First, let me say what you read here is going to be wrong in several ways. HFT covers such a wide path of trading that different parties participate or are impacted in different ways. I wanted to put this out there as a starting point . Hopefully the comments will help further educate us all
1. Electronic trading is part of HFT, but not all electronic trading is high frequency trading.
Trading equities and other financial instruments has been around for a long time. it is Electronic Trading that has lead to far smaller spreads and lower actual trading costs from your broker. Very often HFT companies take credit for reducing spreads. They did not. Electronic trading did.
We all trade electronically now. It’s no big deal
2. Speed is not a problem
People like to look at the speed of trading as the problem. It is not. We have had a need for speed since the first stock quotes were communicated cross country via telegraph. The search for speed has been never ending. While i dont think co location and sub second trading adds value to the market, it does NOT create problems for the market
3. There has always been a delta in speed of trading.
From the days of the aforementioned telegraph to sub milisecond trading not everyone has traded at the same speed. You may trade stocks on a 100mbs broadband connection that is faster than your neighbors dial up connection. That delta in speed gives you faster information to news, information, research, getting quotes and getting your trades to your broker faster.
The same applies to brokers, banks and HFT. THey compete to get the fastest possible speed. Again the speed is not a problem.
4. So what has changed ? What is the problem
What has changed is this. In the past people used their speed advantages to trade their own portfolios. They knew they had an advantage with faster information or placing of trades and they used it to buy and own stocks. If only for hours. That is acceptable. The market is very darwinian. If you were able to figure out how to leverage the speed to buy and sell stocks that you took ownership of , more power to you. If you day traded in 1999 because you could see movement in stocks faster than the guy on dial up, and you made money. More power to you.
What changed is that the exchanges both delivered information faster to those who paid for the right AND ALSO gave them the ability via order types where the faster traders were guaranteed the right to jump in front of all those who were slower (Traders feel free to challenge me on this) . Not only that , they were able to use algorithms to see activity and/or directly see quotes from all those who were even milliseconds slower.
With these changes the fastest players were now able to make money simply because they were the fastest traders. They didn’t care what they traded. They realized they could make money on what is called Latency Arbitrage. You make money by being the fastest and taking advantage of slower traders.
It didn’t matter what exchanges the trades were on, or if they were across exchanges. If they were faster and were able to see or anticipate the slower trades they could profit from it.
This is where the problems start.
If you have the fastest access to information and the exchanges have given you incentives to jump in front of those users and make trades by paying you for any volume you create (maker/taker), then you can use that combination to make trades that you are pretty much GUARANTEED TO MAKE A PROFIT on.
So basically, the fastest players, who have spent billions of dollars in aggregate to get the fastest possible access are using that speed to jump to the front of the trading line. They get to see , either directly or algorithmically the trades that are coming in to the market.
When I say algorithmically, it means that firms are using their speed and their brainpower to take as many data points as they can use to predict what trades will happen next. This isn’t easy to do. It is very hard. It takes very smart people. If you create winning algorithms that can anticipate/predict what will happen in the next milliseconds in markets/equities, you will make millions of dollars a year. (Note:not all algorithms are bad. Algorithms are just functions. What matters is what their intent is and how they are used)
These algorithms take any number of data points to direct where and what to buy and sell and they do it as quickly as they can. Speed of processing is also an issue. To the point that there are specialty CPUs being used to process instruction sets. In simple terms, as fast as we possibly can, if we think this is going to happen, then do that.
The output of the algorithms , the This Then That creates the trade (again this is a simplification, im open to better examples) which creates a profit of some relatively small amount. When you do this millions of times a day, that totals up to real money . IMHO, this is the definition of High Frequency Trading. Taking advantage of an advantage in speed and algorithmic processing to jump in front of trades from slower market participants to create small guaranteed wins millions of times a day. A High Frequency of Trades is required to make money.
There in lies the problem. This is where the game is rigged.
If you know that by getting to the front of the line you are able to see or anticipate some material number of the trades that are about to happen, you are GUARANTEED to make a profit. What is the definition of a rigged market ? When you are guaranteed to make a profit. In casino terms, the trader who owns the front of the line is the house. The house always wins.
So when Michael Lewis and others talk about the stock market being rigged, this is what they are talking about. You can’t say the ENTIRE stock market is rigged, but you can say that for those equities/indexs where HFT plays, the game is rigged so that the fastest,smart players are guaranteed to make money.
6. Is this bad for individual investors ?
If you buy and sell stocks, why should you care if someone takes advantage of their investment in speed to make a few pennies from you ? You decide, but here is what you need to know:
a. Billions of dollars has been spent to get to the front of the line. All of those traders who invested in speed and expensive algorithm writers need to get a return on their investment. They do so by jumping in front of your trade and scalping just a little bit. What would happen if they weren’t there ? There is a good chance that whatever profit they made by jumping in front of your trade would go to you or your broker/banker.
b. If you trade in small stocks, this doesn’t impact small stock trades. HFT doesn’t deal with low volume stocks. By definition they need to do a High Frequency of Trades. If the stocks you buy or sell don’t have volume (i dont know what the minimum amount of volume is), then they aren’t messing with your stocks
c. Is this a problem of ethics to you and other investors ? If you believe that investors will turn away from the market because they feel that it is ethically wrong for any part of the market to offer a select few participants a guaranteed way to make money, then it could create significant out flows of investors cash which could impact your net worth. IMHO, this is why Schwab and other brokers that deal with retail investors are concerned. They could lose customers who think Schwab, etc can’t keep up with other brokers or are not routing their orders as efficiently as others.
7. Are There Systemic Risks That Result From All of This.
The simple answer is that I personally believe that without question the answer is YES. Why ?
If you know that a game is rigged AND that it is LEGAL to participate in this rigged game, would you do everything possible to participate if you could ?
Of course you would. But this isn’t a new phenomena. The battle to capture all of this guaranteed money has been going on for several years now. And what has happened is very darwinian. The smarter players have risen to the top. They are capturing much of the loot. It truly is an arms race. More speed gives you more slots at the front of the lines. So more money is being spent on speed.
Money is also being spent on algorithms. You need the best and brightest in order to write algorithms that make you money. You also need to know how to influence markets in order to give your algorithms the best chance to succeed. There is a problem in the markets known as quote stuffing. This is where HFT create quotes that are supposed to trick other algorithms , traders, investors into believing their is a true order available to be hit. In reality those are not real orders. They are decoys. Rather than letting anyone hit the order, because they are faster than everyone else, they can see your intent to hit the order or your reaction either directly or algorithmically to the quote and take action. And not only that, it creates such a huge volume of information flow that it makes it more expensive for everyone else to process that information, which in turn slows them down and puts them further at a disadvantage.
IMHO, this isn’t fair. It isn’t a real intent. At it’s heart it is a FRAUD ON THE MARKET. There was never an intent to execute a trade. It is there merely to deceive.
But Order Stuffing is not the only problem.
Everyone in the HFT business wants to get to the front of the line. THey want that guaranteed money. In order to get there HFT not only uses speed, but they use algorithms and other tools (feel free to provide more info here HFT folks) to try to influence other algorithms. It takes a certain amount of arrogance to be good at HFT. If you think you can out think other HFT firms you are going to try to trick them into taking actions that cause their algorithms to not trade or to make bad trades. It’s analogous to great poker players vs the rest of us.
What we don’t know is just how far afield HFT firms and their algorithms will go to get to the front of the line. There is a moral hazard involved. Will they take risks knowing that if they fail they may lose their money but the results could also have systemic implications ?. We saw what happened with the Flash Crash. Is there any way we can prevent the same thing from happening again ? I don’t think so. Is it possible that something far worse could happen ? I have no idea. And neither does anyone else
It is this lack of ability to quantify risks that creates a huge cost for all of us. Warren Buffet called derivatives weapons of mass destruction because he had and has no idea what the potential negative impact of a bad actor could be. The same problem applies with HFT. How do we pay for that risk ? And when ?
When you have HFT algorithms fighting to get to the front of the line to get that guaranteed money , who knows to what extent they will take risks and what they impact will be not only on our US Equities Markets, but also currencies, foreign markets and ? ? ?
What about what HFT players are doing right now outside of US markets ? All markets are correlated at some level. Problems outside the US could create huge problems for us here.
IMHO, there are real systemic issues at play.
8. So Why are some of the Big Banks and Funds not screaming bloody murder ?
To use a black jack analogy , its because they know how to count cards. They have the resources to figure out how to match the fastest HFT firms in their trading speeds. They can afford to buy the speed or they can partner with those that can. They also have the brainpower to figure out generically how the algorithms work and where they are scalping their profits. By knowing this they can avoid it. And because they have the brain power to figure this out, they can actually use HFT to their advantage from time to time. Where they can see HFT at work, they can feed them trades which provides some real liquidity as opposed to volume.
The next point of course is that if the big guys can do it , and the little guys can let the big guys manage their money , shouldn’t we all just shut up and work with them ? Of course not. We shouldn’t have to invest with only the biggest firms to avoid some of the risks of HFT. We should be able to make our decisions as investors to work with those that give us the best support in making investments. Not those who have the best solution to outsmarting HFT.
But more importantly, even the biggest and smartest of traders , those who can see and anticipate the HFT firms actions can’t account for the actions of bad actors. They can’t keep up with the arms race to get to the front of the line. Its not their core competency. It is a problem for them, but they also know that by being able to deal with it better than their peers, it gives them a selling advantage. “We can deal with HFT no problem”. So they aren’t screaming bloody murder.
9. So My Conclusion ?
IMHO, it’s not worth the risk. I know why there is HFT. I just don’t see why we let it continue. It adds no value. But if it does continue, then we should require that all ALGORITHMIC players to register their Algorithms. While I’m not a fan of the SEC, they do have smart players at their market structure group. (the value of going to SEC Speaks :). While having copies of the algorithms locked up at the SEC wont prevent a market collapse/meltdown, at least we can reverse engineer it if it happens.
I know this sounds stupid on its face. Reverse engineer a collapse ? But that may be a better solution than expecting the SEC to figure out how to regulate and pre empt a market crash
10…FINAL FINAL THOUGHTS
i wrote this in about 2 hours. Not because i thought it would be definitive or correct. I expect to get ABSOLUTELY CRUSHED on many points here. But there is so little knowledge and understanding of what is going on with HFT, that I believed that someone needed to start the conversation
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nice post. thank you.
Comment by yalinosgb -
I noticed that many respondents, come up with frightening scenarios about imminent apocalyptic crashes precipitated by HFT malfeasance, dwarfing the Great Recession and “Flash crash”.
They would be great screenplays for “Armageddon”-like movies, but I am sorry to inform you, that for many reasons they cannot happen any more, so tonight you can sleep little better.
Most, if not all exchanges impose various breaks and limits on HFT transactions as follows:
* Number of messages/sec: (ex. CME – 1,000 msgs/sec), all messages exceeding the limit are discarded by the exchange, if you reach the limit in 0.1 sec or 1 millisecond, for the remaining 0.9 sec or 0.999 sec all your messages will be discarded by the exchange, and you will be for all practical purposes disconnected from the exchange unable to trade.
In addition, if after reaching the limit, you continue to flood the exchange with messages during the remaining period when you should be idle, if it persists for a while, you will be unceremoniously disconnected from the exchange network and questioned by friendly folks from the exchange compliance office trying to find out what happened, was it an unintentional software or hardware error or was it more intentional?
If this scenario happens frequently, you will be simply banned from trading on that exchange.
That takes care of the denial of service type of abuse and frequently repeated fairy-tale scenario of HFT firms executing millions of trades per second.
* Ratio of messages to trades: (ex. CME – 500 msgs/trade) forcing traders to trade, fines for exceeding the limit.
It limits so-called quote-stuffing or spoofing, whereby you would send thousands of “fake” orders to pull the market in one direction and then suddenly cancel all these orders and reap ill-gotten rewards on the rebound.
Regulators are also looking for that type of trading behavior, and if they find it, there are very bitter consequences.
* Circuit breakers limiting price movement: very simple, the exchange computers monitor price movements for all traded instruments. If a particular instrument price changes by more than a specified percentage during specified time interval, the trading in that instrumented is simply suspended for a specified “cooling off” period, after which it is carefully restarted.
For example + or – 10% price change in 30 min, trading is suspended.
These limits assure that another “Flash crash” or worse is simply not possible to occur again, anyway not one caused by HFT.
If the economy tanks or we have another Credit Default Swap precipitated bubble followed by losses of $8 trillion, then all bets are off, but please don’t blame it on HFT (by the way, Flash crash was not caused by HFT trading but by a “fat finger”, and its severity was exacerbated by the lack of Circuit breakers implemented as the result of it).
Finally, I’d like to offer some interesting statistics.
In 2012 entire HFT profits in US were $1.25bn and according to WSJ total 2013 HFT investment was $1.5bn.
All that for facilitating estimated 50+% of all financial transactions worth tens of trillions of dollars.
These numbers don’t even register as rounding errors as compared with other financial sectors or even individual companies, yet the public is in frenzy calling for burning HFT at the stake, fueled, by among others, the recent 60 Minutes program and book by Michael Lewis, both full of factual errors and conspiracy theories, as well as recent subpoenas of HFT trading companies by NYAG Mr. Schneiderman, who no doubt would like to get the recognition like his predecessors Mr. Spitzer and Major Giuliani.
Wouldn’t you expect HFT to show enormous profits, at least matching the level of alleged abuses and world-wide hysteria, instead of paltry $1.25bn?
I’ll let you draw your own conclusions.
Best
Ultra-low Latency Architect/Developer
Comment by Chris Nerkowski -
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The market is Darwinian, and always will be. The same applies to algorithms that govern search engine rankings. Except Google has a monopoly, and they dictate the rules of the game.
Comment by AlphaWolf -
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Mr. Cuban, I have a reality show competition concept that I believe you will be interested in. I won’t waste your time by hyping it up on your blog. If you are willing to refer me to an agency that will represent me I will give you the first right of refusal to purchase an interest in this concept. I appreciate any assistance you are willing to provide me. Sincerely, Justin Weber
Comment by Justin Weber -
As one of the idiots on this topic, I hasten to offer a BIG “thank you” to Mark. His post is extremely helpful to me, and it has triggered a fabulous discussion during which a number of experts more or less confirmed most of his central points. Please allow this idiot to raise some questions/observations from the “peanut gallery”, addressing algo usage in general.
1. Wouldn’t the algorithms tend to produce the same trading response, subject to some minor random variation, given the same set of values on their input variable’s? The classes of variables that are relevant and their pertinent ranges of variation are not terribly difficult to imagine. Also, among these variables the values often tend to make “recurrent tracks” across their ranges, rather than to continually move into brand new territory (earnings per share reports, e.g.) . This leads me to wonder whether “algo behavior” tends to set up certain recurrent price change patterns, certain kinds of short-term waves of price movement, for example. If so, might it not be profitable for individual traders to find out how to sense these patterns and capitalize upon them in their trading? For example, if my memory is correct going back to the 80s and 90s we might in those days have to wait weeks for a popular stock to move to certain ” deemed to be extreme” price levels and set up special buying or selling opportunity, whereas now we may have to wait only a few days or even one day to see such stocks move to deemed extremes (or by extreme amounts from heir initial positions).
2. If we view a market crash as the result of contagion of fear within a crowd, and during the “reign of fear” the market might fall X% over a number of days, should we not expect that in future crashes it may well take minutes, rather than days, for a fall of X% to take place? (n other words, the Flash Crash may have been an isolated event; but the now prevailing technologies (widespread use of algos) imply that under the right set of fear triggers crashes of similar or greater magnitude should be expected. While algos do not feel fear, their software logics might often be such that a network of algos interacting could easily simulate intense fear contagion (self-reinforcing selling waves or massive withdrawal of bids) . Is this all nonsense?
If not, the implications for the individual investor are enormous, I think. For example, we must intensify our usage of insurance positions via options.
3. While I see that my trades are most likely handled internally by the broker, I feel uneasy about the apparent fact that time honoured principles and procedures in interpreting published price patterns may be becoming obsolete as a result of algo behaviour.
Comment by Theodore Monk (@SmilingUnderdog) -
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IMHO there are few points that are being glossed over in the recent HFT discussion.
1. HFT supporters can often be heard taking credit for an increase in liquidity. Which I believe is really more of an increase in volume as opposed to real liquidity, but even if I concede that true liquidity has increased, I wonder, was it really needed? Has traditional electronic trading not created a sufficient opportunity to efficiently match real buyers and sellers? Idk, but perhaps it’s worth discussing,
2. While one, two, or ten HFT firms and their latency arbitrage strategies existing in the market may have a negligible effect on market orders I wonder if we have reached a toxic level of participation. Michael Lewis mentioned that over 99 percent of all open orders are sent in by HFT firms and that roughly 50% of all filled orders can be attributed to HFT. Now I have no idea how accurate those stats truly are, but if they are even in the ballpark then I think we, as market participants, should be concerned about an overdose.
3. Mark mentions systemic risk to the global marketplace and I believe that therein lies the rub with regulation. It’s impossible to determine if our current market environment is being propped up by millions of arbitrage capitalists or not. If the last five years of “growth” has been synthetic, to what degree will the global markets be affected if our regulators remove HFT firms and their ilk from the exchanges? I think the uncertainty around the answer is one reason we see such a subdued reaction across the board.
Obviously there are several sides to this conversation and I’m simply following Mark’s lead, hoping to extend the discourse. Let me know your thoughts
Comment by Andrew Peters (@NorthStar_AM) -
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I have lot of qualitative posts at your blog, and this being one of them
http://www.makeupreviewshall.com/2014/04/best-way-to-scrub-face-properly.html
Comment by Preity Gupta -
Reblogged this on The Leading Indicator: Ludovic Dumas' Blog and commented:
For those that may not have the time to pick up Michael Lewis’ new book entitled “Flash Boys: A Wall Street Revolt” here is a fairly good high level introduction to high frequency trading by Mark Cuban. I also suggest reading Michael Lewis’ article in the NY Times entitled “The Wolf Hunters of Wall Street” http://nyti.ms/1iRYw3Y. It is a major issue that regulators have to tackle to restore confidence in the financial markets.
Comment by Ludovic Dumas -
http://edpalermo.com IMHO the way to counter this is through technology. It seems that IEX has found the answer to the speed advantage. Other exchanges can also follow their lead. I just don’t see how you police this properly, it is a cutting edge technology race. Can you penalize the most efficient without taking away incentives to improve efficiencies?
Comment by edpalermo13 -
I know this is not the right blog to be posting this on. I also know that this will probably never be responeded to, but I don’t want to go through life wandering “what if”. I am a teacher that has just recently been let go due to the dwindling number of students at our school. I have a child on the way and am sitting on an idea that I have kept stored away until I had the courage to persue it. The idea will make a very large profit for anybody that invests in the initial start-up. Mark, if you do happen to stumble upon this, I would be more than happy to discuss the details with you. I have already been doing some research, and have not found anything like what I have to offer. This idea doesn’t focus on a specific demographic and will help people in HUGE ways across the USA. All I need is a partner that can help me get the whole thing up and running. I do have some people that are interested in the idea and are wanting to do lunch next week to discuss how to get it started, but I wanted to partner up with somebody that has experience in this field. Hope all is well MC! GO MAVS!
Comment by therealkeen -
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Mark, good writeup to start the conversation. I largely agree, except the small guy is penalized. Most “small guys” have their money invested in the market via mutual funds. These vehicles process enormous bulk trades since they are representing a pool of assets. So although the small guy might not get whacked trading individual stocks… since the bulk of their wealth is in mutual funds and 401k plans, they are actually the ones that suffer from HFTs frontrunning their trades.
SEC, your move.
Comment by MisterArcher.com (@MisterArcher) -
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The stock market is structured in a way that allows the big guy to fleece the little guy. HFT is just another chapter in that story. I think it would be great if we could create a format and the regulations that would make the market more “fair” and give individual investors a fighting chance. But that seems really unlikely, due to the huge amounts of potential profit being made under the current system. And the fact that no matter what new laws you put in place, there will always be really smart and well financed people with a lot to gain by figuring out the loopholes. If you think of this as two competing sides, doesn’t the side with an unfair advantage have a lot more incentive (and financial muscle) than the side represented by the SEC and the individual investor?
Comment by Jason Wilber -
Great food for thought from streetwise professor.
http://streetwiseprofessor.com/?p=8340
“Pinging: Who is the Predator, and Who Is the Prey?”
The debate over Lewis’s Flash Boys is generating more informed commentary than the book itself. One thing that is emerging in the debate is the identity of the main contending parties: HFT vs. the Buy Side, mainly big institutional traders.
One of the criticisms of HFT is that it engages in various strategies to attempt to ferret out institutional order flows, which upsets the buy side. But the issue is not nearly so clearcut as the buy side would have you believe.
The main issue is that not all institutional orders are alike. In particular, there is considerable variation in the informativeness of institutional order flow. Some (e.g., index fund order flow) is unlikely to be informed. Other order flow is more informed: some may even be informed by inside information.
Informed order flow is toxic for market makers. They lose on average when trading against it. So they try to determine what order flow is informed, and what order flow isn’t.
Informed order flow must hide in order to profit on its information. Informed order flow uses various strategies based on order types, order submission strategies, choice of trading venues, etc., to attempt to become indistinguishable from uninformed order flow. Uninformed order flow tries to devise in strategies to signal that it is indeed uninformed, but that encourages the informed traders to alter their strategies to mimic the uninformed.
To the extent that market makers-be they humans or machines-can get signals about the informativeness of order flow, and in particular about undisclosed flow that may be hitting the market soon, they can adjust their quotes accordingly and mitigate adverse selection problems. The ability to adjust quotes quickly in response to information about pending informed orders allows them to quote narrower markets. By pinging dark pools or engage in other strategies that allow them to make inferences about latent informed order flow, HFT can enhance liquidity.
Informed traders of course are furious at this. They hate being sniffed out and seeing prices change before their latent orders are executed. They excoriate “junk liquidity”-quotes that disappear before they can execute. Because the mitigation of adverse selection reduces the profits they generate from their information.
It can be frustrating for uninformed institutional investors too, because to the extent that HFT can’t distinguish perfectly between uninformed and informed order flow, the uninformed will often see prices move against them before they trade too. This creates a commercial opportunity for new trading venues, dark pools, mainly, to devise ways to do a better way of screening out informed order flow.
But even if uninformed order flow often finds quotes running away from them, their trading costs will be lower on average the better that market makers, including HFT, are able to detect more accurately impending informed orders. Pooling equilibria hurt the uninformed: separating equilibria help them. The opposite is true of informed traders. Market makers that can evaluate more accurately the informativeness of order flow induce more separation and less pooling.
Ultimately, then, the driver of this dynamic is the informed traders. They may well be the true predators, and the uninformed (or lesser informed) and the market makers are their prey. The prey attempt to take measures to protect themselves, and ironically are often condemned for it: informed traders’ anger at market makers that anticipate their orders is no different that the anger of a cat that sees the mouse flee before it can pounce. The criticisms of both dark pools and HFT (and particularly HFT strategies that attempt to uncover information about trading interest and impending order flow) are prominent examples.
The welfare impacts of all this are unknown, and likely unknowable. To the extent that HFT or dark pools reduce the returns to informed trading, there will be less investment in the collection of private information. Prices will be less informative, but trading will be less costly and risk allocation improved. The latter effects are beneficial, but hard to quantify. The benefits of more informative prices are impossible to quantify, and the social benefits of more informed prices may be larger, perhaps substantially so, than the private benefits, meaning that excessive resources are devoted to gathering private information.
More informative prices can improve the allocation of capital. But not all improvements in price efficiency improve the allocation of capital by anything near the cost of acquiring the information that results in these improvements, or the costs imposed on uninformed traders due to adverse selection. For instance, developing information that permits a better forecast of a company’s next earnings report may have very little effect on the investment decisions of that company, or any other company. The company has the information already, and other companies for which this information may be valuable (e.g., firms in the same industry, competitors) are going to get it well within their normal decision making cycle. In this case, incurring costs to acquire the information is a pure waste. No decision is improved, risk allocation is impaired (because those trading for risk allocation reasons bear higher costs), and resources are consumed.
In other words, it is impossible to know how the social benefits of private information about securities values relate to the private benefits. It is quite possible (and in my view, likely) that the private benefits exceed the social benefits. If so, traders who are able to uncover and anticipate informed trading and take measures that reduce the private returns to informed trading are enhancing welfare, even if prices are less informative as a result.
I cannot see any way of evaluating the welfare effects of financial trading, and in particular informed trading. The social benefits (how do more informative prices improve the allocation of real resources) are impossible to quantify: they are often difficult even to identify, except in the most general way (“capital allocation is improved”). Unlike the trade for most goods and services, there is no reason to believe that social and private benefits align. My intuition-and it is no more than that-is that the bulk of informed trading is rent seeking, and a tax on the risk allocation functions of financial markets.
It is therefore at least strongly arguable that the development of trading technologies that reduce the returns to informed trading are a good thing. To the extent that one of the charges against HFT-that it is better able to detect and anticipate (I will not say front-run) informed order flow-is true, that is a feature, not a bug.
I don’t know and I am pretty sure nobody knows or even can know the answers to these questions. Which means that strongly moralistic treatments of HFT or any other financial market technology or structure that affects the returns to informed trading is theology, not economics/finance. Agnosticism is a defensible position. Certitude is not.
– See more at: http://streetwiseprofessor.com/?p=8340#sthash.jbNHJptQ.dpuf
Comment by Jack Sparrow (@mercenaryjack) -
Mr. Cuban if you can spare the time please help a blue collar guy understand ?
Do stock markets benefit to society?
If so how?
(is this a place where need for capital is matched with investors?)
Does HFT provide any benefit to those wishing to raise capital?
Does HFT provide any benefit to investors?
Does HFT provide any benefit to anyone other than the owner of the HFT system?
Have I read comments by yourself to the effect that taxing trades not held for a certain time period would discourage this practice?
Would not the money absorbed by HFT not be better (for society as a whole) invested in building businesses instead?
Comment by michaeldschaaf -
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The problem is not technology simpliciter.
What frustrates me about this whole discussion is the fact that a lot of incorrect things are being said and certain facts are slightly adjusted where they become juicy fiction all to fit better in the fairy tale of the evil HFT firms rigging the market in conspiracy with the exchanges. Are all HFT honest participants with a fair market in their mind? No. Should they be closely monitored and should regulations adapt to their developments to ensure the market stays free and fair and stable? Absolutely. There are certainly risks in HFT that could affect the market (and economy!) as a whole (find me an HFT firm who denies this!). But a wise professor once told me “You should be against something for the RIGHT reasons”:
First it’s obvious that jealousy should be avoided in a rational discussion of HFT. If you think the only thing wrong with HFT firms is that they make too much money, you should try to tax them more or change the rules of the markets to prevent them from making as much profit as they do (transaction tax?). Or perhaps you should start a HFT firm yourself, there are plenty of people who have enough money to start one, if successful the dividends tend to be high so investors should not be hard to find if your plans are sound. Hint: the biggest challenge is not having the money, but having the expertise and the human capital.
The Alleged front-running: Front running in the strict sense of the word is highly illegal. If a broker gets a limit order from a customer, which she is free to manage on his behalf, it means that the broker is 100% sure her customer will buy/sell at that volume/price as that is what an order is (the probability of a customer not honouring his order is negligible). If the broker finds a better price, OTC or on the exchange, she should give that better price to her customer and only receive the agreed brokerage fee. If a broker buys/sells the product herself to then make money at the expense of her customer, she is front running and ripping of her customer and this is obviously illegal.
The term front running in this discussion of HFT is abused. A HFT firm’s algo’s that trade on the public exchanges only have access to the public information available to everyone else and are only able to make trading decisions based on this public feed (nevertheless within 300 microseconds). Orders on exchanges can be cancelled at any time (again within 300 microseconds). There is no way to know the origin of an order on the exchange, in fact the only thing that is visible is the order book (how much volume at which price level). When the volume at a price level changes from 100 to 105, it is very likely that someone sent in an order of volume 5 at that level, but there is no way to know whether this order is from any of the same persons that sent in the orders making up the initial 100 volume… The exchange operate at FIFO principle (first in, first out). No matter the origin of the order, if it arrives first at the exchange it will be the first one to be filled by a matching opposite order (buy vs sell). It is impossible to jump in front of an order once it has arrived at the exchange’s matching engine.
In what way then can there be a perception/fear of front running by HFT? Due to the speed advantage and processing advantage (faster computers), and intelligence advantage (fast and clever algo’s), HFT firms are faster than other market participators to spot a movement of the market (due to ask and demand or otherwise) by interpreting the public feed. Say a HFT market maker has the following orders in the market: buy: 100@99 50@100 — sell: 50@102 100@103. Now a Pension fund sent in a large order to buy 500 stocks via a brokerage firm. The brokerage firm decides to put in an iceberg order to not cause the market to move against her (if she would just put in the market order, other market participants will see her eagerness to buy and think ‘oh lets see how badly she wants it, let me higher my prices’). So she puts in an iceberg order slicing up the original order in slices of 50 volume (only putting in orders of 50 volume after each other when the previous slice is filled). after the first 50 volume order at 102 of the HFT firm is filled, the algorithm automatically fills up the level again: 100@99 50@100 — 50@102 100@103. The iceberg order will trigger again another trade at 50@102. Now the HFT firm has a short position of 100 and just did 2 consecutive sells. This means there is an increase in demand, while his position is short! The HFT firm needs to retreat or risks losing money… 100@100 50@101 — 50@103 100@104. the algo of the HFT firm adjusts its prices upward for two reasons: 1. It wants to make it more attractive for other participants to sell to him (e.g. 2×50@101, and make 1 dollar/share on buying back the 100 shares sold at 102). 2. ask more credit for participants that are willing to sell (at 103 instead of 102). When the algo anticipates very big movements, it might even decide to move prices up quite a lot. By moving up prices to 100@101 50@102 — 50@104 100@105 the HTF firm will very likely buy the stocks at 102 from other participants who were not fast enough to move their prices (because they are unaware of the buying pressure or their computers were to slow to react), before the big order is completely filled it will have moved prices up past 103 and the broker will be forced to buy from the HFT firm at a higher price 104 (big orders eventually always move the market!). The HFT firm has now done a nice scalp, it has bought the shares cheap from slower participants and sold to the broker when prices were higher, making the 2 dollar/share spread he needs to cover his risks and operational costs (co-location, fiber optic cables, fast computers, clever programmers, etc…).
This is not front running! Reading buying/selling pressure based on the public feed comes with a huge risk (you could be wrong and sit on a position while the market moves against you!), HFT firms need to estimate the chance of a big order indicating buying/selling pressure. They don’t know whether the orders are real intents or will get cancelled (hence they will rather react to trades + orders, rather than orders simpliciter). Indeed they do have loss making days! They don’t have any advantage in information (available to everyone) and they don’t play by different rules (no way of jumping the queue). But do they have an advantage due to speed, fiber optic cables, co-location, fast and clever algo’s? Definitely! Is this advantage unfair? Depends on what you call fair..
Around the 16 hundreds there were a couple of big companies involved in transporting and trading products between Europe and their colonies. These companies were so big they were owned by hundreds of people and their shares were traded amongst investors. Some people specialised in the mere buying and selling of these shares as news came out about their successes and losses, influencing the price of the shares. News however came out painstakingly slow. Initially one had to wait several weeks for one of the big ships to return to hear about the fail or success stories of the enterprise. Soon, people specialised in trading these shares based on the information that got out, hired people with smaller and faster ships to travel to the colonies and get the news about a company before the ship would have returned. Paying for these ships or the information that came out of them only made sense if you traded a lot and hence your profit depended highly on this information. For a normal investor with a longterm perspective who would only trade their shares a few times a year it would not make sense to pay for this faster information as the costs would be higher than his return on investment. Was it fair that there were people specialised in the mere trading of those shares that were able to pay for these faster ships to get hold of this information before anyone else?
The issue is not technology simpliciter, and it upsets me that Lewis’ his book plays on the fears of people towards complex technology to sell a juicy fairy tale about HFT rigging the market.
Another thing to note, is that while descent regulation is good and necessary, the more complex regulation and expensive compliance to that regulation becomes, the more difficult it is for smaller participants to stay afloat, which causes the big players to gain even more market share and a privileged position. The big players have no issues adjusting their operations to new regulations.
From MC: You are also over simplifying, but more importantly, while you dont want to call it front running of the illegal variety, its still the equivalent of front running and you are making Michael Lewis’s point that this type of HFT is costing consumers money. Those trades could have crossed in a lit market very easily. Without the need for the intermediaries to get a return on their huge capital investment. THose trades could have been completed without the need to “iceberg orders” to hide them. Without the need to have 30 plus exchanges and pools to route orders through.
Dont you think this complications of markets has costs to investors ? Someone has to pay for all that investment. Its not a contribution to investors.
We dont know the math of just how much capital is invested by the HFT players or just how much risk they are willing to take to get a return. Nor do we have a way of knowing just how much risk is introduced to the system by their efforts and their algorithms.
Yes, its true that old school market makers had to take big risks and many lost money. But those risks were a reflection of supply and demand for the shares of stocks they made markets in. Investors paid market makers for those risks, but they knew what they were paying and they knew what they were getting.
And in your over simplification, unless its changed dramatically in recent weeks, exchanges in particular, via order types do put people to the front of the line, or create multiple lines. All so the exchanges can compete as public companies for orders. Do you think exchanges want fair markets or higher stock prices ?
Comment by anarchlinux -
Responding to MC (quoting him from bottom of my post): “You make my points. The algos compete because like market makers of the past, there are guaranteed profits available. Unlike the past the competition between algos create huge risk. Systemic risk. Take out HFT and yes spreads may widen. But so what. Thats far better than having systemic that could impact us far worse than. The flash crash”
But the subtle differences are everything. The notion of “guaranteed profits” is false. Floor traders can, and did, go bust back in the day. Same with market makers. Those guys went against the tide as a matter of course, and sometimes they drowned. Floor traders and market makers live in perpetual fear of informed buyers moving size. The perception of “guaranteed profits” is weighed against the risk they take every day of getting picked off or drowned. HFTs take the same risk. Part of the reason they move so quickly, in addition to competing with each other, is to get the hell out of the way. I don’t think it’s accurate to use a phrase like guaranteed profits when the business model itself contains real inherent risk, along with huge implementation costs and the substantial risk of being competed out of business by one’s fellows. Floor traders and market makers also ate each other back in the day, which is why the weaker ones went under. Same with HFTs. This brutal competition process belies the notion of guaranteed profits and makes the markets function better.
As for systemic risk, flash crashes etcetera, we had all that stuff before HFTs existed. The crash of 87 for example. Or any of the big crashes and panics going back since forever. The old system was not set up to handle crashes — the human beings just stepped aside when everything went under. Systemic crash risk is an age-old market problem relating more to human emotion, monetary policy and economic boom / bust cycles than market maker functions.
Also, it’s a very big step, and a heck of an assumption, to say that getting rid of HFT is worth it just to forestall the possibility of future flash crashes. There are strong arguments, and empirical evidence, that HFTs are doing a better job as liquidity providers than the previous guys did, as evidenced by lower trading costs on net and consistently tighter bid/ask spreads over time. If we really wanted to stop the possibility of market crashes, we could go back to nickel spreads and put breakers on everything. But then trading costs would skyrocket, the i-banks like Morgan and Goldman would go back to making many billions off spreads, whereas the HFT guys are making far, far less via heightened competition, and trading and investing would be more expensive for everyone — with future market crashes still a fact-of-life likelihood anyway. It is necessary to have a better sense of the good HFT provides — which requires taking a hard look at the benefits of liquidity provision — before deciding that the bad is worth banning HFT on light evidence. Again, the car example: If all we heard was the negative side, “get rid of cars” would be an easy sell.
From MC> Every crash has been because of market participants ignoring the obvious and saying that we can’t be afraid of something because of “black swan” risk. That black swan risks are always there. THere are black swan risks to HFT. We cant quantify them at all.
And just because some HFT participants lose money by being willing to take more risk doesn’t mean that the game is not rigged.
A Slot Machine is rigged. Right ? No one hosts a slot machine that pays out 100pct or more. Right ? But if one company wants to pay more rent to host that slot machine, or wants to slice and dice and try to get in front of individual pulls of the slot machine, that doesn’t make the slot machine any less rigged against the “investor/trader/player” Order types, latency arbitrage , etc create a riggged opportunity for HFT players in the AGGREGATE
All in all, you continue to make my point. The game is so rigged that people are willing to invest incredible amounts of money to play the game. In their rush to play some take on more. Some lose . That doesn’t make the game any less rigged. You have the exchanges doing everything possible to create as many pulls of the One Armed Bandit as they can and to incent more HFT players to come on board. That doesnt make the overall game any less rigged
As far as the market makers, yes, a lot went out of business. PArticularly as spreads narrowed. But they knew the game they were playing. That is not the case today. No one knows exactly how the game is played or the impact of the risks HFT Players are trading. Both the good guys and bad guys. Which is why there is so much confusion.
And this is before we have seen any malicious players. What happens when people start trying to hack the messaging systems or do the equivalent of DDOS attacks on quotes to create confusion ?
We dont know what happens.
Comment by Jack Sparrow (@mercenaryjack) -
The other issue nobody talks about with HFT is the almost complete lack of system security. When every microsecond counts adding code to check for malicious and malformed messages is a luxury few can afford. The will come a time when somebody figures out how to crash or manipulate the opposing traders systems with a malformed data packet and then things will get really interesting.
From MC> right on !
Comment by John Pettitt -
Amen.
Comment by CyberDust ID - Blogmaverick -
A friend pointed me toward this post and asked my opinion. Thought I’d post up my reply to him:
“Front Running” implies illegal activity or violation of a customer relationship. To front run someone means operating on illegally obtained information, screwing over a client with whom you have a fiduciary relationship, or both at the same time. Neither applies to HFT. The information they use is legally obtained and technically in the public domain. Whether the exchanges should provide it is another question. But there is no front running if one is rigorous as to what front running actually means.
The idea of a “guaranteed profit” does not fit empirical evidence – HFTs erode their own profits by narrowing the spreads. HFTs compete viciously with each other to capture a piece of the bid/ask spread, which in turn narrows that spread and lowers trading costs. Technically an old school market maker would have a guaranteed profit if he were the only MM connecting the bid and offer. But the presence of multiple market makers introduces competition, which is why margins are narrowing. Consider: “TABB Group estimates that US equity HFT revenues have declined from approximately $7.2 billion in 2009 to about $1.3 billion in 2014. Looking at recent public data, the profitability of HFT firms in the US equities market has declined, just as the number of players has decreased… If the exchanges, brokers and HFTs are not reaping the rewards, then where is this leakage going? This money is going back to investors in the form of better and cheaper executions, as few if any institutional investors we have interviewed – and we have interviewed thousands – have ever expressed that their equity implementation costs have increased, meaning … trading just becomes cheaper and cheaper. That cost comes from somewhere: market makers, speculators, brokers and exchanges.”
The idea of a “guaranteed profit” also does not fit risks and costs of HFT. The whole reason Knight Capital got acquired is because their algo blew up and cost them hundreds of millions (I forget the amount). HFTs take a lot of risk in the same manner that old floor trader and market makers took risk. Market crash? Hosed. Algo crash? Hosed. HFTs also invest huge amounts in software and infrastructure. What happens if your firm invests $500 million and then your algorithm goes bad? Hosed. There is no guaranteed profit any more than a grocery store has a guaranteed profit because it can mark up the wholesale price. The risks lie elsewhere.
Much of Cuban’s characterization, on balance, can be applied (or mis-applied) to the old systems. If one wanted to critique floor trading, or old school exchange market making, one could similarly hand wave about guaranteed profits and such. But those guys can and did have real risks, and went bust at times, and had general competitive risks from each other that thinned the herds dramatically. Even in floor trading’s heyday, the majority of would-be floor traders busted out.
The liquidity provision of HFT is underestimated. These guys who bitch about the sketchy issues are still overstating the magnitude of the problem — which resides at the margins — versus the beneficial aspects of the core activity. It’s a weighting thing. They are under-weighting the value of large-scale buying and selling activity. For those of us who buy and sell infrequently, it is value-add to have others who buy and sell very frequently, as such that odds are greater that when we want to transact, someone is Johnny-On-The-Spot. If you underweight that core provisional value, the relative size of the problems gets distorted. Imagine a conversation of the relative merits of the automobile — people getting killed, pollution, fuel cost, traffic jams etc — without factoring in the net positives.
The smartest guys in the room (who are non-HFT) are not bothered. Cliff Asness runs ~$100 billion for fees measured in basis points. If anyone should be up in arms at HFT shenanigans it’d be him, as every basis point taken from an institutional money manager’s performance is food out of mouths. But he is chill about it. This is a simple point but one of the largest points of all.
From:MC. Did you read my post? You make my points. The algos compete because like market makers of the past, there are guaranteed profits available. Unlike the past the competition between algos create huge risk. Systemic risk. Take out HFT and yes spreads may widen. But so what. Thats far better than having systemic that could impact us far worse than. The flash crash
Comment by Jack Sparrow (@mercenaryjack) -
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Very good summary, given that it took only 2 hours.
Exchanges don’t regulate because exchanges make money out of volume. The way to regulate is simple. First HFT should not have information on the order book. Second, all trades can enter a very short “time zone” in which they are randomised in such a way that the flow is not disturbed.
The third way is to create an exchange only for HFT. Let them fight it out as grown ups. Stealing candies from babies is not really ethical.
No one can really know the impact of HFT on price formation. Excessive leverage in any system creates unknown risks.
Comment by Paul Thind (@paul_thind) -
Before HFT did we not have market makers who took the spread? And is quote stuffing not just price discovery (although illegal) ?
Comment by Simon Galbraith -
I first would comment that you are either are completely unaware, or completely misinforming your readers in regards to how retail trades would be executed via their online brokerage. In general, with any retail brokerage firm, your stock order will actually never reach an exchange, and never be able to be bought or sold by competing HFT firms. In reality, TD, Schwab, etc. will have sold your order flow to a particular market making firm. These firms get first dibs on your order, and its easy to understand why. Let’s say I want to buy stock A, and being a liquid name, I decide to enter a market order when the bid is 60, offer is 60.02. The firm paying for my order flow will know that as long as my order is executed inside the NBBO, it is a legitimate order. They might try to buy the stock at 60.01 in the actual market place, and then sell me 60.02, and pocket this difference. They might even trade it at the same price and collect the rebate. If they don’t want my order they can dump it on the exchange for HFT firms to fight over. I won’t comment on whether payment for order flow is bad, but it has been going on before HFT.
Furthermore, in regards to algorithms “jumping ahead,” of orders, there is no way to jump ahead of an order in a FIFO market. If I decide to place a bid at the beginning of the day at 60.01, a HFT can’t jump ahead of me at noon because they are faster. Additionally, let’s follow up on your example of jumping ahead of a larger trader establishing a position. If a large trader lifts all the offering orders on a single exchange, there is no way for a firm to cancel those resting orders. Now, after those resting orders are hit, they can adjust the price they are willing to sell that security. But, this is no different than how market makers of the past functioned, or most aspects of business function. If a farmer sells apples to restaurants, he initially establishes a price. If more and more restaurants, or a single restaurant keeps buying his apples, he has the right not to sell apples for the same price. A restaurant doesn’t need to keep buying apples from him, and ultimately, they could buy apples instead of oranges. On the institutional brokerage level, or prime broker level, I would just say that if a broker’s execution is slipping because they can’t keep up with bigger/more savvy firms, it is akin to competition in any other industry.
In regards to strategies, and profitability, I believe you’ve not conceptualized reality in that both personnel and technology related costs could make a profitable strategy actually unprofitable. Every time Google, Twitter, or any website sells ad space, they are making money. It’s always a profitable transaction. However, after factoring costs for servers, programmers, etc., it might be a net loser.
Fragmentation, payment for orderflow, massive indexing/etfs, poor risk controls, etc. are all risks to the financial markets. There are been crashes in ’08 that had legitimate fundamental reasons, and crashes like the flash crash. There are problems that need to be addressed, however, a long-term investor should be more concerned about what amounts to a one bps cost to their investment.
Comment by Philip Martin -
Sorry. I am not talking about conspiracy theory.
Comment by ssregi11 -
To be sure, I am talking about a big conspiracy theory. Most retails brokers don’t have capital or talents to handle retail orders properly. So they just reroute the orders to an order processor in exchange for order flow rebate.
Almost all the people in HFT I have met have no training in regulation, practically no understanding of fiduciary obligation, or worse yet the regulatory premise of leverage or order submission.
Their compliance officers, of course, have no idea of technology.
So, there have been so many accidental strategies somehow making money everyday. Most of them did not make a big money.
Those who understood why they were making money and exploited the regulatory incompetence made big. As my example shows, the order matching system did not front run client orders, but what happens on the exchange is fronrunning. I believe that this is a breach of fiduciary obligation. Do you think regulators have the equipment to discern this kind of subtle difference? Computer clocks are based on 60MHz crystal. And the time markings are done on different machines.
Again, there are a handful of HTFs that make money as a fully independent systems, but not that many.
The so-called latency arb is certainly profitable, but not a something worthy of $250MM trading capital, unless you know how to create latency when you wants. (I believe creating latency intentionally is a fraud per Exchange Act.)
Comment by ssregi11 -
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Knight used to process 1/3 all the U.S. retails orders. Retail brokers route their client orders in exchange of order flow rebate. Knight may match the orders internally or just reroute the order to an exchange.
Comment by ssregi11 -
ssregi11:
Hmm. I don’t think I’m getting you. Why would TD Ameritrade be sending an order to a prop-shop’s firm-wide back end? I feel like we are talking past eachother. Or maybe there is somthing I’m not understanding.
Thanks!
Comment by Richard (@darthallies) -
No, I am not underestimating the scale of HFTs. My points are
Completely Independent Prop HFT should abide by Reg T fully and preemptively. And the Reg T applies to even unexecuted open orders. The capital cost is quite high. Layering short orders are practically impossible as all the short orders should have borrowed the stocks in advance. Don’t tell me HFT can borrow stocks in milliseconds.
Most HFTs are working as a broker dealer or just using BD’s regulatory exemption. To utilize the BD’s exemption, the regulatory checks should be done through firm wide regulatory checking system. There is no room for optimization.
Once, a BDs’ exemption is utilized, the system is a BD. As such, the system should 1) maintain orderly and fair market and 2) keep its fiduciary obligation. It does not matter TD America routed the order to the system or not. Once the system sees an order (X) that is not its own, the system should stop any processing its own order till the order X is published by the exchange if the order is routed to an exchange.
Comment by ssregi11 -
Tyler Cowen has been running HFT posts and links to HFT posts: http://marginalrevolution.com/marginalrevolution/2014/04/a-study-of-limiting-hft.html , or http://streetwiseprofessor.com/?p=8333 , or http://marginalrevolution.com/marginalrevolution/2014/04/high-frequency-trading-and-the-retail-investor.html that are probably probably going to accomplish this: “I expect to get ABSOLUTELY CRUSHED on many points here.”
Beyond that, I think this is true: “there is so little knowledge and understanding of what is going on with HFT, that I believed that someone needed to start the conversation” because the issue is complex and inherently not reducible to sound-bites or easy metaphors that link up with normal everyday human experience. There is also very little knowledge and understanding of how quantum mechanics works, for similar reasons.
Comment by Jake Seliger -
ctintexas:
Thanks for the link.
It’s not just quotes stuffing! I suspect simular funnyness on the depth feeds also. But this is not an essential result of HFT. It’s a bit sleezy I agree, and infinately simple to fix at the regulatory (even exchange self-regulatory) level.
Also, there are are ways to side step the issues created by quote stuffing.
I’m currently reading the Flash Boys book. And I find it facinating, it fills in a few holes in my understanding, and confirms things I thought… but it’s way over-the-top sensationalism. It’s designed to get you angry, so that you will tell your friends and they will buy the books too.
It’s typical American fear-based media. (I highly recomend it 😉
Comment by Richard (@darthallies) -
> I don’t think that most HFTs are that profitable to justify the trading capital.
You greatly underestimate the scale of these operations.
Comment by Richard (@darthallies) -
@mcuban
Mark, one item that is missing from all of these arguments is that HFT companies receive a rebate (get paid) to provide “liquidity”.
So while the “normal” investor pays commission to purchase and sell; the HFT companies get paid by the exchanges every time they get hit on the bid-side.
Not only do they make money on the front-running, but also receive healthy payments from the exchange for the illusion of their volume.
I quit trading years ago; when the exchanges overturned “flash crash” trades; meaning I couldn’t even make money when the algos went wrong.
It’s more than fixed – it’s geared heavily on the side of the algo traders (because they don’t have to pay when they make mistakes).
Comment by johngalt1929 -
Richard – @darthallies… You are absolutely correct, there is no such thing as a truly riskless financial instrument. Even T-Bills have a theoretical risk. However, consider that the (recently delayed) IPO for Virtu, one of the larger HFT firms around, in their pre-IPO disclosures indicated that from January 1, 2009 through December 31, 2013, a total of 1,238 trading days, they lost money on exactly 1 day. Definitely not riskless, but pretty close.
Even if you had the ability to reverse engineer all of the various proprietary algorithms in HFT land, “Quote Stuffing” (explained well in this article: http://wapo.st/QLKNCJ ) often rendered Thor (RBC’s smart routing mechanism) ineffective.
There are many layers of this onion and I can only hope that many more will now be revealed soon. I’m simply thankful that we now live in a day/time where social media, Twitter, blogs and the like make these kind of secret little evils much easier to expose. From the late 1990’s through the early 2000’s, SOES (Small Order Execution Service) bandits were the scourge of the trading industry. Despite substantial efforts by industry associations to educate congress, regulators and anybody else that would listen, these leaches found a way to expose an order routing system that was created for small retail investors to their advantage, making billions in the process. This practice went on unchecked until the SEC finally woke up in 2003 and ended their honey hole. Not surprisingly, many of the current day HFT firms sprang from the SOES firms.
Comment by ctintexas -
About optimized regulatory checking.
If an automated system performs regulatory checks by itself, the system should have a separated account with its own trading capital, and probably a separate firm id. Absent these independence, HTF has no legal way to optimize regulatory checks better than firm wide regulatory checks. Obtaining these independence cost a significant trading capital. I don’t think that most HFTs are that profitable to justify the trading capital.
Comment by ssregi11 -
For the order internalization. Client orders may be internally matched against SIP feed abiding by all the regulations except one. For a buy order, if the actual market is down and the SIP feed is stale, the order processor can just match the order (sell), and buy back from the market.
As this is a riskless principal trade, the execution should be marked as such and the client should be informed. I am not sure that those executions are marked properly.
Comment by ssregi11 -
HFTs are self checking systems. HFT orders does not go through firms checking systems.
Who do you think process your orders to ETrade, TD America, Merrill Edge, and so on?
Comment by ssregi11 -
Hello ssregi11:
If your broker is selling access to your orders BEFORE they get to the exchange, then blame your broker, not HFT.
> HFT’s order are being sent out without any checks.
My understanding is that is not true. HFT have regulatory requirements too. Although they are free to optimize them.
Comment by Richard (@darthallies) -
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Let’s say I sent an order of 10K (~$300K) MSFT. The internal matching engine of my broker (or the broker’s order processing firm) will probably just reroute the order to an exchange and send an prop order of 2K MSFT back to back to the same exchange. Which order do you think will arrive at the exchange first?
Just before a client order being routed to an exchange, the order should go through many regulatory checks and the order information should be checked in to a database system (Oracle). HFT’s order are being sent out without any checks.
Retail orders can be front-run in reality though the matching engine itself did not front-run retail orders.
Comment by ssregi11 -
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People that says HFT has NO RISK lack imagination. Take the Thor program described in Lewis’s book Flash Boys. They way it’s described it would completely mitigates the HFT advantage RBC had identified. I would content it would be trivial to modify it it not only take away the risk, but game it to your favour. There is no Algorithm, once you know how it works, that can’t be exploited to your gain.
Comment by Richard (@darthallies) -
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Bottom line for me is that I – a small time investor – got out of the market a few years ago for this reason. I expect The Tax Man to have his hand in my pocket, but not some mystery person/business that controls the topside of my trade. Now I invest only in what I can see and control (right now that’s real estate), which is much different than what my parents and grandparents did to grow their capital. If Wall Street wants to continue seeing dollars flow through the markets, they should protect the system by shutting down this kind of skimming.
Comment by Gracie Lake -
Please give citation where exchanges accept money for permitting special order types… I’m assuming your talking about intermarket sweep orders.. price to comply.. hide not slide??
What changed is that the exchanges both delivered information faster to those who paid for the right AND ALSO gave them the ability via order types where the faster traders were guaranteed the right to jump in front of all those who were slower (Traders feel free to challenge me on this) .
Comment by The Biz (@biznittle) -
There is a subtle difference between volume and liquidity. Just because there is volume doesn’t mean there is liquidity. Very interesting and informative article.
Comment by MTSRepo (@MTSRepo) -
I think Michael Lewis makes a good point in that the HFT firms take NO RISK. Once they invest in the tech, they basically mint money. And if this is the case, how are they ‘participating’ in the market?
They are simply ‘taxing’ everyone else. Question is, should they be allowed to? And more importantly, can you actually stop them?
Comment by Adam Carey (@admancarey) -
In my opinion, HFT provides NO value to the Market or investors. It siphons billions of $$ to a bunch of really smart people that should be spending their time creating something productive. I think the best solution (Mark said this during an interview) would be for companies to require that their stock have a minimum holding period (10 sec, 30 sec, or 1 min). I think this would make corporations look like they care a little more about their long term investors – the people that vote for their boards. I still think Insider Trading is a much bigger problem and find it unfortunate that the SEC (with it’s limited resources) has to spend time dealing with HFT and not the bigger issues.
Comment by Jason Deppner -
Good recap of the situation Mark, however one important point that should be highlighted is the complicity of our for profit exchanges. While HFT’s reap the rewards of dashing in and out of the markets in the microsecond world, the exchanges are the ones that have made it possible by providing premium co-location services and special order types. While these “services” are available to anybody, most of the investing public does not have an extra few million/year to drop a server into the exchange’s data center… ensuring their fiber optic cable to the exchange’s box is a couple feet shorter than the competition, thereby giving them a couple picoseconds advantage. The exchanges, in lockstep with HFT, have reaped these rewards through these co-location fees and increased volumes. I feel that this point, should it ever come to be widely understood, could truly shake the confidence of the investor. Not only were the thief’s stealing, so were the police… just in a different “kinda sorta” way.
Having been a sell side trader for the better part of two decades, I’ve had to watch in horror as my customer’s orders have been screwed and tattooed in the name of the HFT’s providing “liquidity”. While my customers are typically large money managers, mutual funds etc, in the end the real customers, those that are paying the price, are the investing public. If a mutual fund manager pays more because an HFT sniffed out his order and scalps a few pennies here and there, so does George and Linda in Dubuque when they invest their 401k in said manager’s fund.
One final point and I’ll go back to my hole… One of the primary reasons the big banks have been slow to display any kind of outrage is because they’re part of the problem. Every major bank in the US (GSAM, Citi, BofA etc) has it’s own black-box HFT style group. Tough to point the finger at yourself!
Comment by ctintexas -
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Here’s my analogy for people who don’t really know how trading and this issue really work:
You go to the grocery store to buy milk. As you walk in the door, the grocery store stamps a sign on you saying “Here to buy milk.” That grocery store has someone paying them to put that sign on you. Then, as you go to get that last carton of milk, someone grabs it before you do. That person then turns around and sells you the milk for more money than the store was charging.
First, there is nothing wrong with speculation in the market…everyone can and should have their own motivations for being involved and that’s what “makes a market”. However, the playing field should be level and selling access to others’ orders is effectively inside information.
I submit one very simple suggestion for leveling things in what I feel is a very fair way:
All orders at a given price are treated on a time priority. That means if I entered my order to buy Apple shares at the same price as you but I did so earlier, then I get the first execution at that price, no exceptions. The “jumping the line” issue that we have now is the real unfairness and is what is allowing the system to be gamed. If someone wants to pay up to the next price level that is a totally fair part of the market but at the same price time priority across all exchanges should exist.
As this debate progresses, also don’t lose sight of how the exchanges are making their money (Putting that sign on the milk buyer’s head). Special access, esoteric orders, etc are all major revenue streams and the HFT crowd is the cash cow to them, so changes will be resisted.
Full disclosure, I spent 8 years as a NASDAQ market maker, another 6 as a proprietary trader, and the last 9 in equity research and portfolio management.
Comment by Jeremy Hellman (@JeremyJBH) -
Brilliant, concise explanation. Just leaves out the cause, which will also answer many of the questions posted. HFTs came about and thrived as a result of stock exchanges converting from private memberships to “for profit” publicly traded corporations. That is when and why they stopped servicing the customer and began exploiting them in an effort to create and exploit new revenue streams. Had exchanges maintained a fiduciary responsibility to the customers they were built to serve instead of the shareholders and investors desperate for constant growth, this debacle never would have happened. The model of a “for profit” exchange is an unsustainable one as it is impossible to continue to exist when you put investor profits ahead of customer fills.
Comment by Josh Kirley (@BerwynLooper) -
Anyone remember rules 127 and 72B? A specialist could sit on your super dot order for more than a minute before giving you a report. In some issues, I couldn’t get 500 shares without paying up a quarter on every trade. Or how about the Nasdaq lawsuit in the late nineties. OTC market Makers were colluding with each other and fading whenever even one of them was called.
Im not defending HFT, they put me out of business as a floor guy, but I don;t see where there is any breach of fiduciary going on here. The fact remains customers have it better than they ever have had it before, and when you eliminate incentives to provide liquidity, it will worsen.
Comment by jimgoose -
As for the transaction tax solution, consider making it rebatable if the position in question is held for a year and a day (the same standard that determines long-term versus short-term capital gain). We already grant long-term positions an extremely favorable tax treatment, so we have already made the political judgment that this is beneficial to society. Does the HFT issue fold-up shop at that point, or does the game just move down the street to someplace else? (honestly have no idea)
Comment by Paul Meloan (@PaulMeloan) -
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Great post, the reality is that hft and the algorithms have changed the structure of parts of the stock market. No value what so ever, in promoting the purpose of the stock market, which is to raise equity capital, and realize liquidity for your equity. If you choose to participate, know what you own, and calculate the value of that piece of equity. This is why alternatives to traditional exchanges are popping up, ie second market.
Comment by John Stanton -
Good post Mark. I’m not trying to challenge you, but rather share my experience.
What HFT trading seeks to do is read the order flow, something that has been happening since the advent of the bucket shop. You point out that it is algo’s now trying to do this, and not necessarily blatant front running, so there is inherently risk involved. Risk of any kind deserves reward.
Reading the order flow used to be something we paid for in the form of seat leases, stand on the floor, and know who is trading what? And when they are opening or closing? etc..Now its a matter of paying the exchanges for the information as fast as possible and having an algo interpret it for you. Exchanges are thriving as a result.
Nothing has changed, just how, and who now has the edge.
If you really want to catch a thief, look into the structured products being marketed through major wirehouses, price them out relative to listed options, then tell me how these firms keep any of their clients or stay out of hot water with FINRA.
Comment by jimgoose -
Given my earlier post, and on further reflection, due to the need to promote “fairness” in all markets I propose that the NBA force Mr. Cuban to buy Kevin Durant to make the Western conference more exciting and equitable in the interest fan welfare.
Comment by hoarderphelps -
HFT Explained
First some history since no one has explained how knowing an order beforehand makes someone “billions”. It doesn’t! Front running an order doesn’t make money unless the order is so large that it moves the market in the front runners favor. Front running a client order is illegal, and technically this is not what is happening, since the HFT trader (who might sit on another floor of the brokerage) is neither aware of nor cares about a client order.
HFT grew out of the need for arbitrage between a stock index and the underlying securities. If there was a misalignment then the market (i.e. everyone) suffers due to misinformation. The problem was really big when stock prices were priced in a 1/8th’s (i.e. 12 1/2 cents) spread. Moving to penny pricing allowed dealing firms to undercut each other which benefited all investors. HFT firms have arbitraged this spread away and are shutting down as a result. Here is why….
In order to make this arb work, on say the SP 500, a dealer needs to buy the index (say the futures contract) or typically have an existing long market exposure through owning all the stocks contained in dealer inventory and then sell every 500 stocks at exactly the same 1. time; 2. appropriate price differential; and 3. appropriate volume to rebalance the portfolio perfectly. AND later buy back every single stock in the same fashion. This is why there was a race to faster computing power and execution speed and why it benefited the market that regulators allowed it. Tighter spreads means better information and pricing value for everyone.
BUT, here is why some in the industry don’t like it…execution speed has gotten so fast that it exceeds that of the exchanges. A dealer can send an order to determine bid/offer and volume depth and then cancel it before it executes; this is called “pinging”. This is done to ensure that all the orders placed can be executed at the same moment and volume to ensure a perfect risk-free arb. Pinging ensures that the market is properly aligned, since there is no order executed unless there is profit to be made, but is this fair? Naturally markets have fixed bandwidth which results in sharp price movements when everyone wants to execute at the same time, such as during stock market crashes or dropped calls on cell phones. Naturally HFT arbitrage benefits hugely during these periods, and as should be clear by now doesn’t cause it. Since the process ensures tighter spreads and accurate pricing for all markets regulators are having trouble how to respond to the “unfairness” of certain participants who know more and sooner than everyone else, but that the nature of the free market in information. To argue otherwise should require those, like Mr. Cuban, to give up all their money to the poor and needy because they didn’t work hard enough or smart enough for it.
And just to get in another dig (since you have read this far) the practice and the complexity of the problem is hard to explain to an ignorant media and public that prefers sound bites over some hard thinking….IMHO.
Comment by hoarderphelps -
To Valerie Alexander and others proposing a tax. So, your solution to the problem of firms shiphoning capital from a pool of capital that is supposed to be available for investment is to have it instead shiphoned off by the government…. brilliant!
Comment by Greg Kruzick -
HFT firms sends out massive amount of orders to the market.
1. Do the orders abide by reg T?
2. Are the shorts really borrowed?
1000 share each over 1000 stocks costs 15MM initial margin. To send out orders over 10 ticks, the firms should have at least $150MM trading capital sitting on their account. Let’s say these are buy orders. Now, the firm cancels bottom tenth orders and send new orders on top of their best price. If the firm sends out the new orders before cancel confirmation, the firm needs extra $15MM. When the market is fast, the firm may need to send out 4 layers of orders above the previous price, which means extra $60MM. Now, what happened to their sell orders sitting above the market? If some of them were executed, let’s say two ticks, that’s another $30MM.
Just to handle reasonably fast market, HFT firms need $250MM trading capital. The real question is whether the capital is committed or just booked via other assets which the firms do now have the ownership.
I am sure that the HFT firms are taking advantage of BD exemptions, but the exemptions are only for making orderly markets not for prop trading
The Risk of HFT? What if all the orders within 10 ticks are executed? The firm should come up with $150MM out of somewhere. For the firm, it is better to sell them and take loss of $5MM rather than ending up in settlement failure, which guarantees FINRA investigation. Look at Knight, they could not settle the trades, doesn’t they?
Comment by ssregi11 -
Pingback: High Frequency Trading Debate Continues
If poker were legal, would the FTC allow a poker site that lets one person see another person’s hand before they bet? Of course not, because it’s not fair to everyone involved.
Would anyone play on that poker site? Of course not, because it’s playing with a bunch of cheaters.
When that game is your whole economy and the financial well being and confidence of your citizens, it’s up to the government to weed out the cheaters especially if it’s out in the open and affecting consumer confidence.
Do you know people that would like to play in a poker game where you can see the other person’s cards? Absolutely! It’s not honest but there are people ready and eager to steal from the unsuspecting. So that would drive normal investors to seek out these types of advantages because they realize they have been on the short end of the stick and want to change teams. When this happens it will exacerbate the situation and lead to a future of all cheaters who are no longer playing poker and the market will die.
If cheaters go unchecked they get greedier and greedier because they don’t really think they are cheating and nobody is calling them on it.
This boils down to the importance of consumer confidence for our US economy.
Peace!
Ace
FightClub.com
Comment by FightClub.com (@fightclubcom) -
Balazs, Cross exchange arbitrage has always existed and I have no problem with that. What you’re describing is front running enabled by the exchanges by selling the ability to execute the trades ahead of an order hitting the book. The fact that only part of the order is front run because some of the order already hit the book on another exchange is irrelevant. That isn’t cross-exchange arbitrage where two trades are made with two separate counter-parties – each at least standing *a chance* of receiving the price that they expected. In your example, it is almost assured that the one counter-party being front run won’t. Payment for order flow is another opportunity to front run whereby an entity gets to choose how orders are routed.
Of course, all of that assumes your assertion that cross-exchange front running is all that’s occurring and that orders aren’t being made available to a select few before they hit any exchange. I wish I shared your faith. Even though we are told that ‘Flash Trades’ (where order information WAS being bought ahead of execution on any exchange) are no longer permitted on major exchanges, I’m not so sure.
Comment by marmun1 -
Reblogged this on The Green Pulpit and commented:
Mark Cuban on the Rigging of the Stock Market Discussed in 60 Minutes: http://www.cbsnews.com/news/michael-lewis-explains-his-new-book-flash-boys/
Comment by thegreenchazzan -
Barry Ritholtz wrote: “Why anyone is allowed to see other people’s orders, than front run ahead of them defies explanation”.
Thank God! I was beginning to think I was the only person asking this question.
I find it ridiculous to see so-called, ‘simple’ solutions being suggested such as applying a transaction tax and introducing a 0.5-1 second lock on orders or calls for new legislation etc.
Front running is already illegal.
Trading on advance/insider information is already illegal too.
What is happening here is akin to allowing a chosen few to see other people’s cards in a Poker game – and then having to listen to venal and corrupt individuals trying to defend it as being a good thing for everyone.
There is NO good reason in allowing anyone to see anyone else’s orders before they hit the book. The fact that Specialists have been able to do so historically is not an excuse to do so in the modern, technological age. They did it that way because there was no better alternative at the time – not because a chosen few being able to all orders before they’re matched was a ‘good’ thing for everyone. HFT front runners pay the exchanges to be able to do this. So, what happens if they don’t pay? They don’t get the information. Which means the exchanges can stop this nonsense in a heartbeat if they wanted to. Actually, we don’t even need them to ‘want to’. We already have laws against front running and inside information. Those laws do not excuse those practices just because they occur at sub-millisecond speeds or for transactions of just a penny.
I wish people would stop considering other alternatives as a remedy. It only distracts attention away from the real problem – and therefore the only solution to stop the cheating and rigging in this way.
If a chosen few were allowed to see your cards in a Poker Game, would you really be calling for a ‘tax’ on them instead of just demanding that the ‘pay-for-view’ stopped?
Comment by marmun1 -
marmun1, it’s not that banks see your order before you place it, but they see it in the first exchange, and then they can frontrun you to other exchanges *assuming* that the first exchange was only part of the order.
Comment by Balazs Rau (@jomagam) -
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Great writing, but I’d suggest its like anything unknown, it seems scarier than it really is, and even if you assume HFT is siphoning off billions (for the sake of argument), that is nothing compared to the trillions of wealth generated in the markets. The drastically declining returns of HFT funds seems to disagree with that hypothesis anyway – IMHO they’ve created so much pricing efficiency (or scared retail investors away from the markets), they’ve caused their own demise and are now largely competing against each other.
This isn’t to say anything is right or moral – just that its not as great a problem as people[/media] are making out. The “evil bankers” are just geeks who love math, code and an infinitely tough challenge – and majority are not making millions. The average quant salary is far less than the west coast. They’re doing it for love of the math & a challenge.
Like all things (cars, planes, jobs), the markets are becoming automated and, better or worse, *high-frequency-trading* is a part of that that will stay. There may be a few hitches along the way (front-running), but the value destroyed and corruption by humans is equally as bad.
The upside from having emotionless markets could bring stability for everyone. Better to level the playing field and let everyone invest with algorithmic precision. Maybe by 2100 the markets will be perfectly correlated to the risk-value at present moment in the business the ticker represents >> Someone buys an iPhone, and AAPL instantly goes up 0.000001c.
Comment by Jared Broad -
Pingback: Mark Cuban’s Primer On HFT For Idiots
Mark, you’re right. Although there is a considerable amount of information about HFT, there is a lack of understanding of what is going on with HFT. And yes, the conversation needs to continue (you needn’t worry that you have to start it; a number of experienced traders, market structure analysts and academics have been doing that for nearly a decade.
This may help the conversation, written after the CBS 60 Minutes segment (not by me). It’s a wee bit longer than your 2,571 words but based on nearly 30 years experience watching/researching/analyzing the evolution to automated trading: “No, Michael Lewis, the US equities market is not rigged.
It’s been quoted for the past four days by major media (NYT, WSJ, CNBC, FT, Bloomberg, LA Times, Barron’s, AFP and MarketWatch, on and offline and TV).
You can find it here: http://tabbforum.com/opinions/no-michael-lewis-the-us-equities-market-is-not-rigged.
Hope this helps….
Comment by marty rabkin (@martyrabkin) -
I used to build the HFT networks for a large financial institution (Fortune 50 sized). Your information is for the most part right on. But as others have noted, the vast majority of investors should be long term investors, where the HFT game really shouldn’t have any impact. Yes, the flash crash phenomenon is a major issue, and needs to continue to be addressed by the SEC. Some of the recent changes they have instituted to prevent flash crashes help, but don’t go far enough. Now, has HFT killed the day trader? Absolutely. Day traders are playing a rigged game against a stacked deck.
The larger issue, not really addressed here, are the so called “dark pools” where a lot of very suspect transactions occur daily, and to date are perfectly legal. The fact that the SEC allows these transactions to occur with little to no oversight is mind boggling.
Comment by Evil Camel (@evilcamel) -
Mark, I bet no HFT trader will seriously challenge your assessment. Everyone knows that this kid of front running is exploiting a loophole in the system and adds no value. Who wants to voluntarily put lipstick on a pig… Hopefully it’ll be one of those “it was nice while it lasted” type of thing for them.
diyinvestorsource, your logic is like saying that cars are so much safer than 50 years ago, so we shouldn’t care about the sudden acceleration in Toyotas. It’s true that Joe Shmo selling 50 shares of MSFT is going to be affected only minimally. But what if the mutual funds in his 401k or his company’s retirement fund gets nicked 1% per year. The book mentions an alleged $300MM per year loss for a $9B fund, which is 3.3%. That is a lot if you start to compound year after year, even if only half of it is true.
Comment by Balazs Rau -
While front-running is making it’s most of money off of big trades, and so not small investors, related HFT strategies like quote stuffing and stop hunting can crush the individual trader. Artificially tripping a stop-loss on an out-of-the-money option can be worth a significant chunk of the total position.
Comment by magnacetaria -
The negative impact you describe is dead-on and hits anyone that decides to go the mutual fund route, which is most small individual investors that shy away from individual small to mid-cap stocks with their lower volumes and lower liquidity and the attention those investments demand. They already pay a price to go the funds route – the funds loads (direct or indirect). HFT is a greed surcharge assessed by the HFT traders that has to impact the small investor in the pocket book and undermine confidence/trust in the markets. Time to bury gold coins in the backyard. 🙂
Comment by Michael May -
Breaking down some of the ways this costs you money:
Quote Stuffing – which should be illegal and IS illegal when a person does it (it’s running a ‘boiler room’). Aside from perpetuating a fraud and slowing things down the way Mark described, it slows things down in real time as investors waste time chasing phantom trades; trying to execute on orders that don’t exist, which prevents them from actually doing the work their clients pay them to do.
Front Running – many of the posters in the comments here seem to think that it’s simple price shaving, it’s not. They are straight raising the price of every large trade. Most trades don’t occur at a single price point, they occur at a range. If you want to buy 10k shares of Apple and are willing to pay $600.98 – $601.00 per share an HFT will see your buy order, buy up every share available at your low end and then sell you it’s newly owned shares at your top end. They effectively cost you $200. How? Because they didn’t even have 10k shares of Apple to sell you. They only bought the shares a microsecond before you so they could sell them to you. If not for the HFT you would have bought the 10k shares from the original seller for $600.98, but because the HFT bought all those shares out from under you you have to pay $601 to get them from the HFT.
They added NO value and no liquidity, all they did was scalp you.
And this too is illegal when a person does it. It’s trading on inside information.
Small Investors – but what if you’re just a small investor, or a simple day trader? That’s fine, As long as you keep it small and do all your own investing. But most people don’t run their own 401k, IRA, or other investment accounts. All those pooled accounts are big deals and they all have to deal with HFTs which means the ROI of any of your pooled investments are losing a % because of HFTs.
In answer to why the exchanges don’t regulate it, because the HFT firms pay the exchanges for access.
Comment by Ray Barrera -
Good stuff Mark – these guys clearly have exploited a hole that needs plugging and they’ve been making a killing while nobody has taken action. They’ve also set themselves up as the great scapegoat when the market does crash…everyone will point their fingers at them and the Fed will get spared while they’ve been the biggest market manipulators of all.
Comment by EParker (@Parkenomics) -
Ok so we agree that this is a really small impact. And only on transactions. Lots of trading = high HFT impact (relatively speaking, it’s still pennies). Little trading = low HFT impact. That’s one point for long-term holdings. As for the crash in 2008 – anyone who was in stocks in 2007 and needed to spend the money in 2009 needs an idiot’s guide to investing. Even at the best of times that’s asking for trouble.
Someone who was in stocks in 2007 and didn’t look at the market until 2012 never knew anything happened. I let others play the short-term game. There is only going to be one trader that is the fastest in the world and they will hurt everyone else who is playing that game. There are millions who have made and will make a profit from long-term holdings. The flash crash? I would have loved to buy into that since it was cheaper than the day before or after. But I’m way too slow because I’m just not paying attention most of the time. I only take advantage of old-school slow crashes.
So if HFT imposes a tax of 0.0125% when I buy today, and the same when I sell in 50 years (ok maybe it’s been regulated out of existence by then). And if all I know between now and the day in 50 years that I sell is that the companies I own keep making profits that get to me eventually, why do I care? Trying to beat the HFTs at their game is a great way to lose. Doesn’t matter to me. I’m patient. Playing a different game is how you win.
People including you are talking about a 1c/share tax to slow this down, which is a far bigger impact than the HFT problem. Whether that cost goes to a trading company or the government it’s the same to me – too small to care.
You can call that rigged, but investors have 99 problems and HFT ain’t one.
Comment by diyinvestorsource -
YOU ROCKSTAR!
Comment by masudosman -
The problem isn’t so much HFT but rather the proliferation of trading venues and their intended purpose. For years, stocks were traded on the NYSE and then Nasdaq with no issue from a market structure perspective. Reg NMS changed this. Counter-intuitively, having more options available to you in terms of places you could buy or sell has now become a bad thing (but what about CAPITALISM you might ask). For profit public exchanges have created two tiers of investors by allowing direct feeds that give an edge through the various means described above (quote stuffing, flash pricing, etc). The second tier is the American retail investor and even large banks in many cases that is continuously being skimmed from getting a better price and shown fake liquidity. That’s not capitalism, it’s stealing. For a small investor, do penny’s on a trade matter? For a large bank, do millions of dollars matter? The answer is, of course. This is America. We don’t trade our markets like we spin a wheel in Vegas. For our stock market to drop 10% intraday due to the above mentioned issues (stub quotes), is unacceptable. This wasn’t a “glitch”, it was predatory trading and it’s something that affects every investor. The real dilemma is how little is known to fix the problem. The answer – a not for profit exchange. It solves every issue mentioned and would foster a fair, capilist market, that we trust. This is something that I plan on devoting quite a bit of time to. Get in touch on LinkedIn:
-Ryan Jameson
Comment by Ryan Jameson -
So if buying, why not just place a limit order which requires an exact price? Why would it matter if you got a partial fill as stocks normally bounce around a bit at any price. You may not get filled immediately, but the vast majority of the orders you placed would be filled at the price you specify.
Comment by Sean Cassidy -
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For me, a novice investor, the best part about posts like this is it helps people to understand there is a huge difference between computer-aided trading and what it’s done for spreads, along with switching to decimals (what the hell is a steenth?) and the skimming or scalping that the front-running does to generate millions of dollars of profits for the HFT houses. I’m a capitalist and applaud when someone invents a products and makes a huge score – good for him or her. But this HFT skimming practice helps no one. It adds nothing to the market, facilitates nothing, adds no depth or liquidity, provides no service and solves no problems. The guys who run these exchanges remind me of the stories of when the mob was getting a one dollar ‘tax’ for every window installed in the city. It only served to make the crooks a little richer, one window at a time.
Comment by joehefferon -
No wonder unemployment is so high, the capital markets have been taken hostage by Banksters who’s desire is to tax every dollar of capital investment. A healthy system would have Financials @ 5% of total GDP, where-as today it’s closer to 45%.
Break-out your pitch-forks, storm the barricades of the Bankster Castles, and string these rapacious rascals by their necks from every street pole across the land.
Charge Pay-per-view for front-row seats @ the reckoning, and we clear the National Debt.
Comment by John Kountz -
Reblogged this on nwuptick.
Comment by nwuptick -
You are mostly correct. 6b is wrong however. HFT are very involved in small illiquid stocks. The game is different and the spreads get wider. The gaming is far more pervasive than the big stocks, Orders for 100 shares frequently get front-run. One tactic is to partially fill to an odd lot order and becoming invisible to the market. The biggest reason for this behavior is broker internalization of order flow, and showing HFTers orders beforehand to get “improvement.” Instead of getting a fill for .0001 better, you don’t get any fill at all as the HFT uses your flashed order as a signal to do the exact same trade you wanted to do except sooner. Taking the displayed liquidity. What is most ironic is that brokers like to talk about price improvement statistics, and only count executed traded, while trades that never occured because they were frontrun are conveniently left out of their statistics.
Comment by Curt Champagne -
Valerie, that creates a disincentive for investors to invest in companies with a low share price. I can buy 1 share of AAPL and pay tax of .001, or a bunch of shares of a cheap stock and pay significantly more.
Comment by Name (@kylejack) -
Pingback: Mark Cuban’s Primer On HFT For IdiotsThe Daily News Source | The Daily News Source
I also see this as a larger problem of the markets becoming a gambling device or in the case of the Fed, to create a ‘wealth effect’ that distorts the stock market as an economic indicator. Wasn’t the purpose of the stock market to allow entrepreneurs to raise capitol to invest in their companies? Aren’t the HFTs essentially acting like rats in the granery?
Comment by Greg Kruzick -
Nice post and great analogies. Broadly speaking, while I think front-running (the heart of the HFT discussion) is morally wrong it is capitalism to the extent it is not deemed illegal by the SEC as insider trading. For long term investors – preferably in small cap stocks – the financial “impact” is negligible. However, the potential for further distrust in the stock market (the life blood of the US economic engine) and Wall Street is irreparable.
A bit of history…dating back to the infancy of the stock market, NYSE market specialists in theory traded on information related to incoming buy/sell orders – i.e., they sold the “ask” price and bought the “bid” price which used to be 1/8 pt apart. In many instances, these market makers knew they had a willing buyer when they bought stock from a seller – thus “front-running” in the loosest sense. Further, all trades had to go through them as they were the market specialist in that name. Over time, this bid/ask spread declined as markets began more fluid and transparent. However, the BIG difference is that the old NYSE market specialists of year’s past took real risk – they held stock overnight, had real capital at risk and where required to always provide a market (i.e., a bid) for a stock.
The issue I have with the HFT firms of today is that are front-running purely based on speed and seeing other buy/sell orders before they are recorded as “market trades” on the ticket tape we laypeople see on CNBC and Bloomberg. They are gaining an advantage without putting any capital at risk or providing incremental value or liquidity to the marketplace. They are merely skimming off the top. And under my moral compass, that is simply wrong.
Unfortunately, this will be nearly impossible to police unless you slow everyone down and distribute trade data at the same speed (albeit this is geographically challenging given co-location). One could suggest bringing trading back to one central exchange maned by real people…but there would still be dark pools. One could suggest taxing all trades a penny…but HFT would still exploit the advantage of speed (but I do like the idea of additional tax revenue being raised to help regulate the trading industry). One could suggest bringing back wider bid/ask ticks…but HFTs would again exploit the market based on their speed until the “real” market data caught up.
At the end of the day I’m not sure what the right answer is…public/long term investor behalf will ultimately drive the outcome. The one positive is Michael Lewis’ new book at a minimum has brought it the forefront of our minds.
Mark – love Shark Tank…American capitalism at its best!
Comment by Todd Nelson (@hawkingvalue) -
Jeff and The Tuna, I take it you are saying that the exchanges permit this despite its harmful nature because they are effectively taking a cut of the HFT profits. This is certainly possible, albeit less likely than not. But given the competitive nature of exchanges, if this is true those exchanges that permit the activity will be at a competitive disadvantage and end up losing more than they gain in the profit split with the HFT because they lose listings and volume.
Now of course it is possible that this won’t happen because of some collective myopia, but the more likely result is that if this is unproductive it will sort itself out without the SEC promulgating additional regulations.
Once you go down the road of regulation you don’t usually get perfectly optimal regulation. This is why people should have to tell a more plausible story of structural market failure before invoking the cumbersome hand of the regulator.
In short, this piece makes a better case for why exchanges are likely to restrict this activity than it does for its (admittedly narrow) proposed remedy of escrowing algorithms with the SEC.
Comment by Douglas W. Anderson -
Perhaps the scariest thing here is that an investor of Mr. Cuban’s caliber is only kinda/sorta pretty sure he knows what he’s talking about in regards to HFT. Not meant as flattery, but guys do not amass the resources to buy NBA teams without having pretty good investment instincts and thorough investment knowledge.
One point Mark alluded to but could have explored further: people are *risking* billions of dollars for a chance that place in the front of the line, and given the open warfare between HFTs, there’s no guarantee the person rigging the market today will be rigging the market tomorrow. Some of those billions sunk into fiber optic cables and algos will go to waste.
But the most important point here is that the securities markets exist to enable people to invest in companies they believe in, or to speculate on the possible future values of securities, providing vital liquidity in the process.
HFTs appear to do nothing to enable this investing process, and therefore there is no reason for the exchanges to allow it, except for the short-term profits they reap while taking on unknowable risks.
Comment by Tom Mangan (@tommangan) -
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Mark it is great of you to clarify in some amount of detail (much more than what is allowed to be publicly discussed on financial news networks) regarding fraudulent aspects of the trade. The mathematics behind HFT varies from very simple to complex artificial intelligence driven algorithms especially on the millisecond and tick level and the MAJORITY of these algorithms are truly providing liquidity in smart ways that benefit the ordinary investor. I don’t contend this. You did not mention the prolonged effect cross exchange arbitrage and darkpools have had, but I thought to touch on it a little bit here; you see the greater the fragmentation of the market because of different order types, the greater the proliferation of dark pools and other HFT pools that can game it from different angles. You’re right when you say the average person isn’t concerned with his investment and the investors aren’t going to sound the alarm because there is too much at stake with retail outflow in recent years. But the retail guys have less liquidity to contend with today in the lit market and are soon coming to the realization of what’s happening under the hood. Day traders are unnecessarily and very swiftly stopped out of intraday positions only for the price to revert seconds or minutes later, almost levitating back to their original prices. I have seen the most out of the money stops get hit on an intraday basis like it was an orchestrated panic. It is unnerving for other people to have that kind of power in the market, or for there not to be enough ‘real’ liquidity chasing ‘real’ price discovery. The average guy is catching up, but in many ways, he’s got no alternative way to express his opinion when all the exchanges seem to dictate the rules of the game, watchdog-free.
Comment by VinnyG (@vin_nyG) -
Pingback: Mark Cuban’s Primer On HFT For IdiotsNot Just The News | Not Just The News
Welcome to the fray. I started blogging in 2010 at pointsandfigures.com because I was upset with what was happening in markets. It wasn’t electric vs open outcry, or speed, or anything nefarious. It was market structure. Totally mismatched to the way we traded. It creates an unlevel playing field. That’s not capitalism, and it’s not how America operates. If we continue, more and more Americans will lose confidence in the free market. When that happens, we are at risk to lose our way as a nation.
Comment by Jeffrey Carter (@pointsnfigures) -
This read more like the low-latency part of HFT. That is mostly front-running of large institutional trades. It does impact the little guy indirectly in as much of that which is being front run is likely their pension/401k/etc. Just because they’re not trading it, doesn’t mean they’re not affected. There’s also the stop hunting algos which don’t require a low-latency to function. The algo will fire of thousands of orders and immediately cancel them in hopes to trigger the hedges or trailing stops of other traders. When those stops get triggered, a cascading effect occurs and the HFT algos monkey hammer the market. You can tell the stop hunting algos as they produce a square wave pattern on the millisecond charts. This is a special privilege as well.
Comment by Dan Underwood -
What if the entire market and its clunky decimal place price levels were to fall victim to the slicers and dicers? If onion skin thin profits on massive volumes are justification for stealing pennies then why have bankers who have harvested “lost decimal points” been prosecuted while these “titans of wall street” are free to boast about their “innovation” (read: we have 50 ways to rip you off and enjoy discussing every one over expensive cocktails at restaurants where you – the little people – cannot get a reservation)?
Comment by Murray Schultz (@mws70) -
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Thanks, Mark. It is interesting to note that this game has been played throughout time, just at much slower speeds. As a former equity market maker for a large bank in the early 2000’s, I was endlessly frustrated dealing with similar fruntrunning. Back then, if you wanted to trade with other dealers with a size larger than the SOES amount, you had to basically send a message to the other dealer with the size and they had to respond. If you sent 50,000 to buy to Knight Trading or any other wholesaler, they would delay their response while they bought everything in sight above them. Then they would sell it all to you all 1/16 higher. Thats how they made money. Seems like ancient times looking back on it now, but that much has changed over the years. SuperSOES went a long way to correct those issues. Now the same game is being played, just in milliseconds vs 10’s of seconds. The real difference as you note is the unknown effects of the super speed algos on the markets in times of stress. There really should be a way to prevent the algos from seeing any order size larger than their offer or bid.
Comment by taspider -
Mark when you keep saying that the market is rigged you’ve going to give people the idea that they put in $1 and get 50 cents back every time. Or maybe just that it’s a slow drain like playing blackjack for too long. And I’m sure you know that. But what you describe is more like adding a commission of 1 penny on each share you buy. Sure it would be nice if that was cleaned up.
On the other hand we’ve gone from paying commissions of $300 for every trade to getting them from $10, $5, $3, or just plain free. Even for big traders that don’t even notice their commissions, this effect would have to be so small that it’s just a tiny blip in the risks they’re already taking. I just don’t see anything that points to this being an issue of market structure that even comes near the scale of the normal risks that every investor has to take in the market let alone a lot of things that have been going on for the last 100 years that were just as questionable. Those didn’t destroy the market. Once in a while they created great buying opportunities for investors who were prepared.
There is a very simple way to outsmart the HFTs. Be a long-term investor. The less you trade the less they can take. And the longer you hold the faster they lose interest. Unless you’re trying to play their game and complaining that someone got a small edge over you, you don’t need to follow their rules.
Comment by diyinvestorsource -
Did you read all of it. i said a specific part of it was rigged . And i didnt say it was anything but pennys or less. And being long term doesnt out smart anyone. All the risk impact the performance of your portfolio. Being long term didnt outsmart the tech crash or 2008 if you had any needs for those funds prior to the years and years it took the market to recover
and electronic trading and decimalization gave you the savings, not HFT
Comment by CyberDust ID - Blogmaverick -
From one idiot – thank you very much. I don’t feel quite so idiotic now.
Comment by Patrick Pine -
Please advise on this video, it involves Forex trading and algorithms, not HFT by definition but short term positions:
https://www.youtube.com/watch?v=uTG5E99Ibmg
Is this something that one could get into benefiting from algorithms on their trades?
Comment by paying bills sucks (@utilityswapper) -
I trade the indexes, futures and commodities every day. How things have changed…years ago things liked value propositions, competency, management, etc derived a value; today, it’s who gets to see my orders, very quickly buy and then sell me the stock. It’s turned into a very large casino with some social interests “guiding” the market and NOTHING to do with the company’s. So with HFT, what is the value of all the fundamental analysis, Cramer and CNBC?
Comment by Ted Wolf -
Great post, Thanks for the incite. I appreciate that you take the time to research and explain all the angles.
Comment by J D -
It’s been going on since the buttonwood tree and trust me it’s cheaper than floor brokers they used to front run marathons now sprints and the mkt needs the hft bids when it crashes! the hustle never ends i was born into it so i know first hand this is nothing!
Comment by Sean Sheehan -
Mark, To me it is all about a somewhat level playing field. If my Mutual Funds,401K Funds, and TD Ameritrade are all using the same High Speed Trading system then we all have a fighting chance at benefiting from HFT. The reality is we don’t. Only the well financed firms that can afford the fee’s and systems that allow then to collocate and get the sub millisecond advantage will make the money and manipulate the market. We no longer have pension structures that are independent of the stock market. All of our retirements accounts plunge most of our hard earned savings into the stock market in hopes that it will be on an up swing when we actually retire. Not always. Asked those that tried to retire in 2007/2008 etc..
The converse of HFT that is even more bizarre is that if a Market Maker shorts a million+ shares of stock, the DTCC (Depository Trust & Clearing Corporation) gives them THREE DAYS to locate the actual shares of stock. If they don’t find those shares or it runs into many days they can just cancel the trade and no harm no foul!.
So you allow both HTF at sub milliseconds and then Days and Days to cover if you are pumping phantom stock.
Neither should be allowed. Pick a reasonable time, 1 second. They have to actually locate the shares within that second whether it is a buy or sell side order and then charge 1cent per transaction and fund the SEC so it can keep everyone honest.
Comment by grumpy (@GrumpeG0lf3r) -
Douglas, the short answer is that Exchanges are making more money allowing the HFT’s to use their pipes. In turn, the Brokers / Market Makers are being paid on trades to use certain exchanges instead of paying a flat rate or fee. This has upended the dynamic the exchanges have historically created, the overall effect of which makes the market that much more ephemeral and opaque. In my humble opinion, this short term view taken by Wall Street does not lend itself to the long term overall health of the markets, foreign or domestic.
Comment by Jeff Pyzyna -
It seems there’s a very easy solution to this, and it would be good for the economy on all levels: add a trading tax of .001 per share sold. This means if you move a million shares, you pay $1,000 for this tax. For a deep-pocket market investor selling a million shares of something, that $1,000 is barely pocket change. A rounding error. For the average market investor, selling maybe 20,000 shares at a time, it’s an added twenty bucks — far less than the commission on the sale. For the HFTs, it would grind their business to a halt.
Since the purpose of the markets is to provide companies with access to capital and provide liquidity to investors (thus encouraging them to provide the capital that companies need), not to create trading schemes to make number crunchers rich through algorithmic trickery, this would solve all of those problems. And, the tax revenues could be used to provide further security for the markets, or to replenish pension funds that were wiped out by dicey derivatives.
Comment by Valerie Alexander -
Why anyone is allowed to see other people’s orders, than front run ahead of them defies explanation. How the SEC allowed the Exchanges to stop serving the public interest is mind boggling
Comment by Barry Ritholtz (@ritholtz) -
Douglas- the exchanges like volume. Volume is a huge part of their business. They, of course, need to provide stability, but the money is in the volume.
Comment by The Tuna (@OriginalTuna) -
Mark, this is a very nice summary. The only thing that I want to comment on your post, is that in reality algorithm design and development for HFT its not really that complicated; and you certainly don’t need the smartest people to implement a successful one for a given market niche.
Comment by Mario Felipe Campuzano Ochoa -
This is the most informative description of HFT I’ve read. Kudos.
Comment by Charles McGarry (@chasman1957) -
Wasn’t HFT the cause of the “Flash Crash” in 2010 also?
Comment by Ryan Marcum (@ryankmarcum) -
I’m an equities and futures day trader, and can say I absolutely see the repercussions of the HFT bots in the markets. The strategies that used to work pre-2008 are now COMPLETELY OBSOLETE. The main way I make money trading stocks is by staying away from anything that averages over 10M shares a day. In the futures market, we have to make sure we only trade when there’s panic or extreme greed. Otherwise we’re just fighting algo’s, which is a losing battle every time.
Mark, thanks for bringing this topic to light!
Here’s a video of me talking about what I think it takes to succeed in the markets today – https://www.youtube.com/watch?v=4rUhj4T1XR0
– Chris Dunn
Comment by Chris Dunn (@ChrisDunnTV) -
I agree with Johan – I am not in a position to argue one way or the other, but I now know enough to pay attention of the direction of the conversation and change/manage my trading behavior accordingly, maybe? I hope?…
Comment by Andrew McCall (@ASMcCall12) -
Thank you, thank you, thank you, Mark!
This is one of the best blog posts I have read in a long time. IMHO, this post achieves 100% of it’s intended goal/purpose. Very informative and very, very clear (the ‘clear’ part is the one which is most difficult to achieve for any writer/expert).
Regards
Harsh
Comment by Harsh Kharshingkar -
100% accurate or not, this is a good discussion with some really important questions!
Comment by Johan (@Brunnsparken) -
All that brainpower doing nothing more than skimming value from real market innovators…for society, it’s a tragic waste of talent.
Comment by Dan Schmisseur -
I think most of your points are on target. HFT is completely fair, legitimate, and legal. The investor with the fastest information has always had the advantage and this problem will never go away. There will likely always be a price you can pay to get faster information and “beat” the market. Nanex has covered a lot of the questionable things that have been done by high-frequency traders. There are many strange things that have occurred that have baffled even industry experts.
I’m not sure how the SEC is going to apply their rules to an algorithm. Math and law don’t really correlate. Back-testing methods that “work” is creating algorithms that always beat the competition. How can the SEC be sure that an algorithm isn’t manipulative or deceptive?
Regardless, I think they are here to stay. In a perfect work, high-frequency traders would comply with all rules and create a market that is so responsive that it’s impossible to cheat or “game” it. They are the final solution to our real-time markets of the future.
Comment by Andrew Strubhar -
Nice post. Question: If HFT causes most market participants to be worse off, why don’t the exchanges regulate it? Note that this could be limited to not providing the asymmetric advantages that you indicate accrue artificially to HFT.
Comment by Douglas W. Anderson -