In the aftermath of Michael Lewis' book "Flash Boys" there has been a renewed surge in interest in High Frequency Trading. Alas, much of it is conflicted, biased, overly technical or simply wrong. And since we can't assume that all those interested have been followed our 5 year of coverage of a topic that finally has earned its day in the public spotlight, below is a simple summary for everyone.
Instead of uttering one more word in a long, seemingly endless tirade that stretches all the way to April 2009, we will this time let such dignified members of the credible, veritable status quo as Credit Suisse, who have released a two part primer on everything HFT related, with an emphasis on the broken market left in the wake of the "high freaks", which is so simple even a member of congress will understand (we would say a member of the SEC, but even at this level of simplicity its comprehension by the rank and file of the SEC is arguable). As Credit Suisse conveniently points out "market manipulation is already banned", but that doesn't mean that there are numerous loophole that HFT can manifest themselves in negative strategies that have virtually the same impact on a two-tiered market (those that have access to HFT and those that do not) as manipulation. Among such strategies are:
- Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
- Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
- Order Book Fade: lightning-fast reactions to news and order book pressure lead to disappearing liquidity
- Momentum ignition: an HFT trader detects a large order targeting a percentage of volume, and front-runs it.
Back in the summer of 2010, when the SEC was still desperate to (laughably) scapegoat the May 6 Flash Crash on Waddell and Reed, in an attempt to telegraph to the public that it was in control of the HFT takeover of the stock market (an attempt which has since failed miserably as days in which there are no occult trading phenomena have become the outlier and have resulted in the wholesale dereliction of stock trading by retail investors), we first presented and endorsed the Nanex proposal that the flash crash was an "on demand" (either on purpose or by mistake) event, one which occurred as a result of massive quote stuffing which prevented regular way trading from occuring and resulting in a 1000 DJIA point plunge in minutes (the audio track to which is still a must hear for anyone who harbor any doubt the market is "safe"). It turns out that in the nearly 3 years since that fateful market crash, not only has nothing been done to repair the market (ostensibly broken beyond repair and only another wholesale crash, this time without DKed trades, and bailed out banks, could possible do something to change the status quo) but the Denial of Service (DoS) attacks that HFT algos launch, for whatever reason, have become a daily occurrence as the following demonstrations from Nanex confirm beyond a shadow of a doubt.
Scientific Proof That High Frequency Trading Induces Adverse Changes In Market Microstructure And Dynamics, And Puts Market Fairness Under QuestionSubmitted by Tyler Durden on 07/13/2010 00:46 -0400
Up until recently, any debate between proponents and opponents of High Frequency Trading would typically be represented by heated debates of high conviction on either side, with discussions rapidly deteriorating into ad hominem attacks and the producer screaming 'cut to commercial' to prevent fistfights. Luckily, all this is about to change. In a research paper by Reginald Smith of the Bouchet Franklin Institute in Rochester titled "Is high-frequency trading inducing changes in market microstructure and dynamics?" the author finds that he "can clearly demonstrate that HFT is having an increasingly large impact on the microstructure of equity trading dynamics. Traded value, and by extension trading volume, fluctuations are starting to show self-similarity at increasingly shorter timescales. Values which were once only present on the orders of several hours or days are now commonplace in the timescale of seconds or minutes. It is important that the trading algorithms of HFT traders, as well as those who seek to understand, improve, or regulate HFT realize that the overall structure of trading is influenced in a measurable manner by HFT and that Gaussian noise models of short term trading volume fluctuations likely are increasingly inapplicable." In other words, the author finds ample evidence that during the past decade (on the NASDAQ) and especially since the 2005 revision of Reg NMS (on the NYSE), stock trading increasingly demonstrates "self similar" fractal patterns, resulting in volatility surges, recursive feedback loops, and a market structure which is increasingly becoming a product of the actual trading mechanism. In the process, as demonstrated by a Hurst Exponent gravitating increasingly further away from 0.5 (i.e., Brown Noise territory), the Markov Process nature of stock trading is put under question, and thus the whole premise of an efficient market has to be reevaluated. Simply said: HFT has been shown to affect the fairness of trading.
A funny exchange between a rather conflicted Larry Tabb of Tabb Group and AFL-CIO's Brandon Rees deserves a watch, as it highlights the latest fault lines in the market structure debate: watch for exchanges to increasingly blame dark pools, and vice versa, even as both do nothing but add to systemic market collapse risks in exchange for a marginal reduction in trading costs. Whether the trade-off of imminent market crashes at any moment courtesy of a market structure that nobody can make sense of any longer in exchange for a few cents per thousand shares is equitable is up to others to decide. It is certainly something that the industry will defend until its last drop of blood, although expect the SEC and the government to finally step in to curb the rampant abuse of front-running "privileges" by exchanges and secrecy and rent internalization by banks through dark pools. The funniest bit of the exchange occurs at 3:35 into the clip, when Tabb publicly discloses that front-running is not only legal but occurs all the time on open exchanges. When Erin Burnett, who unfortunately still thinks that the Deutsche Mark is used in Germany, asks who is doing the front running, Tabb says "It could be anyone." And as retail investors tend to not have access to dark pools (in fact Reg ATS allows banks to singlehandedly determine who is allowed access to their dark pools without any appeal recourse), now you know that every single time you put in an order, it is by definition frontran by everyone who has a million dollar collocated trading station: thank you Mr. Tabb for once again proving our breathless rantings. Which brings us to our question from early 2009 - when will the SEC finally look into this broken, criminal and endlessly front-running market?
"Banning flash orders and imposing limits on dark pools should not be the end of the story, nor should they be seen as sacrificial lambs offered up by a substantial majority of Wall Street players as the price to ward off deeper review. Chief among the systemic issues that must be carefully reviewed is high frequency trading, which now makes up over 70% of the daily market volume. The SEC needs to closely review these strategies -- whether employed in dark pools or the public markets -- to ensure that high frequency traders are not able to take advantage of the long-term investors who are the backbone of our capital markets. It is the SEC’s mission to protect long-term investors, who care about the valuations of the underlying companies, not those who quest for trading profits achieved in milliseconds." - Senator Ted Kaufman
"Has the era of the dark pool come to an end?" Thus begins the Traders Magazine cover article "End of the Line? SEC Targets Dark Pools and Off-Board Trading", which deconstructs all the incipient issues, criticisms and concerns facing the utterly discredited Mary Schapiro who is hell bent on getting at least one thing right during her career at the SEC, before she is brushed off as even less effective than her arguably much worse predecessor Chris Cox.
Matt Taibbi has put together a very informative piece on Goldman's lobbying attempts, specifically in the context on the upcoming discussion over naked short selling. The contention here by the majority is that naked short selling, or NSS, promotes bear raids on crippled companies which tend to feed upon each other, with CDS traders also joining in the fray. The argument is a dramatic oversimplification and has little substantiation by facts. "Bear raids" occur only and exclusively in financial stocks: why can't you have a bear raid on a firm like Coke or Johnson and Johnson, or even some leveraged behemoth like Hertz.
Read on for some major exciting changes to market structure.