Commentaries

HFT and big dollars

There’s more evidence today about the big profitability of computer-driven high-frequency trading.

The Wall Street Journal says Ken Griffin’s Citadel Investment Group hedge fund empire made $1 billion from proprietary trading with HFT last year. The profitability number came out during testimony in an ongoing lawsuit Citadel has filed against a group of former HFT employees who left to start their own firm.

This is the same upstart firm that alleged Goldman Sachs HFT computer code thief Sergey Aleynikov had gone to work for before being nabbed July 4 weekend at Newark Liberty Airport. Aleynikov, who has pleaded not guilty and is trying to work out a plea deal, is set to be in court again on Oct. 16.

What’s worth remembering is this $1 billion figure is just the money raked in by Citadel’s prop trading HFT business. It doesn’t include the dollars Griffin’s empire takes in from market making–a business that’s also driving by HFT computer programs.

None of this is really a surprise given the way big HFT players like Goldman and Citadel have gone to protect the secret sauce of their lightening fast trading platforms.

Citadel’s big Lehman loss

It’s long been suspected that Ken Griffin’s Citadel Investment Group took a big blow when Lehman Brothers went bust nearly a year ago. But Griffin and his management team have been reluctant to put a number on the damage to the Chicago-based fund.

That is, until now.

In a brief, one-page filing, Citadel claims it is owed some $470 million on a derivatives contract. The $12 billion hedge fund conglomerate offers no details about the derivatives deal in the proof of claim, submitted as part of the Lehman bankruptcy filing.

To date, Citadel’s claim is the third largest submitted by a creditor in the bankruptcy.

As the one-year anniversary of Lehman’s collapse approaches, expect more hedge funds and banks to fess-up about their Lehman losses.

Regulators ram Citadel’s gate

The Office of Thrift Supervision isn’t known as the world’s most aggressive regulators. In fact, the Obama administration wants to merge it out of existence.

So I was quite surprised when the OTS late Friday decided to suspend consideration of an application that would have enabled Citadel Investment Group to get control over virtually all of E*Trade Financial customer trades–what’s known as order flow on Wall Street.

I wrote about this move by Citadel earlier today and how it would have been a big boon to Citadel’s highly-profitable high-frequency trading business. And I urged the OTS to move cautiously on this application.

OTS spokesman William Ruberry said the agency has decided to “suspend consideration of the application while we examine certain issues.” He declined to elaborate on the regulator’s action. He added that a confidential “policy and law” letter about the decision to suspend the application had been sent to the parties.

I had been expecting the OTS to approve the deal, since E*Trade desperately needs the $100 million in cash that Citadel was prepared to pay it for access to the customer trades. But maybe this is an indication that regulators are finally starting to take a close look at high-frequency trading and the ramifications it has on the markets.

And how ironic that it’s the least respected regulator that may have taken the first bold step towards controlling the rapid spread of HFT.

Mary Schaprio and the SEC, are you paying attention.

Citadel’s E*Trade Bonanza

Citadel Investment Group’s move to aggressively sell off its substantial stake in E*Trade Financial looks like hedge fund magnate Ken Griffin is throwing in the towel on his big gamble on the online broker.

But Citadel isn’t bailing on E*Trade. In fact, if Griffin gets his way, the Chicago hedge fund will have its fingers dug deeper into E*Trade, getting daily access to virtually all of the online broker’s stock and option trades.

With little fanfare, Citadel and E*Trade struck a tentative deal in June that would require the online broker to begin routing 97.5 percent of its customers’ Nasdaq stock and stock option trades to the hedge fund’s market-making operation.

Right now, E*Trade sends about 40 percent of its customer trades to Citadel’s market-maker division under a nearly two-year-old agreement that dates back to the hedge fund’s initial $2.5 billion investment in the broker.

This new exclusive six-year arrangement would mean even bigger bucks for Citadel’s already highly-profitable high-frequency trading business, given that E*Trade customers make more than 4 million trades a month.

Indeed, the deal is so potentially lucrative for Citadel that the hedge fund is willing to make an upfront $100 million cash payment to the financially-strapped online broker.

E*Trade’s regulator, the Office of Thrift Supervision, must approve the deal before it can take effect. And there are indications the OTS is about ready to give the deal the green light — possibly as soon as today.

Wall Street meets The Matrix

Michael Durbin is no Wall Street rebel. But Durbin, who has been on the front lines of high-frequency trading (HFT) since its early days, isn’t afraid to buck the industry line that lightning-fast trading of stock, options and commodities poses little or no risk to the stability of the markets.

Durbin says it’s reasonable to wonder whether Wall Street’s unfettered embrace of algorithmic automated trading could be setting the stage for a future meltdown.

“You have multiple HFT trading firms and sometimes their agendas are complementary and sometimes they’re not,” explains Durbin, director of HFT research with Blue Capital Group, a small Chicago-based options trading firm.

“There could be a time where these HFT programs unintentionally collaborate and you have a two- or three-minute period where the markets are going crazy. Then other traders respond to it and it simply gets out of control.”

What Durbin’s talking about is the dreaded contagion effect, in which a bad trade or a rogue algorithm misfires — sparking copycat sell orders at other high frequency desks.

It’s the kind of machine-driven crash that sounds like the plot line for “Wall Street” meets “The Matrix”.

High frequency trading programs are designed to scour the markets to decipher trends in trading patterns and place buy and sell orders a millisecond ahead of the pack. It all happens at warp speed, and except for developing the algorithmic programs, the human element is all but gone from the equation.

What’s the frequency, SEC?

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.

Citadel joins the Sergey fray

Ken Griffin’s Citadel Investment Group just filed a lawsuit against former top trader Misha Malyshev for apparently violating a non-compete agreement he signed when leaving the big Chicago hedge fund earlier this year. Malyshev, of course, is the founder of Teza Technologies, an upstart high-frequency trading hedge fund that hired away alleged Goldman Sachs code-cracker Sergey Aleynikov.

Malyshev and his partners, all former Citadel people, put out a statement on Tuesday saying they suspended Aleynikov after learning of his July 3 arrest. The former Citadel guys also say they were unware of Aleynikov’s alleged theft of Goldman’s proprietary trading computer code.

I don’t have a copy of the complaint yet, so I don’t know whether Citadel has sued anyone else at Teza. Nor do I know the exact nature of the legal claims. I’ll update when I get more.

Update:

Just got the complaint and motion for preliminary injunction filed by Citadel and the hedge fund has come out smoking, calling this a case of “industrial espionage.” The big hedge fund is suing Malyshev, his two partners and the upstart fund.

Citadel seems to suggest that in hiring Aleynikov, a man charged with stealing computer code from Goldman, it needs to put the kibosh on Misha & Co. to protect its own trading secrets and proprietary codes.

Personally, linking the hiring of Aleynikov to a violation of any non-compete agreements Misha & Co. had with Citadel seems a bit of a stretch. If Misha & Co. are in violation of the terms of the non-compete agreement, one could argue the Citadel’s trade secrets might be in jeopardy regardless of Aleynikov.

Sergey and Misha

The name of the Chicago firm that hired alleged Goldman code-cracker Sergey Aleynikov is out and it’s a name you’ve probably never heard of before. That’s because Teza Technologies LLC is a new firm–formed in May–by former Citadel Investment Group trader Misha Malyshev.

Malyshev, who had been a top high-frequency trader at Citadel, left the giant hedge fund in February because he felt he was not being sufficiently compensated, says a source familiar with the situation. Malyshev’s group was one of the more profitable last year for Ken Griffin’s operation, which overall had one of its worst years ever in 2008

And here’s the thing: I’m told Malyshev signed a nine month non-compete agreement with Citadel when he left.

Bloomberg first reported that Teza hired Aleynikov and got an email statement from the start-up, in which the firm said it “was not aware of the alleged misconduct.”

In the email statement, Teza also said it has suspended Aleynikov without pay and didn’t learn of his July 3 arrest until July 5. That, of course, is the day that we at Reuters broke the news that Aleynikov was arrested by federal authorities and charged with stealing the source code for Goldman’s rapid-fire stock and commodities trading platform.

Right now, Teza is a small operation at best. There’s no website for the firm and it doesn’t appear to have a listed phone number. Illinois incorporation records reveal the company was formed on May 5. One of the mailing addresses appears to be the home address for one of the principals, Matthew Hinerfeld, who is an ex-Citadel guy too.

Hinerfeld worked in the counsel’s office at Citadel. So is another founder, Jace Kohlmeier, who had the same non-compete agreement with Citadel as Malyshev.