High Frequency Trading (HFT) Hits Mainstream on 60 Minutes Last Night

Monday, October 11, 2010

High frequency trading has now left the corner of the financial world and hit the minds of Main Street's 401(k) and mutual fund owners. The May 6th flash crash left investors of all kinds wondering, "what the heck happened?" Last night, 60 Minutes covered the topic in a short 13-minute story attempting to explain what HFT is, how it works and what happened on the frightful day in May when the Dow Jones Industrial Average lost 600 points in minutes before rebounding.

Tradeworx explains their HFT operations

Tradeworx CEO, Manoj Narang, has recently been one of the only HFT practitioners to allow the public limelight to shine on his operations. Narang shows how his firm is attempting to extract pennies from the marketplace in return for creating valuable liquidity for everyday investors that wish to buy and sell stocks. While he admits that his trading does not concern itself with company fundamentals or the capital-raising function of the market, he asserts that his goal is the same as any other participant: to make money. But is his definition of liquidity the right one? Liquidity, on average days, is arguably needlessly high in many stocks and ETFs. Yet, on May 6th, when it was needed most, Tradeworx shutdown their trading.

Clearly, no market participant is willingly going to lose money just for the sake of continuing to provide liquidity to the market. No one will catch a falling knife unless they believe the odds are in their favor to make money on the trade. Without stringent regulation and control of HFT firms, they have no fiduciary duty to anyone to continue making trades in the market during calamitous times. HFT has grown exponentially in recent years and their primary defense against allegations of unfairly extracting profits from the markets has been their beneficial liquidity provision. We must ask though: what good is liquidity if it's there to rake in pennies when you don't need it, and entirely gone in the rare instances when it's desperately needed?

Themis Trading strikes back

Joe Saluzzi of Themis Trading is not a fan of many types of HFT. He believes that any market participant making money everyday, day in and day out, must be paying for an unfair advantage. The secretiveness of most HFT firms certainly lends credence to the belief that these firms are engaging in unsavory behavior. Though arguments along these lines are countered by Lawrence Liebowitz, COO of the NYSE, who argues that accusations of uneven playing fields for those willing to pay for it have been around since the markets began.

Thinking about this sparked the vague recollection of something I read in Gerald Loeb's The Battle for Investment Survival a couple years ago and after searching I located the following excerpt from his book about his job in 1923:
In those days telegraph connection with New York markets was irregular and fast service was confined to only a very few security houses with privately leaded wires. I had noted that it was the custom in San Francisco for the local bond traders to "arbitrage," as they called it, by concealing rapid changes in the New York market of various bonds popular in the west. The bought these bonds cheaply in San Francisco when the New York market stiffened suddenly or sold them in the west at what seemed concessions in the price when they knew the New York market was sharply lower. In this way the local traders handled a few orders at a wide profit per order. I felt that the best way for me to break into this institutional field was to give a service that was calculated to bring me a great many orders at the low standard New York Stock Exchange commission for each. So I began to keep all the western traders posted on the New York changes just as a matter of accommodation. Instead of my trying to grab an undue spread, I told them the story and left it to them to route their orders my way instead of the competition. It took only a few days for me to develop one of the largest bond businesses of that type in the city. When the others started doing the same thing, I had the lead because I was there first and had forced them into adopting my method.
In my opinion, the value of information has always been very high. All market participants, in one way other another, are trying to gather information and deploy strategies before the general market recognizes the value. Even those outside of HFT shops still use a extraordinary amount of technology to receive and assimilate information to create trading strategies. Statistical arbitrage opportunities will always exist in one form or another, the only hope is that over time the margins on such opportunities will continue to be squeezed.

I believe this is quickly becoming the case in US equity markets as HFT strategies have proliferated. The tactic of manipulating prices is clearly something the SEC must work to eliminate and systemic risk issues should be addressed. So-called latency arbitrage, on the other hand, will likely take care of itself. We are already seeing inter-market strategies take hold as the next wave in innovative strategies with intra-market opportunities in US equities largely being reduced to razor thin margins.

The race for technological superiority is and will be persistent but ultimately code complexity will be the defining factor between those that triumph and the many HFT firms that will fail. The video below is well worth watching and the shots of the new Mahwah data center are impressive to say the least. The new world of trading will play out in microseconds, there is no going back. The public study of HFT must continue as regulators have clearly fallen behind in the race and situations such as May 6th cannot happen again otherwise confidence in the integrity of markets will continue to erode.

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.
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