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.

Calling all HFT victims

Now that the SEC has rebuffed my request to gather information about investor complaints about high-frequency trading, I’m calling on you for help.

If you have sent a complaint in the past year complaining about HFT and the impact it is having on particular stocks, or the broader market, I’d like to hear from you. You can reach me by email: matthew.goldstein@thomsonreuters.com

Let’s make sure the regulators are doing their jobs.

SEC’s flash in the pan

Securities regulators will often settle for the proverbial low-hanging fruit — prosecuting easy cases that don’t make a big difference in the way Wall Street operates. But it does give the appearance they’re doing something.

And so it is with the Securities and Exchange Commission’s proposal to stamp out flash trading, an unsavory practice that has permitted some high-frequency trading desks to get a millisecond sneak peak at market trade orders.

Banning flash trading certainly makes sense, because there’s no reason that trading firms with lightning-fast, computer-driven buy and sell programs should get an advantage over the rest of the market.

But the furor over flash trading has always been something of a sideshow because it affects a minuscule percentage of the tens of millions of high-frequency stock trades made each day.

There’s reason to worry that after cracking down on flash trading, the SEC will consider its work largely done. Mary Schapiro, the commission’s chairman, says regulators are taking a hard look at a wide range of “market structure issues,” including high-frequency trading. But Schapiro has offered few specifics and largely spoken in generalities on the subject.

Schapiro hasn’t said much publicly on the two main criticisms of high-frequency trading: its ability to add unnecessary volatility to the markets, and its potential to spark a market meltdown because so many computer programs employ the same algorithmic strategies.

And Schapiro’s silence on the matter could leave one wondering just how rigorous this SEC review is going to be, and whether the ban on flash trading is all that regulators plan to take on.

The flatness of being a high-frequency trader

A common claim made by the high-frequency trading crowd is that their funds end the day flat–with little overnight exposure to a given stock.

In other words, high-frequency traders argue they always manage to find some other sucker–I mean trader–to layoff their positions on before shutting down their algorithims for the night.

It’s a claim that sort of defies logic when you consider that most high-frequency traders compare themselves to good old-fashioned market makers–firms that put their own capital at risk to make markets in stocks. Based on that logic, it would seem high-frequency traders would need to go home at night with a sizeable exposure in certain stocks based on trades they did with other parties.

But a story in The Wall Street Journal helps explain how high-frequency traders can make this claim and why these rapid-fire, computer driven traders really aren’t classic market makers. The WSJ story points out that most rapid-fire algorthimic trading is in highly-liquid big-cap stocks–not less liquid small-cap stocks.

And, when you think about it, it makes sense that high-frequency traders generally shun small-cap stocks in favor of bigger names. That’s becuase it’s far easier to trade in and out of stock with lots of shares outstanding–and to do that trading in milliseconds. In a big-cap name, there’s not only more shares available for trading, but more potential buyers.

Of course, it’s the complete opposite with a small-cap stock–some of which may only trade a few thousands a shares a day in a handful of transactions.

The other problem with small-caps is the potential to get stuck with a big position at the end of the day. The slim trading in these stocks raises the possiblity that a high-frequency trading firm could end the day with a lot more exposure than it wants.

Keeping Citadel’s E*Trade Gambit a Secret

Who really knows what Ken Griffin has up his sleeve for E*Trade Financial.

Last month, Griffin indicated that his Citadel Investment Group hedge fund gradually would sell-off about 10% of of its E*Trade stock. Then yesterday, Griffin and Citadel said, “never mind.”

Citadel offered no explanation for its sudden change of heart beyond pointing to the press release it issued on the matter.

The Citadel about face also comes a few weeks after E*Trade’s regulator put the kibosh on an application by the hedge fund’s big high-frequency powered market making unit to get its hands on most of the online broker’s customer order flow. The Office of Thrift Supervision, on Aug. 14, put the application on ice and asked Citadel and E*Trade for more information.

Did the OTS decision impact Griffin’s decision to put off the stock sale? It’s hard to know since neither Citadel nor E*Trade are talking. And the OTS is not helping matters much, either.

The OTS, the regulator the Obama administration would like to merge out of existence, recently denied my request for a copy of the letter it sent E*Trade and Citadel about its decision to “suspend consideration” of the order flow application.

I’ve attached a copy of the letter denying my Freedom of Information Act below. The regulator’s FOIA officer says the request was denied because it might impinge on “trade secrets and commercial financial information,” as well as reveal “information contained in or related to examination, operating, or condition reports.”

The Getco get

The owners of Getco, the Chicago-based high-frequency trading firm, long have been tight lipped–preferring to say little despite the firm’s outsized role in computer-driven, lightening fast trading. So I was looking forward to reading today’s Getco profile in The Wall Street Journal. But after reading the story, I came away disappointed.

Sure, as a general profile of Getco and its founders, the story is fine. And the article gives a good illustration of how high-frequency trading works. But the story fell short on so many levels.

First, where were the critics of high-frequency trading? The story briefly summarizes one of the criticisms–that it enables superfast traders to frontrun the market. (The WSJ never actually uses the phrase frontrun; instead it says “trade ahead”). But couldn’t we hear from an actual live critic?

Second, the criticism of high-frequency trading goes well beyond the issue of frontrunning. There’s the real concern about a rogue algorithm or a misfiring computer code, sparking an unintentional sell-off in a stock, or the broader market. But that issue wasn’t even mentioned.

Instead, we get Getco co-founder Dan Tierney telling us that without high-frequency trading, last October’s market plunge would have been much worse. But where’s the support for Tierney’s claim and why is it permitted to go unchallenged in the story.

Third, we’re told that Getco earned $400 million in 2008. That’s a nice sum for a 10-year-old firm with 250 employees. But what about the bonuses and salaries commanded by its traders and computer programmers? Presumably, the $400 million figure is earnings after paying out compensation. That’s the figure we all want to know.

Look, getting information on salaries and bonuses is difficult when dealing with a private company. But there’s no indication the WSJ even asked the question.

The liquidity canard

It’s often said on Wall Street that the more liquidity there is in a given market, the better things are for investors trading stocks, bonds or commodities. And while there’s a lot of truth to that, there are times when too much liquidity can be just the wrong tonic.

After all, Wall Street’s churning-out of one subprime-mortgage backed security after another pumped a lot of liquidity into the U.S. housing market, and that simply encouraged a lot of reckless — even fraudulent — lending.

That’s why I’m not impressed with the securities industry’s main defense of computer-driven high-frequency trading, which essentially is that all this lightning-fast trading provides liquidity and better prices for investors.

It’s a hard argument to swallow when you consider that many high-frequency trading programs are simply engaged in trading the same stock thousands of times a day in less than penny increments. Now maybe all those rapid-fire automated trades are getting better prices for some investors. But when a broker excessively buys and sells securities to generate higher commissions, it’s called churning, and that can result in an investor lawsuit or a regulatory sanction.

Indeed, when fast-fingered day traders were doing much the same thing as today’s high-frequency traders — albeit without the benefit of a sophisticated algorithmic program to guide them — Wall Street’s biggest firms were quick to dismiss them as either amateurs or rogues who were causing unnecessary volatility in the price of tech stocks.

So with critics raising legitimate concerns about the potential of a rogue algorithm sparking an unintentional market meltdown, the notion that high-frequency trading is OK because it creates more liquidity simply won’t wash.

If the main purpose of all that extra liquidity is to simply make fat profits for high-frequency traders at Goldman Sachs, UBS, GETCO, Citadel Investment Group and Interactive Brokers, that’s liquidity the markets can do without.

The right response to HFT

Kudos to Sen. Edward Kaufman for asking securities regulators to take a comprehensive look at the impact of high-frequency trading and related super-fast trading strategies on the markets.

The Delaware senator is taking the right approach in asking the Securities and Exchange Commission to conduct a broad review of HFT, so-called flash orders and dark pools. It’s a much better approach than the more narrow one taken by Sen. Chuck Schumer, who last month focused solely on the impact of flash orders on the market.

While the issue of flash orders is important–it’s pretty clear that most HFT traders are not getting an early sneak peak at the order flow coming into regulated exchanges. But Schumer was quick to zero in on flash orders simply because that’s what a story in The New York Times mainly focused on.

Unfortunately, Schumer’s own letter to the SEC put too much focus on flash orders and made it sound like that was what HFT is all about. Kaufman, however, is helping to recalibrate the debate about HFT with his own letter to SEC Chairman Mary Schapiro.

One can only hope that Schapiro will be as responsive to Kaufman as she was to Schumer.

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.