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Nanex White Paper: High Frequency Trading Is Insatiable - Its Hidden Costs

Submitted by Tyler Durden on 10/14/2011 14:27 -0400

Submitted by Nanex

HFT is Insatiable - its Hidden Costs

We have spent the last 24 years working with real-time market data on a tick-by-tick basis. We monitor our commercial datafeed in real-time to stay on top of market changes or issues. This past year, we have spent considerable time and effort studying the relentless growth of equity quotes. Based on our findings, virtually all of the additional quotes contribute zero or negative economic value to stock pricing, because they are either way outside the market or end up expiring before any investor or trader could possibly act on them. Furthermore, we can't find any self-limiting mechanism in place that will ever put a stop to this unnecessary and expensive growth of misinformation. The only thing that prevents a sudden explosion in quote traffic is the capacity limitation set by SIAC which runs the Consolidated Quote System (CQS) for the exchanges.

Every 3 months or so, SIAC increases the capacity limitation for CQS. Shortly after each increase, often the next trading day, quote rates will surge to new record levels and completely fill the new capacity. The chart on the right beautifully captures this phenomenon: it shows the 2 ms peak quote rate for CQS on 30 minute intervals over each trading day since July 2010. Recent dates are colored towards the red end of the spectrum: older dates towards the violet. The gaps between groups of lines chronicle the immediate jump in quote traffic after the capacity limit is raised. The gap between the green and orange groups occurred after the limit was raised on July 5th: traditionally one of the quietest trading sessions of the year. The lone green line near the 600,000 level marks the only time when it took more than a day to hit the new limit. See if you can distinguish between the quiet trading days of July and the tumultuous trading days of August among the orange group.

When CQS capacity fills, new stock quotes are placed in a queue to prevent loss. In a trading environment running at the speed of HFT, most of these quotes will end up expiring before exiting the queue. In effect, when quote traffic is high, most of the additional quotes will be canceled long before a trader or investor receives them. And quote traffic is often highest when reliable information is most important.

Extra capacity is vital for times of market stress from surprise news events or shocks to the system. The lack of capacity during these times will quickly lead to a drop in liquidity as traders pull out from lack of clear pricing information. This was a major cause of the flash crash.

We understand that market makers and HFT need to adjust their quotes to fast changing market conditions. But 10,000 times per second per symbol, or more, in an inactive stock? Every quote has a non-zero cost: millions of computers and miles of network cables must process and transport each one, costing both time and energy. Sending quotes and then canceling them before they ever leave the exchange network is absurd.

We think we found a possible solution to the HFT/non-HFT divide that lets the market itself decide the value of an equity quote. The solution is incredibly simple and has virtually zero impact on the millions of systems already in place. It also requires no cancellation fees or transaction taxes, and it lets trading go as fast as the speed of light.

Stay tuned

The chart below shows 2 ms peak quote rates on 1 minute intervals, illustrating just how often capacity limits are hit.

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Fri, 10/14/2011 - 14:30 | 1774656 Robert-Paulson

You ever analyzed a HFT 1 min interval chart.......on weed?

Fri, 10/14/2011 - 14:31 | 1774659 Divided States ...

Honestly cant someone just develop a virus and wreak havoc in the HFT space? I mean everything that goes on in it is already predatory in nature.

Fri, 10/14/2011 - 14:33 | 1774668 wisefool

institute a tax. thats what they did in the old days to people who were smart but not already rich.

Fri, 10/14/2011 - 15:01 | 1774786 imapopulistnow

Israel

Fri, 10/14/2011 - 14:32 | 1774661 RobotTrader

Actually, when you look at a daily chart of most big cap stocks and how they trade, they don't look much different than they did 10 years ago.

Maybe the 5-min. charts are different for the daytraders, but for longer term investors, probably no impact at all.

Yeah, an occasional flash crash now and again, but there will always be swarms of vultures with pre-set programs ready to buy Proctor & Gamble at $2/share again instantaneously.

LOL....

Fri, 10/14/2011 - 14:41 | 1774692 long-shorty

Robo,

You truly are as stupid as everyone here says you are.

1. Hurst exponents on many stocks have risen dramatically in the last five years.

2. You can't even buy in a flash crash, because you just get sub-pennied. Market participants are catching on to this; that is why standing gtc order volume is completely drying up.

Fri, 10/14/2011 - 14:47 | 1774708 LawsofPhysics

I don't know. I am one of those vultures. On a long enough time line...

Fri, 10/14/2011 - 14:43 | 1774694 SheepDog-One

LOL....you dont have any idea what youre talking about, better stick with the pop-stock fanboy stuff.

Fri, 10/14/2011 - 15:38 | 1774944 homersimpson

Buy and hold died when the average stock hold became 1 day..

There are no more long term investors - just long term speculators who happen to be gamblers.

Fri, 10/14/2011 - 14:35 | 1774674 Fidel Sarcastro

Here's a thought -- Make all quotes non-cancelable for at least 2 seconds. No fees are needed. That would put an end to all of this shit.

Fri, 10/14/2011 - 15:55 | 1775007 Thunder Dome

1/2 second would more than suffice. That would also mean TPTB could no longer steal the golden crumbs, so don't count on it.

Fri, 10/14/2011 - 14:44 | 1774697 InconvenientCou...

The corporate "siren song" is that monopolies are good for everyone. In desperate times, it sounds like the truth.

It isn't the truth. It's the opposite of truth. Not good or evil -- it's just plain false.

Fri, 10/14/2011 - 16:55 | 1775275 NotApplicable

Remember, all corporations, and all monopolies are creations of the state.

Fri, 10/14/2011 - 14:44 | 1774699 falak pema

high frequency trading is the expression of illegal market capture. Its the overt, prim and proper, patriotic, entrepreneurial Oligarchy shed of its fig leaf, with its true, covert, hidden face of Borgia exposed.

Fri, 10/14/2011 - 14:45 | 1774703 LawsofPhysics

Bullish for gay pride! My god what has this sham been reduced to.

Fri, 10/14/2011 - 14:48 | 1774705 SheepDog-One

Any market trade should have a CAPTCHA correctly answered to be exercised.

I mean hell I've got to answer a damn CAPTCHA to even post a comment on a damn youtube video, or get into my own email! Why should there be one to carry out a stock market trade!

Fri, 10/14/2011 - 14:48 | 1774713 Deadpool

bring back fractions!

Fri, 10/14/2011 - 20:33 | 1775858 StychoKiller

Truncating quotes to two decimal places would put a halt to a large share of this clusterfsck! Ever receive a micro-penny in change?

Fri, 10/14/2011 - 14:55 | 1774721 earleflorida

blackrock inc. does all the hft for the frb's bidding via gs, jpmc,... and the bis via luxembourg (7/2011) ? jmo

Fri, 10/14/2011 - 14:51 | 1774735 RobotTrader

HFT has had no impact on my trading.

If I make a mistake, its my fault from bad timing, not the fault of all the machines which are quote stuffing.

But then again, I don't daytrade, either, so maybe its different for others on this board.

Fri, 10/14/2011 - 14:57 | 1774764 Fluffybunny

I'm sure the impact of HFT's is non-existant when all you trade is Pokémon cards.

Fri, 10/14/2011 - 16:19 | 1775102 rocker

Robo told us last week that Robo buys last week's winners as advertised in IBD.

I acutally thought Robo was a trader until I followed and realized stock post two day's later are usually loosers.

Fri, 10/14/2011 - 15:37 | 1774930 Golden Receiver

Then perhaps you do not understand HFT. It affects every trade, regardless of your trading strategy. That is the entire point of the article.

Fri, 10/14/2011 - 15:44 | 1774966 homersimpson

"If I make a mistake" You never make a mistake. You're the best Monday Morning QB ZH has to offer.

Fri, 10/14/2011 - 15:29 | 1774905 George Parr

Painfully trivial solution to the problem.

Let the exchanges give away for free a fixed number of quotes.
Let us say 1 quote per second for each name.
That would be more than enough for "legitimate" algorithmic trading.
After that, charge $0.01 for each additional quote.

Fri, 10/14/2011 - 15:36 | 1774906 George Parr

Actually, make the cost of additional quotes progressive.

For each name:
$0.00 for the first 23,400 (one per second)
$0.01 for the second 23,400
$0.02 for the third 23,400
...

Fri, 10/14/2011 - 15:39 | 1774949 Kat

Get used to it.

The SEC has made all other kinds of trading impossible. HFT is here to stay.

Fri, 10/14/2011 - 15:48 | 1774980 gatorontheloose

teasing the HFTs with limit orders is fun sometimes

Fri, 10/14/2011 - 15:55 | 1775004 Bansters-in-my-...

WOW....

Dig the etch-a-sketch,man.

In color too.

Fri, 10/14/2011 - 16:01 | 1775031 AngryGerman

i know sth about backing a statement up with data, and NANEX comes pretty close to perfection. forget all academic studies on HFT, as they said a long time ago, the moment a paper is written up reality has worsened again.

hft is a billion dollar industry, and that's why it will stay where it is. it's a no brainer for the firms involved.

does it affect ma and pa's portfolio: no, bc they have been screwed and are atill being screwed by forces much stronger than split-second algos.

Fri, 10/14/2011 - 16:11 | 1775071 SeventhCereal

as predicted in an earlier comment, whenever the market starts upticking ZH is bound to release an article bashing HFT.

Fri, 10/14/2011 - 17:02 | 1775295 doggings

lame. the only time the talking heads mention HFTs is in the same sentence as "crash" ZH just supply the balance.

plus they have some clue wtf they are talking about, unlike anybody else you hear mention it.

Fri, 10/14/2011 - 16:31 | 1775155 Chappy

HFT's have made stop loss orders dangerous. It's agravating to see stocks dip down to your stop, bounce off higher, then come down to your second stop and bouce higher again. I have had this happen several times in thinnly traded stocks. Yes, I understand that I put the stop in place but generally they are there for protection, not so the price can be manipulatyed down to strip the stock from you.

Fri, 10/14/2011 - 20:36 | 1775868 StychoKiller

Shaking hands with a 'droid is not advised.

Fri, 10/14/2011 - 16:45 | 1775233 TheLooza