The problem with high frequency trading

By Felix Salmon
October 6, 2012
an essay about high frequency trading. I hope it's fun to listen to, but if you want to read it, here you go.

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Last night, on BBC Radio 3, I was featured reading an essay about high frequency trading. I hope it’s fun to listen to, but if you want to read it, here you go.

One of the many consequences of global warming is that it’s now, for the first time, possible to drill under the sea bed of the Arctic ocean. The oil companies are all there, of course, running geological tests and bickering with each other about the potential environmental consequences of an oil spill. But they’re not the only people drilling. Because there’s something even more valuable than oil just waiting to be found under the Arctic.

What is worth so much money that three different consortiums would spend billions of pounds to retrofit icebreakers and send them into some of the coldest and most dangerous waters in the world? The answer, of course, is information.

A couple of days ago, I called a friend in Tokyo, and we had a lovely chat. If he puts something up on Twitter, I can see it immediately. And on the web there are thousands of webcams showing me what’s going on in Japan this very second. It doesn’t look like there’s any great information bottleneck there: anything important which happens in Japan can be, and is, transmitted to the rest of the world in a fraction of a second.

But if you’re a City trader, a fraction of a second is a veritable eternity. Let’s say you want to know the price of a stock on the Tokyo Stock exchange, or the exact number of yen being traded for one dollar. Just like the light from the sun is eight minutes old by the time it reaches us, all that financial information is about 188 milliseconds old by the time it reaches London. That’s zero point one eight eight seconds. And it takes that much time because it has to travel on fiber-optic cables which take a long and circuitous route: they either have to cross the Atlantic, and then the US, and then the Pacific, or else they have to go across Europe, through the Middle East, across the Indian Ocean, and then up through the South China Sea between China and the Philippines.

But! If you can lay an undersea cable across the Arctic, you can save yourself about 5,000 miles, not to mention the risk of routing your information past a lot of political flash points. And when you’re sitting in your office in London and you get that dollar/yen exchange rate from Tokyo, it’s fresh from the oven, comparatively speaking: only 0.168 seconds old. If everybody else is using the old cables and you’re using the new ones, then you have somewhere between 20 milliseconds and 60 milliseconds when you know something they don’t.

Those are periods of time so short that humans can barely notice them. This essay, for instance, is about 900,000 milliseconds long, and it takes me hundreds milliseconds just to say the word “cable”. Which is a word with more than one meaning. To you, it probably means some kind of wire. But to City traders, it means 1.6254, or something very close to that number. Because in the City, “cable” means the pound/dollar exchange rate. And it’s named that after a transatlantic cable which was used to telegraph the exchange-rate information from London to New York as far back as 1858.

So what we’re talking about here is nothing new, in terms of kind. Nathan Rothschild built a significant chunk of his fortune by using a system of couriers who told him the result of the Battle of Waterloo a full day before anybody else in London knew it. And my own employer, the Reuters news agency, was founded on sending financial information between Brussels and Aachen using carrier pigeons.

What’s new is that billions of pounds can be made by having access to information not a day in advance, or an hour, or even a second, but even just a millisecond or two. Stock exchanges aren’t physical places where human beings bargain with each other any more: they’re racks of computers in places like Mahwah, New Jersey, where the cables are carefully measured to be exactly the same length so that no one has an infinitesimal advantage thanks to the amount of time it takes information to travel an extra few millimeters down a wire.

Obviously, only computer algorithms can make money from an information advantage which is measured in milliseconds. It’s computers which are making the decisions to buy and sell: if they had to wait for a human to sign off on those things, they’d never make any money at all. That’s a little bit scary, and not only because of the classic science-fiction stories where computers become so sophisticated that they gain consciousness and start waging battles against the humans who built them.

The more obvious problem with exchanges run by computers is that computers don’t have any common sense. We saw this on the 6th of May, 2010 — the day of the so-called “flash crash”, when in a matter of a couple of minutes the US stock market plunged hundreds of points for no particular reason, and some stocks traded at a price of just one cent. It was sheer luck that the crash happened just before 3pm, rather than just before 4pm, and that as a result there was time for the market to recover before the closing bell. If there hadn’t been, then Asian markets would have sold off as well, and then European markets, and hundreds of billions of pounds of value would have been destroyed, just because of a trading glitch which started on something called the e-mini contract in Chicago.

Most of the trading on US stock exchanges is done by something called algobots, these days. These are algorithms: they’re computers which are programmed to put in orders, take out orders, trade in big size, trade in small size – all according to very sophisticated rules, called algorithms. And one of the ironies about the flash crash is that it was actually caused in large part by algobots not trading. The US has over a dozen different stock exchanges, places where stocks are bought and sold. Most of us have only ever heard of the listing exchanges, the New York Stock Exchange and the Nasdaq. But there are many more you probably haven’t heard of, with names like Arca and BATS, as well as sinister-sounding things called Dark Pools. What happened in the flash crash is that when the trading got completely crazy, the algobots just switched themselves off. This was something they weren’t used to, they didn’t know how to react, and so they just went away. And there was suddenly no liquidity in the market. No one was offering to trade. And with no one offering to trade, the prices just plunged, all the way down to one cent. Because there were no bids in the market any more.

The algobots can be very useful, on a day-to-day basis. If a normal person like me buys a few shares in some company or other, that trade doesn’t even happen on any stock exchange at all. It just happens directly with a broker, an algobot, who’s happy to take the other side of my trade because small individual investors like me are normally pretty stupid, and tend to buy high and sell low.

In any case, if any given stock exchange is an incredibly complicated thing, the fragmentation of the stock exchanges has created a much more complex system yet. Most big banks and stockbrokers — and the algobots they control — have access to all of the different exchanges, and they trade wherever they think they can get the best prices. Since the best prices tend to be found wherever the most traders are trading, you end up with something a bit like six-year-olds playing football: everybody’s running towards the ball at the same time. And the result is these huge waves of activity, where traders move en masse, from one stock exchange to the next, in very unpredictable ways. If you layer that unpredictability on top of the complexity inherent in any system of multiple stock exchanges, you end up with something which will almost certainly break in a pretty catastrophic manner at some point. We don’t know how, and we don’t know when, but there’s an ironclad rule of any system: the more complex it is, the less predictable it is, and the more likely it is to fail catastrophically in some unforeseeable manner.

If Twitter fails, that’s fine. A bunch of people get annoyed, and then they want to express how cross they are on Twitter, and then they remember that they can’t, and that makes them even more annoyed. But little actual harm is done. If the stock market fails, on the other hand, or the bond market, or the foreign-exchange market, or the oil market, that’s really, really bad news. Billions or even possibly trillions of pounds could evaporate.

And that’s the biggest reason why it’s time to start cracking down on high-frequency trading. Virtually every major financial center in the world is trying to work out what to do and how to do it: these decisions aren’t easy, partly because any crackdown on the algobots is likely to have its own significant up-front costs.

After all, high-frequency trading has been genuinely wonderful for small investors like you and me. We might not be particularly clever, but when we put in an order to buy this or sell that, the order gets filled immediately. We pay almost nothing in trading costs — just a few pounds, normally. And we get the very best price in the market: something called NBBO, for “national best bid/offer”. If you look at all the prices being quoted on all of the stock exchanges in the country, we get the lowest price of all if we’re buying, and the highest price of all if we’re selling.

That wasn’t true ten years ago. During the dot-com boom, especially, small investors generally had no idea how much they were going to end up paying for a stock they wanted to buy, and all too often their trades could take minutes or even hours to get filled. Today, all individual investors get filled in a fraction of a second: we’ve never had it so good. So if anybody tells you that high-frequency trading is bad for the little guy, and that it means there isn’t a level playing field any more, they don’t know what they’re talking about. Yes, high-frequency traders do make money from small investors, but they do so honestly, just by assuming that whatever those small investors do, the opposite thing is likely to make money. As a result, there’s always someone willing to take the opposite side of the trade whenever you want to buy or sell a stock.

This is a real improvement, which means that the rise of high-frequency trading had genuinely beneficial effects between, say, 2002 and 2007. In those years, the computers helped markets to become ever more efficient and liquid — and they were just in time, too. When the financial crisis came along in 2008, bond markets seized up, but the world’s stock markets actually came through with flying colors. They did what markets are supposed to do: they went down when people were selling, and they kept on falling until they were so cheap that people started buying again. If you wanted to sell, you could always sell, and if you wanted to buy, you could always buy. We take these things for granted, but creating a system which stays that liquid, all the way through such a big crisis, is a real achievement, and the algobots deserve a lot of credit there. After all, imagine what would have happened if you had to phone up your broker at Lehman Brothers in order to sell your shares.

But if you look at what’s happened over the past five years, since 2007, the benefits of high-frequency trading have pretty much plateaued. And the downsides are becoming more and more obvious. There was the flash crash, of course, and then there was the implosion of Knight Capital, one of the biggest and most respected high-frequency trading shops, which released a faulty algorithm one morning and was almost bankrupt an hour later, after losing somewhere in the region of $10 million per minute. If that could happen to Knight, it could happen to anybody. Then there was the botched flotation of one of the stock exchanges, BATS. Once again, its algorithms turned out to be not up to the task. And this was in an expected, rather than an unexpected, situation.

There are more subtle signs, too, which are if anything even more worrying. For instance, look at stock-market volume — the amount of money which changes hands every day. That’s going nowhere: if anything, it’s going down, even as high-frequency traders get bigger and bigger. That says two things.

The first is that real-money investors, the people who the market needs the most, are being scared away by the algobots, because even if the bots are good for the little guy, they’re really bad for big, institutional investors. For big investors, the stock market is more of a rigged game now than it has been in a long time – and they’re taking their ball and they’re going home.

The second reason that volumes are dropping is that the algobots are getting so sophisticated at sparring with each other that they’re not even trading with each other any more. They’re called high-frequency traders, but maybe that’s a misnomer: a better name might be high-frequency spambots. Because what they’re doing, most of the time, is putting buy or sell orders out there on the stock market, only to take those orders back a fraction of a second later, and replace them with new ones. The result is millions of orders, but almost no trades.

I’ll give you one example from a stock with the ticker symbol EFZ. It doesn’t matter what that ticker represents: the computers certainly don’t care. On September 11, between 6:51 and 7:08 in the morning, the US stock markets saw more than 280,000 quotes to trade EFZ. And how many times did it actually trade? Zero.

I can even demonstrate what that kind of thing sounds like. If you map all those offers to buy or sell onto a piano, and play them back, you get something which sounds like this. Remember, each note is an offer to buy or to sell; there’s no actual trading going on.

 

There’s no value being created here. If the economics of high-frequency trading means that fiber-optic cables get laid under the Arctic ocean, that’s good for everybody. But if it all just devolves into meaningless noise, then something has gone very, very wrong. Especially since the more noise and complexity you have, the bigger the danger that everything could just implode for some unforeseeable reason. Any one of these notes has the potential to be the butterfly wing-flap which results in global disaster. If they’re not doing anybody any good, it makes sense that regulators should crack down on them.

 

25 comments

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I think it’s important to be much more specific about what in particular we want to change–for example, it’s very far from clear that just increasing the ‘delay’ between trades will make the system more stable. In fact, in most complex feedback systems precisely the opposite is true…

Posted by mw1 | Report as abusive

Easy to see why the BBC featured you, FS. A seriously impressive presentation it is – perhaps too seriously sophisticated for the likes of me, who get hung-up on this –

“… even if the bots are good for the little guy, they’re really bad for big, institutional investors. For big investors, the stock market is more of a rigged game now than it has been in a long time – and they’re taking their ball and they’re going home.”

Really do have a hard time getting my head around the idea that a process that has made markets too ‘rigged’ for pros to play in is beneficial for individuals. Matter of fact, so hard to see how anyone getting in the middle of trades between real buyers and sellers and claiming a cut of the deal could be to the benefit of the buyer/seller, when they are viewed as one unit. I mean, no matter how wild the bid/ask spreads may be, as long as it’s just the two real players involved, it’s a closed system – nobody else extracts money from it but them – one’s detriment is necessarily the other’s gain.

HFT narrows spreads – get that OK. But it does so by pocketing the excessive portion of the spreads into the accounts of the HFT traders – money leaks out of the transaction between the buyer and seller. If you (and KidD) say this is good for them, so be it. I’m just not clever enough to see how. Unless, the ‘status quo ante’ leakage was worse – was it? And whether it was or wasn’t – who got it? And, do those middlemen displaced by the ‘bots’ acknowledge that the leakage is lower now?

Posted by MrRFox | Report as abusive

Again, I’m pretty underwhelmed by many, though not all, of the arguments against HFT. The argument that HFT creates systemic risk is particularly underwhelming. Remember that for real investors, stocks are claims on future cash flows. For HFT to seriously hurt the fundamental valuation of stocks, it would need to actually hurt future demand for the company products in the real world. That gets into a much larger discussion involving what causes demand to fall, but my belief is that monetary policy never really runs out of ammunition. In 1987, the real-world economy barely registered the crash. The crash after Lehman was certainly registered, but that was because the Fed was late in using unorthodox policies at the zero-bound.

The other argument could go that HFT could cause serious evaporation of wealth just by changing prices, even without changing fundamental cash flows. In the case of 1987, the stock market was fundamentally overvalued due to portfolio insurance. One could say ordinary investors were hurt by portfolio insurance, but they were only hurt if they bought overvalued stocks. It’s an odd policy goal to protect investors who buy overvalued stocks. For countries which did not have portfolio insurance in 1987, they bounced back just like stock markets bounced back in the flash crash.

As far as Knight Capital nearly failing, so? The issue there is not companies failing, but the more general issue that we can’t let some financial companies fail. If someone says the big issue of the financial crisis was that so many big investment banks nearly failed, they would be wrong. The big issue was that Main Street was very exposed to investment banks even if they didn’t know it. If the Fed did not bail out money market funds, many companies would have been unable to make payroll. Furthermore, many pension funds and insurance companies had substantial exposure to banks through the repo market, or essentially huge, uninsured bank accounts. The natural course would have been for many pensions and insurance companies to go bankrupt, with taxpayers backstopping their obligations. Financial regulation should deal far less with the inner-workings of markets and instead create a robust system of information-insensitive banking for corporations, pensions and insurance companies which will ultimately allow financial intermediaries to engage in whichever transactions they wish as long as the ultimate funders are information-sensitive. Making finance robust to people on Wall Street being wrong is the ultimate goal, and that has nothing to do with HFT.

Worthwhile arguments against HFT are that it represents a tax on big, institutional investors. I see no reason to allow so many orders to be made and then canceled. The only reason to do such things is to find the limits in limit orders. I’m not sure how much regulation is necessary, as institutional investors find ways around the tricks and HFT investors start losing money. After all, if HFT investors just try to get money from each other, then half will lose money every year and investments like fiber across the arctic will also lose money.

Posted by mwwaters | Report as abusive

The system has always been rigged against the little guy — less so now than in the past. Transactions are quicker, cheaper, more reliable, and more transparent. I typically know my cost on a $10,000 order to within ten dollars before I commit.

Felix is being a bit misleading when he writes, “because small individual investors like me are normally pretty stupid, and tend to buy high and sell low.” The profit per share turned by the algobots is insignificant to me as a small investor, and far better than the historic pricing. Moreover, I’m pretty certain that my orders aren’t large enough to be gamed. I click, a few hundred shares change hands, and it is done. I don’t pay attention to the short term movements and the bots don’t have a chance to react to my orders. Would be very different if I were trading thousands of shares in a transaction with multiple transactions. The bots can then sniff out the parameters of the order and react to that.

Still, I don’t see the point to allowing unrestricted HFT trading. You can get all the benefits with a fraction of the activity, and perhaps achieve greater stability as well. The seeming liquidity is an illusion — which lulls people into believing it will be there when they need it.

Posted by TFF | Report as abusive

Felix,

“Stock exchanges aren’t physical places where human beings bargain with each other any more: they’re racks of computers in places like Mahwah, New Jersey, where the cables are carefully measured to be exactly the same length so that no one has an infinitesimal advantage thanks to the amount of time it takes information to travel an extra few millimeters down a wire.”

Think you meant to state that the server boxes are carefully arranged to minimise cable length, according to how much the investment banks and hedge funds have paid the exchange, in order to gain a few milliseconds in cycle time and maximise trading revenue.

Fixed!

Posted by crocodilechuck | Report as abusive

The Rothschild story is generally regarded as a myth, apparently floated in the mid-19th century in France, with anti-Semitic intent. See Ferguson’s “The House of Rothschild”. A good story, but apparently false, and best not to propagate.

Posted by lex46 | Report as abusive

@lex46, I did check on that. See
http://www.businessweek.com/1998/49/b360 7071.htm
Rothschild did have couriers, and he did get the news first. The only question is how much money he made from having that advantage w/t/t Waterloo in particular. More generally, the Rothschilds’ information advantage was very valuable to them.

Posted by FelixSalmon | Report as abusive

Felix and all other contributors,

It is a great essay about HFT. Well done Felix. I have been trying to understand these amazing and new money-making tool, obviously not for everyone, especially not for me as a little trader.

However, I need to ask you one thing: What is the function and rationale of hundreds of thousands of orders of HFT put in and then immediately taken out, all eventually resulting in zero trade. How an HFT expert makes money out of this strategy? Cannot get my head around that. Many thanks in advance.

You all being great.

Posted by kado | Report as abusive

HFT is just an old fashioned wire con. You can always make money if you know the state of events before some other trader. That’s how the con works. It has nothing to do with stability. Eliminating the specialists is what has hurt stability. HFT just takes a certain amount of money from one party and gives it to another. For an entertaining take on the wire con, watch The Sting.

You note that there are often hundreds of thousands of orders posted that are never filled. That is just the old fashioned bait and switch, the $250 washer advertised but never sold. You can always make money using bait and switch because the other party incurs an opportunity cost. It’s like spam. The per message cost is so low, it is worth flooding everyone’s mailboxes with bogus deals in order to take a sucker now and then.

Yes, it is possible to make money by using old fashioned cons.

Posted by Kaleberg | Report as abusive

@kado no one knows how HFT’s make money… without breaking the rules. What little rules there are anyway.

I can understand the ability to cancel an erroneous order sent to the exchange by mistake, one out of 1000 trades.

The largest single issue with HFT is that firms can send and then cancel thousands of trades every day. The whole premise behind that is to probe for information about the intentions of large counterparties. If a mutual fund is trying to get out of a large position (say a few million shares) of HPQ. Lets say SAC discerns this they know that the large selling pressure will drop the price. They rush in ahead of the fund selling every share they can knowing that they can cover their shorts at a lower price from the fund.

Posted by y2kurtus | Report as abusive

@y2kurtus

Then the mutual fund trader is incompetent. There is no reason why they would reveal the size of their order, and buying/selling programs are very effective at using volume when it’s there in order to minimize price impact.

How do you think that the HFT knows about the large order before it would happen?

Indeed, if you had read any of the academic literature on HFT, you would know that HFTs actually minimize the price impact of large trades. The reasons are obvious: there is very little to no information in these trades, and thus any move caused by them would push price away from the “fair” valuation. That’s the sort of thing bots go after, not some magical front running.

Posted by qusma | Report as abusive

@qusma

Then explain how they make money… you say: “HFT’s minimize the price impact of large trades.”

Walk me through how they do that exactly. I know why the fund managers use programs to break million share trades into 1000 share trades… they do it to hide their size releasing the order in tiny pieces. If they drop the price by a penny they slow down… even buy a few shares back. It’s no use though… HFT’s have access to level 3 quotes and can stack both sides of the order book with buys and sells. Because they pay for the fastest connections, the fastest servers, and the best available co-location of their machines. These advantages allow them to spot imbalances in demand for a stock which always occur when a big player is trying to buy or sell in size.

I’ve read minimum 1,000 pages on HFT and have yet to see any compelling defense of this argument.

So qusma, if you game answer me this one question: Should a HFT be allowed to place and then cancel thousands of orders every day without any fee, or penalty, or tax imposed by the exchanges?

Posted by y2kurtus | Report as abusive

“After all, high-frequency trading has been genuinely wonderful for small investors like you and me.”

We have to qualify that term “small investors” to designate people who only invest directly in shares and not through mutual funds. If those “small investors” buy mutual funds, they indirectly get worse execution because the mutual funds get picked off by the algobots.

Posted by dkelland | Report as abusive

I would challenge @Y2kurtus or other apologists show some quality links to unbiased research demonstrating that HFT diminishes the cost of larger trades. Any buy-side trader (meaning executor/implementor of buy-side investment decisions) will tell you the same story which is well exposed by Tudor’s Marcos Lopez de Prado in his Working Paper Low Frequency Traders in a High Frequency World: A Survival Guide.
That is not to say that electronic trading, algorithmic execution, electronic market-making, or short-term trading should be banned or are inherently bad. But it is just wrong and disingenuous to suggest that most or even much of HFT is benign. Some is, such as bona-fide electronic market-making, but much is not, particularly the overtly predatory strategies, the strategies that game market structure and structural information asymmetry, and the ones that are in many senses are so close to being illegal by painting a false and mis-leading market (e.g. spoofing, quote dangling) that they should be prohibited.

But before we lynch them, however, older hands (those of us old enough to be most HFT programmers’ parents) will recognize these same nefarious practices and criticisms could have been leveled at many of the Specialists and market-makers, who were no less unsavoury or more munificent.

Technology is moving to a market structure that has certain characteristics. We cannot without consequence, outlaw those who (like speculators of old) used their wits to wager on the direction of prices, even if those wagers are based upon sophisticated maths that allow them to front run “real” orders. There is nothing more noble about fundamental spec than a mathematically-derived spec. However, the latter, in the spirit of the public interest, should not be advantaged by market structure, fragmentation, and asymmetric access to exchange info in the broadest possible sense to make these wagers, and if proved in whatever form to be excessively destabilizing, then it is incumbent upon the regulators and the exchange(s) themselves to throttle mechanisms, erect gates, and otherwise do whatever is necessary to encourage, fair and orderly markets that transparently facilitate the exchange of securities between bona-fide buyers and sellers.

One final thought: Insurance underwriters require, of the purchaser, a bona-fide insurable interest. One cannot buy a life policy on a stranger and spec on his demise. While not a perfect metaphor, wonder if participants should bring something to the table – a true willingness to commit capital. For there is something amiss in a participant (e.g. certain HFT) injecting themselves into transaction in which they have no bona-fide investment interest per se. I know this is philosophically-speaking a slippery slope, yet it doesn’t feel correct that we should treat the imaginary so-called “market-maker”, who is using a privileged position to capture private information and front run trades, and not only runs away from possible adversely-selected transactions, as quick as possible, but goes the other way, the same we we treat a bona-fide buyer, or bona-fide seller of the securities in question. To do so, it would seem would be tacit approval of simultaneously impoverishing the farmer, and the end consumer, for the sole and anti-social benefit of the carpet-bagging risk-averse intermediary.

Posted by nihoncassandra | Report as abusive

I would challenge @Y2kurtus or other apologists show some quality links to unbiased research demonstrating that HFT diminishes the cost of larger trades. Any buy-side trader (meaning executor/implementor of buy-side investment decisions) will tell you the same story which is well exposed by Tudor’s Marcos Lopez de Prado in his Working Paper Low Frequency Traders in a High Frequency World: A Survival Guide.
That is not to say that electronic trading, algorithmic execution, electronic market-making, or short-term trading should be banned or are inherently bad. But it is just wrong and disingenuous to suggest that most or even much of HFT is benign. Some is, such as bona-fide electronic market-making, but much is not, particularly the overtly predatory strategies, the strategies that game market structure and structural information asymmetry, and the ones that are in many senses are so close to being illegal by painting a false and mis-leading market (e.g. spoofing, quote dangling) that they should be prohibited.

But before we lynch them, however, older hands (those of us old enough to be most HFT programmers’ parents) will recognize these same nefarious practices and criticisms could have been leveled at many of the Specialists and market-makers, who were no less unsavoury or more munificent.

Technology is moving to a market structure that has certain characteristics. We cannot without consequence, outlaw those who (like speculators of old) used their wits to wager on the direction of prices, even if those wagers are based upon sophisticated maths that allow them to front run “real” orders. There is nothing more noble about fundamental spec than a mathematically-derived spec. However, the latter, in the spirit of the public interest, should not be advantaged by market structure, fragmentation, and asymmetric access to exchange info in the broadest possible sense to make these wagers, and if proved in whatever form to be excessively destabilizing, then it is incumbent upon the regulators and the exchange(s) themselves to throttle mechanisms, erect gates, and otherwise do whatever is necessary to encourage, fair and orderly markets that transparently facilitate the exchange of securities between bona-fide buyers and sellers.

One final thought: Insurance underwriters require, of the purchaser, a bona-fide insurable interest. One cannot buy a life policy on a stranger and spec on his demise. While not a perfect metaphor, wonder if participants should bring something to the table – a true willingness to commit capital. For there is something amiss in a participant (e.g. certain HFT) injecting themselves into transaction in which they have no bona-fide investment interest per se. I know this is philosophically-speaking a slippery slope, yet it doesn’t feel correct that we should treat the imaginary so-called “market-maker”, who is using a privileged position to capture private information and front run trades, and not only runs away from possible adversely-selected transactions, as quick as possible, but goes the other way, the same we we treat a bona-fide buyer, or bona-fide seller of the securities in question. To do so, it would seem would be tacit approval of simultaneously impoverishing the farmer, and the end consumer, for the sole and anti-social benefit of the carpet-bagging risk-averse intermediary.

Posted by nihoncassandra | Report as abusive

“If those “small investors” buy mutual funds, they indirectly get worse execution because the mutual funds get picked off by the algobots.”

Mutual funds get their cake eaten three ways from Wednesday. They might have made sense back in the 80s and 90s (direct investing was much more difficult and costlier then), but today you have just two sensible choices:

(1) Pick your own.

(2) Index.

Posted by TFF | Report as abusive

Hey Nihoncassandra how did I get labeled a HFT apologist?

Didn’t I claim that they mostly exist to discover large legitimate trades as they happen and try and outrun the “real investors” sniping them out of pennies again and again and again?

I would support a 10 cent per share tax on any canceled order.

I would support basically opening and closing the stock market at one second intervals. Lets trade at one price every second of the day and not more. What do we gain breaking the day down into hundredths of a second? Nothing that I can see.

HFT is a cold war everyone spends money and no one is any better off for it. Zero social utility.

And if KidDynomite is reading this thread I would bet my teeth that we would still have .01 increments and plenty of real liquidity to take care of all the real participants who you know want to buy stock to become an investor in a company.

Posted by y2kurtus | Report as abusive

I’m a little late to this, but hoping Felix reads this comment: EFZ is a particularly egregious example for a ticker that will see many orderbook updates with few trades. EFZ is the Proshares Short MSCI EAFE (Europe, Australasia and Far East) ETF. It is a small ETF, with a capitalization of only 150M, and has very few trades (50K-100K shares/day). Yet it has one Lead Market Maker, and perhaps a few other liquidity providers, signed up to provide tight two-sided quotes at all times.

Also, unlike stocks, the prices of an ETF such as EFZ depend on a lot of readily observable and rapidly updated real-world inputs: the prices of stocks, indices and futures in many other liquid markets (Western Europe, Japan, Australia, …), prices of liquid US-listed ETFs on the same or similar indices (EFA, VEA, …), FX rates, and so on. So, even if there are no trades in EFZ, there are plenty of other inputs to make the liquidity providers update their quotes to keep prices in line with where they should be.

Finally, this particular ETF is too illiquid to attract any interest from the HFTs of this world. You can still complain about all the quote traffic, but those complaints will have to target automation, the wide and rapid availability of information, and the increasing linkages in the global financial system, not HFT.

Posted by m_m | Report as abusive

Do we really need to be confused with all this detail? Let us get to basics. Any useful economic activity will require a minimum of a few hours or a maximum of about ten years. The financial markets are needed to provide the capital required for such activity. Barter is not a substitute for a market because a buyer and a seller for a specific item may not meet too often. (The coincidence of wants). So a financial market is needed since a person needing capital may not get to meet a person with the capital. The financial market is expected to do this efficiently, minimizing the cost of the capital. So the banks, institutional investors and now the computers must compete with this goal. Unless they invest for the time frame of economic activity as mentioned above, a few days for an artisan, a few months for a garage operator, a few years for a builder of a nuclear power station, they are only gambling. Today most of the activity in the financial market is simply gambling. A nation of gamblers is an absurdity. Remembering the old Christian objection to usury, we need to restrict gambling

Posted by Lakshmikumar | Report as abusive

Have a look at the way the bots were in action last week during the US Presidential election courtesy of Carl Weiss from sceeto
High Frequency Trading and these type of algos as a matter of fact are responsible these days for more than 70 to 80% of all the daily US volume. Surprised that people find this news , as hfts have been quote stuffing, i.e placing massive buy sell orders within milliseconds for a long time now. If anyone is interested sceeto is one of the first small companies that anywhere in the world that tracks the hft’s in real time. Have a look for yourself ,Carl Weiss has done numerous videos on these algos.
The chief software developer of sceeto he has for a decade tested to come up with software designed a system to sniff these out and try to at least agin level the playing field a bit for the ordinary investor.

Posted by sceeto | Report as abusive

This and other topics that are relevant for speed traders and institutional investors will be discussed at High-Frequency Trading Leaders Forum 2013 London, next Thursday March 21.

Posted by EllieKim | Report as abusive

Well done, Felix. I thoroughly enjoyed it.

The EFZ example can be explained as algo-bot warming up with test orders, this is quite common in pre-trading hours, especially when a new algo is just deployed into production. “Flex the muscle” and get ready to go.

It’s common practice for brokerage houses to submit test orders in the morning to make sure all systems are ready. Of course, they don’t usually submit that many orders.

Many bots also need calibration in a live setting with many “test” orders to adjust latencies, optimize trading paths, etc. first before market opens. So…
is that wrong?

Posted by AllenZ | Report as abusive

any happening there isand this is perhaps all gratitude to this very awesome mobile phone spying device. Think about if you possibly could instantaneously get a grip of all personal information

Great website you have here but I was curious if you knew of any message boards that cover the same topics discussed in this article? I’d really love to be a part of online community where I can get feedback from other knowledgeable individuals that share the same interest. If you have any suggestions, please let me know. Thanks a lot!

You could certainly see your enthusiasm in the paintings you write. The sector hopes for even more passionate writers like you who aren’t afraid to mention how they believe. Always go after your heart. “We may pass violets looking for roses. We may pass contentment looking for victory.” by Bern Williams.