Latency Arbitrage

One of the New Normal responses to allegations, first started here in 2009 and subsequently everywhere, that all HFT does is to frontrun traditional market players (among many other evils) now that its conventional and flawed defense that it "provides liquidity" lies dead and buried, is that "everyone does it" so you must acquit because how can you possibly prosecute a technology that accounts for over 60% of all market volume and where if you throw one person in jail you would throw everyone in jail. Today we learn that this indeed may be the case, and not only at the traditional locus of HFT frontrunning such as conventional exchanges for stocks such as the NYSE or even dark pools, but at the heart of the biggest futures exchange in the US, the CME where as the WSJ's Scott Patterson explains frontrunning by HFT algos is not only a way of life, but is perfectly accepted and even smiled upon.

Back in 2009 Zero Hedge was first the only, and shortly thereafter, one of very few non-conformist voices objecting to pervasive high frequency trading and other type of quantitative market manipulation in the form of Flash Trading (which has recently reemerged in yet another form of frontrunning known as "Hide not Slide" practices) quote stuffing, and naturally latency arbitrage: one of the most subversive means to rob the less than sophisticated investor blind, due to an illegal coordination between market markers, exchanges and regulators, which effectively encouraged a two-tier market (one for the ultra fast frontrunning professionals, and one for everyone else). A week ago we were amused to see that the SEC charged the NYSE with a wristslap, one for $5 million dollars and where the NYSE naturally neither admitted nor denied guilt, accusing it of doing precisely what we said it, and all others, had been doing for years: namely getting paid by wealthy traders, those using the prop data feed OpenBook Ultra and other paid systems, to create and perpetuate a two-tiered market, all the while the regulator, i.e., the SEC was paid to look the other way. This action was nothing but a desperate, and futile, attempt to regain some investor confidence in the market. It has failed, and since said "enforcement" action has done nothing to restore confidence, expect to see more exchanges slapped with fines for actively perpetuating latency arbitrage opportunities for "some" clients. Well, since the SEC will be desperate to come up with more means of "restoring credibility" of both the market and its regulator, another exchange it may want to look at is the NASDAQ, which as Nanex demonstrates, may well have been engaging in comparable (most likely not pro-bono) latency arbitrage benefiting some: those paying for its direct feed aka TotalView, and thus not harming others, or those relying on the Consolidated Feed (UQDF) for data dissemination.

The rational and efficient market mythbusters at Nanex have made another major discovery, having gone through the SEC's proposed plan to deal with extraordinary market conditions, better known as Limit Up/Limit Down Plan to Address Extraordinary Market Volatility, brilliantly abbreviated to LULD, and find that even if said been had been in place before May 6, 2010 it would have done absolutely nothing to prevent the 1000 swing in the Dow. Cutting through the chase, and partially explaining once again why there has been over $150 billion in domestic equity mutual fund outflows since the beginning of 2010, is that "The SEC has proposed many band-aid fixes since May 6, 2010 in an effort to make investors feel confident again about the equity market. The sad truth though is that none of their proposals so far will prevent another flash crash. Worse, some proposals, such as this one, will likely make things even worse." Bottom line: investors have no confidence that this market is at all better, and in fact it is very likely that the market could crash just as violently as May 6, at any given moment, as the SEC has done nothing to fix the underlying problems, but merely redirect and pretend that it is on top of things, while taking a nip and a tuck at some of the easily remedied symptoms. And as long as this mutually acceptable delusion continues, stocks are in constant danger of another epic wipe out courtesy of the SEC, which will eliminate what little confidence there is, even among those who trade purely with "Other People's Money." We thank Nanex for their ongoing pursuit of the truth behind the SEC's endless lies. Because if the regulator itself is corrupt and incompetent, then there really is no hope for market efficiency and fairness.

In a recent article Nanex has shown that quote stuffing can slow down the updating of series of stock prices, bids and asks. The article was less clear about why one might do that. There could be arbitraging opportunities. One of the first games these clowns got into was latency arbitrage. HFTer offers a number of shares for sale at one price, and at the first sign of interest, pulls all of the offers and resubmits them at a higher price. The latency comes into play because as another player send his orders in to fill HFTer, and these orders all find their ways to the market via differing routes, each of which has a different latency (lag time)--so instead of all arriving at once, they arrive singly, giving HFTer time to pull the rest of his bids....Saturating the quotes on individual lines will change the time lags (latency factor) during the intervals the quotes are generated. For Thor to work properly, it has to estimate by observation the precise lag between sending an order and having it arrive on each market. Randomly changing the lags for the different lines would confound RBC's (and others) attempts at ensuring all its orders arrive on all markets at the same time. And curiously all of this comes just days after the CQS decided to increase the cross-system capacity for quote stuffing in the market from 750,000 quotes per second to 1 million.... Almost as if someone is urgently trying to recreate the market instability that sent the Dow plunging by 1,000 points in seconds.

A few months ago we reported on Deutsche Boerse's Alpha Stream: a product suite especially designed to allow subscribers to get a millisecond advantage when market moving economic data is reported, which would then set HFT algos off the races, with the expectation that those paying a pretty penny for such access could scalp a few nickels from those without this critical (in our day and age of collocated needs) data feed. As a reminder, among the key benefits to customers, Deustche Boerse, now the owner of NYSE Euronext were that i) Data is sent directly by our journalists from government lock-ups; ii) Designed for easy direct integration into trading algorithms; iii) Global co-location and other connectivity options iv) AlphaFlash uses the high speed global network of Deutsche Börse and was designed by technology experts from the world of low latency trading. And while Euronext has had about 3 market halts in Europe in the past week, that appears to be irrelevant: with reverse merger listing fees now a thing of the past, the Deustche Borse has to continue raking in high margin HFT clients with the promise of some free latency arbitrage. Therefore, in order to make its product offering that much more appealing to 19 year old Ph.D.'s everywhere, NYSE Boerse has just announced its purchase of Kingsbury International Ltd., which surveys managers for the Chicago Business Barometer, also known as the company that hosts the Chicago PMI data, in order to bring PMI data direct to feed subscribers. Net result: expect even more market volatility at each PMI release, now that the market is not two but three-tiered, and consisting of regular HFTs, HFTs with access to the Deutsche Boerse feed, and everyone else. Does this make capital markets any more efficient? Hell no. Does it benefit the willing participants in a rigged casino who are about to purchase a faster reaction time for one of the blackjack tables? But of course.

Anywhere one turns these days, bashing HFT is the new market normal. Having written 150 articles on the topic, beginning in April 2009, we are happy to have brought the world's attention to this most dangerous of market aberrations. Yet until the SEC finally bans the practices of micro churning, quote stuffing, positive feedback loop chasing, flash trading, subpennying, DMA accessing, and all other aspects conceived merely to provide some market participants with an unfair advantage over everyone else, the fight against HFT must continue. Which is why we draw your attention to two items: the first is a paper by Bluemont Capital "The Marginalizing of the Individual Investor" in which the authors question if HFT has distorted true market valuation (yes) and to what degree. Some relevant soundbites: "Unfortunately, high-frequency trader interaction with computerized algorithms of large-cap financial institutions is providing opportunities for high-speed, virtually undetectable market manipulation", "At a minimum, computerized high-frequency and algorithmic trading are undermining traditional value investing strategies. Short-term liquidity and data movements are distorting information on real business performance", "Essentially, high-frequency trading platforms function as positive feedback loops. Engineers treat positive feedback loops as inherently unstable, as each positive response generates stepped-up repetition of the same actions. Positive feedback loops result in an ever- expanding balloon, but like all balloons, the risk of bursting increases with the balloon’s size", and concludes that the "continuing advances in computerized trading pose challenges for regulators throughout the world—and leave individual investors marginalized... Regulators should not only seek to assure that markets are able to continue to function under stress, but they also need to devise remedial actions that protect individual investors who have fundamentally different objectives from the high-turnover objectives of high frequency traders and computerized algorithms." The other notable item is the appearance of our friends at Nanex on ABC radio over in Australia, where firm founder Eric Hunsader discusses the previously highlighted concepts of latency arbitrage as a potential progenitor to the May 6 crash, as well as possible ways that the NBBO arbitrage could have provided for unfair and illegal mispricing opportunities for a select few.

Another day, another stunner from the statistical wizards at Nanex. As readers will recall, in our latest piece we discussed the implications of the temporal arbing of the NBBO between the Consolidated Quote System and proprietary pricing tapes, like NYSE's OpenBook, which indicated a major discrepancy in the pricing data in widely held stocks like GE. In summary, at its peak, at 14:45:55 on May 6, the latency between the CQS and OpenBook pricing hit a high of 24 seconds, making a mockery of the NBBO as all those who had premium access to OpenBook were all too aware that 99% of the investing public were seeing pricing data almost half a minute stale, and could trade accordingly on secondary "dark" venues. At the time we were disgusted with the implications this phenomenon had on the NBBO, as this was nothing less than a full-blown NBBO arbitrage opportunity for the haves vs the have nots. Yet today Nanex takes this observation, and our collective blood pressure, to a whole new level, by not only confirming that there is in fact a trigger threshold in terms of quote saturation which immediately causes a latency arbitrage between the CQS and OpenBook, but closes the circle on the ongoing constant presentation of mysterious "crop circle" quote stuffing data. In essence, what Nanex' data implies is that HFTs can create latency arbitrage on demand between the NYSE pricing data dissemination to the CQS, but not to NYSE's own proprietary product, OpenBook, by pushing the consolidated NYSE quote rate beyond a magic number of 20,000/second. This immediately begs the question: just how much of the NYT's as defined "conspiracy theory" for an "on demand" Flash Crash is theory and how much is fact, if the cause and effect of the May 6 events have been inverted, and the NYSE's Liquidity Replenishment Points failed only as a result of HFT quote bombardment.

One of the key tenets of Reg NMS (which has always been the cherry on top of a long process that began with a bunch of Wall Street banks and quants bribing regulators and politicians to first roofie stocks, and subsequently culminating with the gang rape by pimply 18 year old math Ph.D.'s of the entire stock market) is the "sanctity" of the NBBO: whatever happens, whatever insanity prevails in the market, buyers would always be prohibited from crossing the best offer, and sellers - the best bid (incidentally, there are exclusions to the rule but they occur only in options paired strategies). Which is why we read with great (lack of) surprise the latest piece by Nanex (recently famous for their dramatic quote-stuffing "crop circles" which day after day exposes the thieving douchebaggery of the HFT community for all to see, not to mention the criminal complicity of the SEC), that puts the very validity and credibility of the most fundamental concept of the stock market into question. In brief - Nanex concludes, and we certainly agree with them based on the presented evidence, that " the NBBO system cannot be relied upon and is meaningless."

Albert Edwards, one of the most prominent uber-bears just got even more bearish: "Our view that this economic and market recovery will collapse like a pack of cards as soon as the steroid-like stimulus is reduced is gaining ground. Most forward-looking leading indicators now signal some sort of second-half slowdown. The only area of debate now seems to be in its magnitude. By the end of this year, I believe we will be back in recession." Albert's vision of a deflationary collapse, following by a reactionary episode in which the Fed (in typical reactive fashion) ends up printing tens trillions in one last attempt to restimulate the economy, resulting in hyperinflation, is well-known, and conforms with our view. As for the turning point, it is still anyone's guess: as today's Freddie record low mortgage rates demonstrates, deflation has now firmly gotten the upper hand. The Fed has can not afford to wait and see how this plays out. Obviously, with ZIRP here at least through 2013, if not much longer, the only true recourse is another failed monetary stimulus. However, with the president's rating in shambles, and any form if stimulus,montary or fiscal, likely guaranteed to bite another 10% at least from his plunging popularity rating (see latest Gallup numbers here), Bernanke likely has his hands tied at least until 2011. Which is why deflationists are likely safe for at least 6 months, assuming of course the forward looking credit market (not stocks, stocks no longer reflect anything except for the latest latency arbitrage available to those rich enough to afford the latest and greatest Routers) does not begin to price in the hyperinflationary episode sooner. With 30 Day Bills near zero, there is little to worry about... for now.

To say that the latest bout of regulatory capture-cum-bribery of SEC individuals by the HFT lobby is getting out of hand, would be like hoping to have your limit bid get hit in any stock without some computer subpennying you to death first. As the below post by Themis Trading indicates, soon there will be no SEC employees left for the HFT lobby left to poach, which is why each HFT firm is now designing new algorithms to predict whom their competitors will poach, and front run said poaching. This explains the installation of collocated "Uncle HFT Wants YOU (and pays big scalped bux)" boxes near the SEC headquarters in Washington. This will soon be followed by High Frequency churning of all the new SEC employees who are hired and fired a few million times each second.

Now this is funny- we have just officially had the latest iteration in the "fat finger" mythology: S&P accidentally withdraws AAA rating of Germany due to "administrative error." Error is caught and promptly corrected, yet somehow none of the usual HFT latency arbitrage first responders do anything to punish German bonds. Time to recalibrate those sub-1millisecond headline response time algorithms. If only the S&P would be as prompt in correcting flawed upgrades of housing, CDOs and pretty much the entire ponzi system.

Volume up - sell, volume down- buy. Rinse, repeat. RoboTrader 3000 is back from Robo Hampton. At least doing the return trip to the closest latency arbitrage/front running NYSE collocation facility on the Long Island fiberoptic network is so much more fun than driving.

This piece was emailed to me by a friend. Its author, John Harris, according to his own bio, is “the founder and managing partner in Ceylon LLC, a provider of communication software libraries that enable traders to conduct electronic trading business on major industry platforms.” So… I get it; he is staked in the debate. Either he or his customers do not want their activities to be scrutinized by the SEC, who is charged with keeping our markets fair and safe. I am not sure I agree with the limits (2million shares per day/ or $20 million value… I would have gone way higher… higher to the point where this is aimed at the HFT the SEC is trying to understand, without catching any traditional mutual funds or hedge funds in the trap) that the SEC is proposing, but I can’t think of a more reasonable approach for the SEC to take, then to collect data on activities it does not understand, yet seeks to regulate. As industry participants who have watched this HFT defenses morph continually after each tactic fails, we are amused. - Sal Arnuk, Themis Trading

Yet another much needed reminder that the topic of High Frequency Trading is far from resolved. On Tuesday, Senator Ted Kaufman reminded that increasingly more regulators and market participants remain divided over HFT, even as concern about possible improprieties associated with market structure grows. Kaufman's most recent topic of focus - order cancellations. He said the SEC should address the "burgeoning" number of order cancellations involved in high frequency trading, which, he added, are "clearly excessive" and virtually a "prima facia" case that battles between competing algorithms have become "all too commonplace, overloading the system and regulators alike."

Nearly a year ago, Zero Hedge first brought broad public attention to the nebulous aspects of the dark and dirty underworld of the market, exposing the "second-tier" of privileged market participants, consisting of quant traders, high frequency trading, flash trading, sponsored access, co-location, latency arbitrage, Morgan Stanley's discussed-below PDT operation, and many other topics (check our Glossary for much more). In April, Zero Hedge wrote an open letter to the quant community, pleading for more transparency absent which the eventual result would be "larger, systematic problems at the largest, most sophisticated quant managers." Since April, the impact of market neutral quants has progressively declined, as factors, one after another, have failed, and market neutral indexes are probing multiyear lows (HSKAX). The question of who has stepped in to replace the whales' liquidity provisioning is still unanswered, although the explosion of small, inexperienced 3 man quant shops consisting of a math Ph.D. and two programmers, may be part of the answer. The integration of Goldman within the structure of the NYSE and other exchanges, may be another: at last check, Goldman is still a key component of the NYSE's SLP program, regarding which there is still barely any information, despite promises by NYSE representatives to the contrary (and with Goldman's prop operation potentially terminally crippled, the question of how extensively intertwined prop trading is with liquidity provisioning, will be a major topic going forward). Today, the WSJ's Scott Patterson takes advantage of the recent furor over quants and in extensive article promotes his new book "The Quants" in which "he suggests how this new breed of mathematicians and computer scientists took over much of the financial system—and the damage they inflicted in the 2007 meltdown." We are glad that, after nearly a year of writing about it, the topic of the market systemic threat presented by a small subcommunity of quantitative traders is finally emerging on the mainstream scene.