Joe Saluzzi: HFT Parasites Are Killing The Market Host

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Submitted by Chris Martenson of Peak Prosperity

Joe Saluzzi: HFT Parasites Are Killing The Market Host

Joe Saluzzi, expert on algorithmic trading -- also known as high-frequency trading, or HFT -- returns as a guest this week to explain how the players behind this machine-driven process act as parasites that are destroying our financial markets (and, increasingly, even themselves).

Since Joe first spoke with us last year, HFT firms have only increased in size and share of market activity. Here are some staggering statistics on how influential they have become:

  • HTFs make up between 50-70% of the volume seen across market exchanges today
  • 2% of the traders on many exchanges (HFTs, specifically) represent 80% of the volume
  • a single large HFT firm (referred to as a Direct Market Maker) can account for 10%+ of a market's volume on a given day
  • Large HFT firms make between $8 to $21 billion a year
  • HFT trades occur in milliseconds (i.e. a small fraction of the time it takes your eye to blink)

With such scale, speed and profitability, HFTs have turned the market away from being an efficient price-setting mechanism and perverted it into a casino where the clientele (i.e. human investors) gets fleeced.

And our regulators are so outmatched by the scope, complexity and funding of these titanic HFT players that at moment, there are pretty much zero consequences for bad actors.

Interestingly, these HFT parasites, which live by generating fractions of pennies in millisecond-timed trades, may be sowing the seeds of their own demise through their blind gluttony and hyper-competitiveness. As their quest for incremental advantage begins to bump up against the limits of physics (such as the speed of light), the marginal cost of the next increment of advantage increases exponentially. Profitability is being squeezed out and will disappear entirely some day.

Sounds good to the rest of us investors, right? Not so fast. A key question to ask should these parasites experience a self-induced mass-extinction effect:

What will happen to asset prices when all that volume suddenly disappears?

HFT's Bloodsucking Role In the Financial Markets

There is a host-parasite relationship. The host is the traditional order or the retail or institutional order. They will always lose. There is no doubt about it. The parasites are circling around that host all day long trying to find where they are going to take advantage of them – whether it is a VWAP order (Volume-Weighted Average Price) or something like that. If there are no hosts or the hosts are starting to decrease – because they are based on the mutual fund outflows that we talked about before – the parasites find it hard to make money. There is no more to feed off of. So they start to feed off of each other, which means that their margins by definition are going to have to start shrinking until it becomes unprofitable. And it will become unprofitable when all of a sudden they have to invest hundreds of millions of dollars to gain an extra microsecond, yet they are not getting their returns back.

 

o the real fear that we have is that when it becomes an unprofitable opportunity or venture for them, what will they do? Will they walk away? Who will be left holding the bag? Where did all that “liquidity” go? Who is left now? Hopefully what will happen was the market will find its own solution at that point. But you would have some scary days, I can bet, between now and then.

The Bastardization of "Investing"

If you are an investor and you want to diversify -- which everybody should be doing, right? -- you want to pick different asset classes. You want to get things that are inversely correlated because that is how you can prevent yourself from taking a large loss, especially if you are a conservative investor.

 

There was actually a report – I think it was a couple of months ago and it was produced by the U.N. --  they studied the correlation between oil and stocks. And they found it at record levels over the last five years. It just shot up off the charts where oil would normally be a negative correlation with stocks. And they were scratching their heads. And one of the things they pointed to was the correlation effect of the high frequency traders trading multiple asset classes.

 

So this has been documented now. It is not just us kind of guessing, saying, “Well, I bet it was the HFT’s correlating asset classes.” Everything trades together. That does not make for a healthy market. That does not make me feel comfortable that I can hedge my position right now unless I was just trading around a zero position all day, like most of these guys do in the high frequency trading world.

 

So what do you do as an investor? How do you diversify yourself? It is very, very troubling and at this point there really is not an answer to it.

The Impotence of Our Regulators

When you are dealing with this type of computing power and this heavy amount of quote traffic as well as trade traffic, the quote traffic is enormous. Every time an exchange tries to update their capacity, it immediately jumps up to the capacity level. It is a constant amount of quotes, trades, and cancellations. They do not have the systems available to track this type of behavior.

 

So you have got one of two options if you are a regulator. Either, a) get up to speed quickly so that you can track this behavior so the investing public could feel confident again. Or, b) you have to start limiting this type of behavior. There is no other option. You cannot allow this to continue to go on. And by limiting it, something that we would suggest is maybe a real cancellation fee, not the ones that have kind of been suggested. Maybe a minimum order timelife. If I said to you, “Hey, we want a 50 millisecond minimum order timelife, would that be a problem?” And I would think it would not be a problem. Because, guess what? I just blink my eyes and it took me 200 milliseconds to do that. So 50 milliseconds really should be that big of an issue. And there have actually been reports – studies by academics that have said, “Any order less than 50 milliseconds really does not contribute to any liquidity.” So do not give me that you are going to be hurting liquidity.

 

So the bottom line is the regulators are overmatched and they need to do something now. And they have really one of two options. And the option of getting up to speed probably is not in their budget right now.

Click the play button below to listen to Chris' interview with Joe Saluzzi (47m:53s):

Transcript available here.