The topic of High-Frequency-Trading quickly dissolves into a smorgasbord of mnemonics and 'inside-baseball' technical terms - just complicated enough to lose everyone that matters or should care about its implications. Despite the fair-and-balanced defense from the mainstream media business channels (sponsored by the belief in the status quo fair markets that 'America the free' is known for), the fact is that HFT does front-run (perfectly legal under the umbrella protection of Reg NMS) order flow, but there may be one more wrinkle - one which would cement the Michael Lewis (accurate) allegation that the market is rigged.
Because if as Nanex shows below, there is in addition to everything else the element of timestamp fraud involved in the distribution of NMS "compliant" trading data for Direct Feed-to-SIP matching purposes, this means that not only is the market rigged, but its rigging goes from the very top all the way to the lowliest algo.
What's worse, the rigged system is so embedded there is nothing anyone can do about it, until it just collapses under its own weight: think May 2010 HFT-created flash crash, only without the mirror-image bounce.
Direct vs SIP Data Feed
The animation below shows how a trade or quote sent on an exchange makes its way to the SIP (Securities Information Processor) and a Direct Feed used by High Frequency Traders (HFT). Reg NMS requires that an exchange (A) send data to the SIP (C) as fast or faster than it sends that data to direct feed subscribers (B). Here's the relavent text from Regulation NMS:
Rule 603(a)(2) requires that any SRO, broker, or dealer that distributes market information must do so on terms that are not unreasonably discriminatory. These requirements prohibit, for example, a market from making its "core data" (i.e., data that it is required to provide to a Network processor) available to vendors on a more timely basis than it makes available the core data to a Network processor.
This is the same rule that NYSE broke and was fined $5M by the SEC in September 2012. We have a nice write up summarizing this fine as it applies to the SIP. Unfortunately, this practice continues at other exchanges. In the animation below, note that the information sent to the SIP has to travel significantly farther distances (40 miles vs 1000 feet), on a slower network (1 GBps vs 40 GBps) with a protocol that adds more latency (TCP vs UDP) than the same information sent to the direct feed. Sometimes this latency on the input side of the SIP shows up in SIP data as fantaseconds (a term we coined to describe trades printing before quotes). See this well documented example.
The animation also shows something that many aren't aware of: the original timestamp gets stripped, and replaced with a fresh timestamp when the SIP transmits it to a subscriber! Watch the timestamp in the box get stripped when it enters, and replaced when it leaves, the circle labeled "SIP Tape A". Keeping original timestamps is crucial for constructing audit trails, or for detecting system delays, which is why it's integral to this solution which allows HFT and non-HFT to coexist.
Understanding the Animation
Reg NMS requires that exchanges provide core data (trades and quotes) to the SIP as fast or faster than direct feeds. In the animation above, that means a trade or quote originating at an exchange (labeled A) must arrive at the SIP (C) no later than it arrives on a direct feed (B).
The animation starts with a trade (or quote) in the symbol "F", timestamped by the exchange at exactly 9:45. One network sends it to direct feed recipients (B) which are all 1000 feet away, and the other network sends it to the SIP (C) which is about 40 miles away. When the trade arrives at the SIP, the timestamp is removed and aggregated with trades from other exchanges (not shown). Finally, at the point where the SIP transmits the trade to a SIP subscriber (blue circle) it gets a new timestamp based on the SIP clock (which could be ahead or behind the original exchange's clock).
This new timestamp, in effect, will hide any delays between the exchange (A) and the blue circle from SIP users. During the flash crash, delays of over 30 seconds occurred in many stocks and were impossible to detect, because of the altered timestamps. Had the original timestamps from the exchange remained, everyone, not just High Frequency Traders, would have been aware they were trading on stale data.
Sending data faster to HFT is against regulations. Period. Changing timestamps is just plain wrong, and one could argue that SIP subscribers are being denied the true timestamp that HFT enjoy. Keep in mind that nearly all brokerage reports on trade execution quality use the SIP and therefore, an altered timestamp.
Nearly 40% of trades are priced based on the SIP - this include practically all retail trades and most dark pools. Even Goldman Sach's Dark Pool is executes based on SIP prices. When SIP prices lock or cross (due to slow input from one of 13 exchanges or even FINRA), it causes internalizers (retail trades) to stop trading until the condition is resolved: a phenomenon made clear during the flash crash.
Furthermore, speed differences between the direct feed and the SIP can lead to other undesirable market behaviors, such as momentum ignition, which have become quite common (we detailed one market-wide momentum ignition event here). Simply put, when prices suddenly move, those who can act earlier (HFT using direct feeds), will profit at the expense of those who cannot, such as internalizers and Dark Pool that are based on the SIP. With nearly 40% of trading based on the SIP, the profitability of this manipulative strategy can be great enough that the cost of inducing price shifts (momentum ignition) is worth the economic and regulatory risk.
- Is the National Best Bid or Offer (NBBO) being Ignored? A great primer on the NBBO and direct feeds.
- Reg NMS Has Been Rescinded! A rubber-stamped proposal from Nasdaq effectively negates Reg NMS.
- HFT Breaks Speed-of-Light Barrier, Sets Trading Speed World Record. Proof of delays on the input side of the SIP.
- Coexisting without Colocating. A proposal for improving the market for everyone.
- Refuting HFT Claims. Do they really provide liquidity, narrow spreads and lower costs?
- Direct Feed Prices - NYSE's filing with the SEC