Whitney Tilson continues investigating High Frequency Trading
From his Sunday letter to clients:
1) An interesting comment from a friend:
The reason these firms make so much more money in fixed income is because the market making and prop trader is the same person. The distressed desk flow traders (the area that I know best) at the big firms have balance sheets up to a couple billion per group and they have all the information about who is buying and who is selling. For a big buy side account to get out of a position usually takes up to a week and can move a bond 25-30% easily, so once a desk gets the first sell order from a Pimco or the like, they immediately start reducing their own exposure or get short because they know that a huge amount of supply is coming. So on top of the fact bond bid/ask has moved from 10bp 2 years ago to 200bp now, these guys take huge prop positions and front run their clients. The weird part is that every single person in the market knows what is going on and nobody does anything about it.
2) An excerpt from another friend's comment (full text below):
My business partner passed on your piece on algorithmic trading and so-called "toxic equity trading." We are fundamental value investors with long holding periods, but I worked with and know well a number of algorithmic traders and the strategy.
I think it’s very, very important to understand that the anti-high frequency trading arguments in the commentary are poorly informed and/or the very biased views of market dinosaurs. As I’m sure you’ve seen, news and manufactured controversy over high frequency trading has somehow exploded in the last couple of weeks. This campaign is an invitation to regulators to wipe away an *enormously valuable* source of liquidity and price competition in the equity markets.
High-frequency trading benefits *all* of us long-term investors by making it easier to enter and exit positions, narrowing spreads, and reducing the trading costs paid to market intermediaries such as broker-dealers, market makers, exchanges and specialists. There are a few key points that need to be understood:
1) Algorithmic traders are in the stock market to make money, plain and simple. That is what we all do. The market is set up for people to trade with each other and try to make money. Calling one type of trading "toxic" and another type "good" is just positioning.
High-frequency trading has in fact reduced the enormous costs that American investors pay to financial intermediaries, which Buffett and Munger so rightly rail against, so you may as well call HFT "good" vs the old high-cost voice market-making world.
2) High-frequency trading creates liquidity across the stock market, primarily (but not exclusively) in larger cap stocks. This is because more volume now trades in these stocks. Any long-term investor who wants to build or exit a position can do it more easily and with less market impact. If 10,000 shares of MSFT trade per day vs 1000, then it is easier to get in and out.
3) High-frequency trading narrows the bid-ask spreads on stocks, in the biggest stocks down to usually a penny a share (and it would be lower except trading in subpennies was barred by the SEC in Rule NMS, at the urging of the NYSE and others). Narrower spreads are good for all investors. You pay less to the person on the other side of the trade in a market order, and it makes limit orders easier to execute.
(One of your commenters cites data from October 2008 to argue that spreads are higher now. No one can claim that the chaos of October 2008 is representative of how markets normally function).
4) High-frequency trading, which has grown hand-in-hand with the rise of low-cost ECNs and electronic broker-dealers, has significantly lowered the fees broker-dealers, market-makers, NYSE specialists, and the exchanges can charge us for commissions, spreads, exchange fees and other costs that these financial intermediaries can impose.
Just ask any traditional broker-dealer, market-maker, or old-school exchange (NYSE, NASDAQ and the Amex) about how the rise of ECNs and high-volume trading have dramatically reduced the costs they can charge investors, and increased how much they have to compete for business. This is why the floor of the NYSE is shrinking and specialists are watching movies during the day, instead of earning huge incomes by getting a private look at customer trades before they execute them at wide spreads. That’s good, not bad. [TD: Please read this for just how good slippage costs courtesy of HFT are.]
5) HFT opponents claim high frequency trading moves prices, changes the P/E ratios of stocks and create an inefficient market. Yes, high-frequency trading is a high percentage of volume. That does not mean that there are artificial price changes caused by this type of trading. Opponents are citing anecdotes (in fact, making up anecdotes) and making conclusory statements, as opposed to demonstrating this by any real analysis of trading data over the last 5 years or so in which HFT has become a significant percentage of market volume.
This is not just about "flash" trading which is a tiny % of volume and which big HFT traders like GETCO publicly oppose. "Flash" trading can be done away with by a simple rule tweak. Your commenters instead are fighting a Luddite rear-guard action against a much bigger efficiency-improvement that threatens their existence, or they are just poorly informed about how computerized markets work. They need to accept the world has changed. The markets are run by computers, software makes trades instead of oligopoly gatekeepers at the exchanges, people with science and technology backgrounds make money instead of people with backslapping skills, and there aren’t any more steak dinners and father-to-son specialist firms on the floor. That’s life, and it’s never perfect.
You’re welcome to quote some or all of this email if you wish, without using our names or our company name. Thanks! I appreciate you looking at this as it’s a very important issue for market participants to understand, and we value investors are huge beneficiaries of this.
3) A third friend's comments:
I have been doing a lot of thinking on the HFT issue. I am probably considered an expert on the HFT issue with respect to equity derivatives. I have built several equity derivative HFT systems. The standard equity world is mathematically less sophisticated so I believe some of my thoughts may apply.
There are roughly three types of HFT systems:
1) Correlation Systems—These systems constantly look across sectors and the market to determine if a transaction in one security should be reflected in other parts of the market. For example, if someone lifts my offer in the Educator STRA, I will attempt to lift someone else’s offer in COCO or CECO as soon as possible. This is a pure arms computer and mathematics arms race. Goldman is a big player here as it fits nicely into their execution business.
2) Dark Pools—Currently the most favored of the HFT traders, these “liquidity enhancements” allow market makers to get a look into the order before it hits the market. Depending on the “Dark Pool” they allow between 1-3 milliseconds for certain players to see the order before the general market. Our experience is that Dark Pools do not enhance execution in any way and may in fact be negative. Knight plays in this space.
3) Momentum Guys—These guys try to quickly figure out what is happening in the market and move join the Gold Rush. As opposed to the Correlation systems, they are attempting to load up the risk as much as possible. The most famous is SAC Capital.
Many of the market makers are playing in all three places, but I tried to indicate the strength of player.
It is only the “Dark Pool” that I find to be effectively illegal. It does two things that allow the market maker to peer into the order. I know that if I can see part of the order, I can take advantage of the market and move my quotes effectively. In a correlation system, I can in fact move all of the related quotes. Lose money on filling a small part of the first order to make a killing on the rest of the sector.
The second is the source of the order also means something. When I call up a stock order, Goldman knows that I am market maker and I will not run them over. If SAC calls, they know that they are getting only part of the order and that there is a lot of momentum behind it. (In fact, SAC’s order is so valuable that they will pay for it in order to take advantage of the information.) Therefore, getting orders from multiple sources can allow be to differentiate as to the value of the source.
For a pure HFT player, obfuscation, complexity of rules, shifting regulatory environment, etc are all boons because they create profit opportunity and they create barriers to entry from other players. Market fragmentation and lack of transparency mean that the people who facilitate execution can demand a bigger vig for their participation.
Philosophically, I believe that there is an important role for market makers in our capitalistic system. They provide liquidity into markets allowing for the free trade of financial markets. They deserve to be rewarded for some of the risks they take.
Historically, we have developed a system of balance to create a reward based system. Market Makers would receive certain advantages for making markets (Location and Time advantage of the floor, exemption from Reg T funding requirements, etc.) in exchange for meeting certain obligations (minimum quote size and spread)
It is very clear that the balance is out of whack. I would go further and state that the increasing proportion of transactions being done by fewer and fewer institutions is also incredibly unhealthy for the market.
4) I'm quoted in this story from this week's Economist:
Asymmetric information is nothing new. Even its critics concede that most HFT is perfectly legal. But some of the advantages that accrue to high-frequency traders look unfair. Flash orders, a type of order displayed on certain exchanges for less than 500 microseconds, expose information that is only valuable to those with the fastest computers. By locating their servers at exchanges or in adjacent data centres traders can maximise speed. “It appears exchanges are conspiring with a privileged group of high-frequency traders in a massive fraud,” says Whitney Tilson, a fund manager. Requiring orders to be posted for at least a second would nullify the value of flash orders and of probing the market.
5) This NYT Op Ed raises some very good points:
That’s rather how I feel when people talk about the latest fashion among investment banks and hedge funds: high-frequency algorithmic trading. On top of an already dangerously influential and morally suspect financial minefield is now being added the unthinking power of the machine.
...So, is trading faster than any human can react truly worrisome? The answers that come back from high-frequency proponents, also rather too quickly, are “No, we are adding liquidity to the market” or “It’s perfectly safe and it speeds up price discovery.” In other words, the traders say, the practice makes it easier for stocks to be bought and sold quickly across exchanges, and it more efficiently sets the value of shares.
Those responses disturb me. Whenever the reply to a complex question is a stock and unconsidered one, it makes me worry all the more. Leaving aside the question of whether or not liquidity is necessarily a great idea (perhaps not being able to get out of a trade might make people think twice before entering it), or whether there is such a thing as a price that must be discovered (just watch the price of unpopular goods fall in your local supermarket — that’s plenty fast enough for me), l want to address the question of whether high-frequency algorithm trading will distort the underlying markets and perhaps the economy.
It has been said that the October 1987 stock market crash was caused in part by something called dynamic portfolio insurance, another approach based on algorithms...
This is the sort of feedback that occurs between a popular strategy and the underlying market, with a long-lasting effect on the broader economy. A rise in price begets a rise. (Think bubbles.) And a fall begets a fall. (Think crashes.) Volatility rises and the market is destabilized. All that’s needed is for a large number of people to be following the same type of strategy. And if we’ve learned only one lesson from the recent financial crisis it is that people do like to copy each other when they see a profitable idea.
...Thus the problem with the sudden popularity of high-frequency trading is that it may increasingly destabilize the market. Hedge funds won’t necessarily care whether the increased volatility causes stocks to rise or fall, as long as they can get in and out quickly with a profit. But the rest of the economy will care.
Buying stocks used to be about long-term value, doing your research and finding the company that you thought had good prospects. Maybe it had a product that you liked the look of, or perhaps a solid management team. Increasingly such real value is becoming irrelevant. The contest is now between the machines — and they’re playing games with real businesses and real people.
6) An article in Saturday's WSJ, answering questions about HFT:
High-frequency trading, long an obscure corner of the market, has leapt into the spotlight this year. Wildly successful in 2008, high-frequency traders are the talk of Wall Street, attracting big bucks and some unwanted attention. Concerns that some traders are taking advantage of less fleet-footed investors has drawn the attention of regulators and members of Congress. The following is an explanation of the core issues, based on interviews with industry participants and regulators.
7) An article about BATS:
Each trading day, as a bell atop the M&I Bank building next door chimes gently, BATS quietly conducts about 25 times the volume of the venerable American Stock Exchange. Here, 1,200 miles from the financial center of the world, a few dozen employees pad around in shorts and polo shirts, amid green cubicles and whiteboards. On any given day, its servers off in New Jersey will process about 12 percent of the trades made in the vast U.S. markets. In less than 36 months, BATS (it stands for Better Alternative Trading System) has evolved from a start-up into an international stock exchange with powerful partners and a nine-figure valuation.
8) An FT article about HFT:
Both BATS and Direct Edge say any investor can participate in flashing prices or receiving them on their trading venues.
Any move to ban the practice, says Direct Edge, is seen as creating a two-tier market as it is likely to push business away from the main electronic platforms towards “dark pools”.
Still, there are concerns that market makers, such as high-frequency traders, cancel many of their flash orders before other investors can execute a trade. This can enable the market maker to come back and offer shares for sale at a higher price, or place a buy order at a lower level.
“Certain black-box models have cancellation rates as high as 99 per cent on orders,” says Paul Zubulake, senior analyst at Aite Group.
Mr Arnuk believes liquidity rebates and flashing should be stopped in order to level the playing field for all investors.
9) Joe Saluzzi was on Bloomberg, clarifying his views on HFT: www.youtube.com/watch?v=iTkCNsnDgws