I thought (see the paper I sent around as part of my last email: www.themistrading.com/article_files/0000/0348/Toxic_Equity_Trading_on_Wall_Street_12-17-08.pdf).
Here's a REALLY interesting comment I received:
I’m writing to communicate that there is significantly more than a bit of truth to this paper. I can tell you from first-hand experience that predatory algorithmic trading, as outlined in your “Toxic Equity Trading” attachment, is an ongoing and rapidly evolving practice. The bleeding edge in this field is currently well beyond the scope and level of sophistication discussed in this article.
More than a decade ago, I attended a presentation by someone who was attempting to perfect the latest iteration of an “automated algorithmic trading system” he had concocted. After a short discussion, I was disgusted to realize that his “investing system” was merely a mechanism to automate the front running of institutional orders. The program ‘sensed’ institutional orders via stochastics rather than ‘pinging’ for algos. He had already implemented his first crude version of the program, so you can extrapolate forward and imagine the current state of these techniques. In fact, you don't have to imagine. I know that co-located servers, predatory algos and funds set-up specifically to execute rebate strategies are all very real. I think you would be really shocked by the way some of the funds operating in the upper mathematical/technological strata conduct business.
The moral issues here are multi-fold; these “high frequency” shops operate with a near constant information advantage (due in part to their co-location contracts) and their operations literally make the markets less efficient, all while systematically reallocating wealth away from normal market participants.
2) Another person's comment:
I just wanted to assure you that everything in the Themis paper is occurring in today's markets. It first started about 10 yrs. ago with the "rebate traders" and has evolved as the paper suggests. High frequency trading and automated market making has been a major growth industry on Wall St. the last few years. The exchanges have been courting them like mad, offering co-location of servers etc. The new push is into the options markets where the rebates are much richer, this is one of the toxic byproducts of "payment for order flow" in both equities and options. Some of the firms out there trading hundreds of millions of shares a day in these strategies are outfits very few have ever heard of, and they would like to keep it that way. The reverse engineering of institutionally used trading algos has been a booming industry. You might enjoy the following story regarding NYSE program trading transparency (or lack thereof) via the blog zero hedge.
http://zerohedge.blogspot.com/2009/06/nyse-halts-transparency-feels-goldman.html
Interestingly, both of these people VERY much wanted to remain anonymous. A lot of people who are making an awful lot of money don't want anyone to know what they're doing...
3) Here's a post from the Zerohedge blog (http://zerohedge.blogspot.com/2009/07/guest-posts-even-simpler-and-high.html) that explains what's going on in plain English:
Even simpler…
My partners frequently poke fun at me (ok there is a long line offolks doing this…), specifically for thinking too deeply about a topic,and expressing an idea with too much detail.
I would like to get real simple here. High Frequency Trading is proprietary computer trading with the goal of collecting rebates, and/or detecting real order flow (ie. instititional flow) and frontrunning it and making pennies.
What bothers me? Two things:
First, whether the market is trading at a 16 P/E, or a 22 P/E, or a 30P/E… this is decided by 30% of the volume in the market. 70% of the volume is noise. In the “olden days” there were many different types of market participants (Value players, MOMOGOGO momentum players, Chartists, GARP players, and so on). None of them were 70% of the volume. This made for an efficient market. This made for a market where we felt strongly that the pricing in the market reflected actual asset values. This new HFT 70% market share makes me very nervous. I hope it does you, as well.
Second, the HFT players are courted by the Exchanges, ATS’s, ECN’sand Dark Pools. They are given whatever they want, as these for-profitdestinations all want their volume. Would they (HFT) have grown to thislevel if the exchanges and trading destinations were not for profit?
Is there a national interest in insuring that (1) our exchanges are the fairest, with equal access for all to the best prices, and not just those with their servers located inside the actual exchange, (2) our exchanges are transparent, and (3) that the system is working as it should, where asset values are reflected in prices? Was it the beginning of the end when all our exchanges went to a for-profit model?
These comments further underscore the need for urgent regulatory action to put a stop to this blatent market manipulation.
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As ususal pension funds, 401Ks, Mutual fund investor is screwed.
In the first set of quoted paragraphs, the individual is referring to algorithms that sense institutional trading and rush in to pick up the rebate. This makes no sense. This is like diving on a grenade. If stock X has NBBO of 9.05-9.06, and my software can sense a lot of institutional selling, I don't want to earn a rebate by putting in a limit order at 9.05, because the price is likely going to 9.03, based on the large amount of selling. What am I missing here? Diving in front of institutional trading means that you are providing "sucker's liquidity". The rebate is minor compared with the loss on the stock you know own.
jbeyer's comment makes sense. also, for every rebate given to an HFT algo for providing liquidity, the liquidity taker pays a fee that is (slightly) higher than the rebate (hence causing a net inflow of money to the exchange/ECN). That means the HFT algos by themselves couldn't 'churn' volume without bleeding money.
i am tempted to conclude that people making arguments claiming that HFT algo's are manipulating market direction by trading amongst themselves couldn't tell their a$$ from a hole in the ground.
so you disagree that agency/facilitation market trades can be used to pay off principal limits? or is that another hole in the ground that never, ever happens based on your extensive expertise?
i am confused by some of the technical details on the subject of HFT, but basically, isn't this frontrunning on a massive scale?
okay - the hole in the ground comment was unwarranted - but it wasn't directed towards you TD.
Having said that, one bank's agency/facilitation market trades don't reach the market (ECN or exchange) if the prop desk is taking the other side. The cross is done 'off-exchange' and gets reported as such. The bank still gets its 1 (or 2?) cent commission for executing the trade - the exchange/ECN rebate doesn't come into the picture.
amen. unfortunately the commentary here has become so far fetched that the blog has lost all its credibility. it's become a megaphone for the complaints of large size, which just can't get itself all moved without moving the price, and needs someone to blame for the existence of gravity. There are a lot of interesting things about hft, but the drool is dripping onto the paper and blurring rational discussion.
Nobody likes gravity!
So, 11696, how DID GS make $3 billion last quarter?
A month ago, I merely thought the stock market was confounding. Thanks to articles like this and others on Zero Hedge, I think its direction is increasingly rigged. If this be proven, it'll be another black eye for the powers that be. And maybe for modern capitalism too, considering our economic straits.
You might not be able to sell trillions of dollars worth of TALF-backed CMBS bonds if the market signaled anything other than Return-To-2007 good times for all.
Mission Accomplished.
Deep down, we both know that you don't really pay enough in taxes anyway. What's a few extra trillion in losses (poof) in order to save the New World Order?
Whitney...you are a pretty smart guy but holy shit talk about asleep at the swtich my friend?! Seriously? You are finding out now?!!>!>! You have been hanging out to much with the CNBC/fastmoney crowd WAY to much....kinda refreshing to be awakened doesn't it?
To all you coachroaches and vampire squids, the dark pool is no longer on a bloomberg terminal it is here at zerohedge....we here may not be well capitalized sharks but we are more like small PIRANHA's (which are nothing as one but quickly rise in lethality with numbers) ....we will turn from utter annoyance (for the likes of Mr. Canada et all) to flesh eating torrents that will evaporate those in seconds when tossed into our dark pool.....your day of reckoning is coming (as well as our politicians) faster than you think.........
I'm no expert, but I suspect we may be overlooking a possible agenda. These things have been operating for years, but since early March they seem to aim only at raising the market, and they've been doing it worldwide. Is this G20 stealth stimulus? The world certainly fears deflationary collapse Are they inserting money into economies through the markets?
Not necessarily. It seems that monetary stimulus in China, for example, is having a real fundamental effect that is driving market values higher. No intervention needed.
In other parts of the world... say Europe? Certainly a possiblity.
I don't believe numbers coming out of China based on all of the closed plants comments from observers on the ground.
Nobody asked Bernanke yesterday. Perhaps someone out there knows a Congressperson who will have a chance to ask today:
"Mr. Bernanke, is the Fed, or has the Fed at any time under your leadership, been involved, directly or indirectly, in the purchase of equities or equity futures or ETF's in the US?"
Just so sensational. Just wait till the programs learn to think for themselves. Then they get 90% of liqidity. Don't put it past 'em. We need regulation now, but who's gonna take down the traders making billions and the exchanges making billions, surely not some regulator agency that is paid thru the taxes generated from the trades. The circle of life.
Has anyone seen stats on HOW MUCH these HFT liquidity providers COST the exchanges? How big is this "loss leader"? How much is the NYSE, for instance, paying to Goldman for all this hammering on their systems? What portion of the $20 billion HFT profit pie is rebates, and what portion is front-running or inter-prop-desk predatory?
HFT liquidity providers cost the exchanges zip, zero, NADA. There's a simple reason why; liquidity provider rebates are always less than the liquidity taker fees. See http://www.batstrading.com/FeeSchedule/ for an example.
It's still not making 100% sense from an economic POV.
If Exchanges/ECNs are taking loss leader in order to attract rebate traders, notwithstanding tape revenue or AMM co-location fees, it seems that volume of HFT will (at some point) cost Exchanges/ECNs more than income generated from retail/inst'l investors fees generated, since HFT/predatory algos volume trading against each other can theoretically outsize retail/inst'l volume. It seems that eventually loss leader for Exchanges/ECNs is not worth the HFT/rebate business unless Exchanges/ECNs put limitations on rebate amounts.
Add to that, jbeyer's 11616 comment: "The rebate is minor compared with the loss [ie, risk] on the stock you now own." Hence, trading patterns as described by Themis Trading makes sense, but such patterns cannot be made to persist 100% of time and given widening spreads could spell trouble even for HFT/rebate traders. Therefore: risk > rebate opportunity. It is noted that what potentially squares this box (cost/benefit) for HFT "liquidity providers" is "frontrunning" opportunity.
If anyone wants to add further clarity here... would be much appreciated.
Apocalypse Now-
Where is Vanguard, American Funds, Fidelity, Barclays, Franklin Templeton, Pimco, Schwab etc. in all of this? I'm calling these companies out because they have the leverage to ensure "fair markets" and handle most of the pension/401K money. These shenanigans could kill the goose that laid the golden egg by destroying all confidence in the exchanges. This would be a novel way of influencing, since the exchanges and the liquidity providers are spooning.
That's right! Crooks can't steal from you if you take your business elsewhere. Obviously, key players in Congress are (literally?) in bed with the crooks, but why expect or ask Congress to do something you can do for yourself. So "act locally". "Employ sanctions". Stop using ETFs and even mutual funds and let them know that you aren't going to use them again until they get together and gang up on The Bad Apple, like they should have been doing all this time anyway.
If effectively HFTs get paid for buying and selling at the same price, why bother with all those complicated predatory algorithms, 'pinging' etc? 3-4 firms could simply arrange to do a certain amount of 'business' with each other every week and eliminate risk altogether. Given the sophistication of exchanges and regulators compared to profit-oriented participants, it shouldn't be that hard to disguise the process, or keep it just low enough to stay below radar. Or do they only get a rebate for trades done versus non-HFT customers?
this is not limited to the stock market - forex and futures markets have the same sickly feel
this is not limited to the stock market - forex and futures markets have the same sickly feel
An information edge is not front running. Mutual funds have enjoyed an information edge for decades that has only recently diminished. When research reports were mailed, people on the East Coast benefited from an information edge when compared to their West Coast peers. An information edge is not front running unless you are using a customer order to make proprietary trades. Furthermore, jumping in front of anticipated order flow is nothing new. If you think an algo or a trader that attempts to find/profit from order imbalances (ie institutional order flow) is something new, you're not the smartest person in the room. Tyler- your post of the Traders Magazine was very important. You really should go that direction instead of losing credibility with this low level stuff.
TD et al, I appreciate these informative topics you've been covering related to HFTrading recently. In many of the names I trade (ETF's in particular), I often get a sense there is false liquidity on the bid/offer. For example, sometimes there will be a 20 or 30K block bid at a given level, and 500 shares will execute there and the bid will drop off a penny or two.
I also often find that I cannot get filled reliably on my typical 3-5K shares unless i hit the bid or lift the offer...and sometimes then my order will seem to stall and suddenly the bid/offer is 3 cents away and i'm left with a partial fill. That happens to me a lot, and I trade names you would think would be highly liquid (20mm+ shares/day).
One thing about all of this I don't quite understand is market direction/manipulation. If these HFT's and algo robots are really that prevalent & therefore our markets really do lack liquidity, why do we keep churning higher relentlessly for months now? Why are there not days (save for a handful) that the market gets crushed on the downside just like it has been crushing to the upside? Is this some sort of algo/HFT bias? Because it would seem to me that we would see some massive downside action once the market starts heading lower. But every time we go lower the market reverses (see yest 1pm & this morning again).
That volume has not increased while HFT is responsible for higher and higher percentages of daily volume suggests that market participation has dramatically decreased. In other words, the equities market is a mostly empty shell--a zombie. I think that's the case with the mortgage and corporate bond markets, too. Bernanke tells Congress that regulation would interfere with the "extraordinary measures" the Fed is involved in to save the economy. Could these measures include forestalling collapse by propping up markets? Actually, all this talk of "saving the economy" by the president and his team makes me think they are involved in ethically suspect shenanigans and if exposed will fall back on the end justifies the means argument.