Commentaries

Now raising intellectual capital

What’s the frequency, SEC?

July 21, 2009

Sergey Aleynikov is not the Wall Street folk hero that some Goldman Sachs conspiracy theorists are making him out to be.

If Aleynikov stole some of the top secret code for Goldman’s automated, super-fast trading platform, as prosecutors contend, then he broke the law, and the 39-year-old former Goldman programmer should be appropriately punished.

But this strange Wall Street crime story isn’t just about one man’s guilt or innocence. The case should also serve as an alarm for securities regulators to start taking a close look at so-called high frequency trading and the impact that this speed-of-light trading strategy is having on the markets.

After all, if a computer code is valuable enough for someone to steal, and critical enough for a Wall Street firm to go to federal authorities to protect, one would think that regulators would want to know why it is so important.

Yet regulators largely have stood by and allowed this secretive corner of the quantitative trading world to grow ever bigger, without mustering up much of a protest.

Computer-driven trading, where complex buy and sell orders are completed in fractions of a second, now account for 73 percent of all daily stock trades in the United States, according to the Tabb Group, a financial services research firm. Tabb also estimates that the 300 securities firms and hedge funds that specialize in rapid-fire algorithmic trading raked in some $21 billion in profits last year.

Admittedly, the $21 billion figure is really just a best-guess estimate. The vast majority of hedge funds and trading firms that engage in high frequency trading — Citadel Investment Group, D.E. Shaw, Global Electronic Trading Company, Renaissance Technologies and Wolverine Trading — are private and don’t reveal much, if anything, about their operations. Even a public company like Goldman, an acknowledged leader in high frequency trading, is silent on the profits it generates.

Still, there’s little doubt there’s a lot of money to be made from automated trading that relies on complex mathematical formulas to predict momentary price moves in stocks and commodities. The name of the game in high frequency trading is literally trying to stay one millisecond ahead of the competition thousands of times a day. High frequency traders also earn lucrative “rebates” from stock exchanges by serving as de facto market makers for fast-moving stocks

The big fear is that with high frequency trading dominating daily trading activity, it could spark another 1987-style market crash. The doomsayers say that could occur if all these automated trading programs — which operate with almost no adult supervision — begin reacting to the same downward price trends in a stock or commodity. Or high frequency trading firms could worsen a sell-off by refusing to execute trades to protect their own capital, a move that would make it difficult for other investors to quickly exit a falling stock.

Some say there’s already evidence high frequency trading may be playing havoc with the markets. James Angel, a professor at Georgetown University’s McDonough School of Business, says the big end-of-the-day price swings in the major stock indexes that were quite common last fall were probably exacerbated by high frequency trading.

High frequency trading may have added to a still unexplained 69 percent plunge in shares of Dendreon on April 28. The Seattle-based drug company’s stock fell precipitously in less then two minutes before officials at the Nasdaq Stock Market were forced to halt trading.

The sell-off began on a rumor that Dendreon was about to announce some bad news. In fact, the opposite occurred, as the company released some positive test results for its prostate cancer treatment drug Provenge. Once trading resumed, the share price quickly recovered.

Now wild price swings in shares of biotech stocks aren’t unusual and such stocks are favorite targets for short sellers. But Angel suspects that high frequency trading programs may have exacerbated the plunge when the algorithms these trading firms use all glommed onto the same trend. “The downside is that when some algo misfires, our market is shockingly not protected from it.”

Angel’s remedy for reining in high frequency trading is for regulators and exchanges to institute a price circuit breaker for every stock — similar to the broad-based circuit breakers that were adopted by the major stock market indexes after the 1987 crash. He points out that many foreign exchanges with heavy electronic trading currently employ some form of automatic price circuit breaker for individual stocks.

“Right now, we rely on humans at the exchanges to pull the alarm, but in the nanosecond world that is too slow,” Angel says.

At first blush, Angel’s suggestion makes a lot of sense. It’s certainly better than anything the regulators are doing to control the risks posed by high frequency trading. (Editing by Martin Langfield)

UPDATE: Joe Saluzzi at Themis Trading, who has been tracking HFT for quite a while on his blog, has a good take on the action in three stocks today.

Comments

Hi Matt, and thanks for continuing to cover this aspect of a very important story.

You might like to check out our Housing Doom site tomorrow morning, if you have a minute. In about 8 hours we’re scheduled to release a full annotated transcript of this fascinating 1/2 hour podcast describing in excruciating detail the importance of low latency for algorithmic trading.
http://www.algotradingpodcast.com/2008/0 5/16/atp-special-edition-low-latency-fea turing-thomas-chippas-deutsche-bank/

All I’ve got to say is, thank heavens for August Dvorak ;-)

 

That trackback’s the transcript I allude to in comment #1. Enjoy.

 

It seems that having computers regulate computers begs the question of true oversight. Are there any other potential regulations?

Posted by Nancy Sobel | Report as abusive
 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  •