The HFT debate

By Felix Salmon
April 1, 2014

CNBC might be guilty of a tiny bit of hyperbole when they say that their HFT debate today, between the CEOs of rival exchanges IEX and BATS, “stopped trading on the floor of the New York Stock Exchange” and “Twitter stopped too”. Still, they undoubtedly caused a lot of buzz, and the debate — coming, as it does, in the wake of the release of Michael Lewis’s new book on the subject — is an extremely important one, and it is indeed of great interest to that most endangered of species, the NYSE floor trader.

Because CNBC lives on maximizing cacophony, the debate ultimately created more noise than illumination. But at least there was a debate, which is great: it’s very important to get these people talking at the same venue, because if that happens often enough, they might conceivably stop talking at cross-purposes to each other, and maybe even start agreeing on some useful changes which can be made to market structure.

There is the potential for finding common ground here. Brad Katsuyama, the founder of IEX and the hero of Lewis’s book, is no white-hat absolutist: he doesn’t like the way in which the term “HFT” is used to cover a multiplicity of different behaviors, and in fact he is all in favor of computerized trading. (Which makes sense, seeing as how he runs a dark pool.) And BATS president Bill O’Brien is happy to concede that the market has become too complex. He said only that the complexity needs to be “managed”, rather than simplified, but in reality simplification is by far the most effective way to manage complexity. A market with only three or four order types, for instance, is a lot simpler and easier to manage than a market with hundreds.

Can the market be fixed? Michael Lewis says he would like to see that — but at the same time he says that he welcomes the way in which the FBI and the New York attorney general are launching investigations into HFT, to see whether anything in that world can be considered criminal insider trading or market manipulation. My feeling is that if you want prosecutions, then law-enforcement should launch investigations — but that if you really want to fix things, then creating a highly adversarial relationship between HFT shops and the government is not going to help and is in fact almost certain to hurt.

After all, a long sub-plot of Lewis’s book concerns the way in which law enforcement is completely clueless about high-frequency trading, and ends up jailing the innocent rather than doing anything constructive. HFT is very, very hard to understand, and trying to break it down along legal/illegal lines is unlikely to be helpful. If we want to make markets safer both for big real-money investors and in terms of the system as a whole, then the exchanges, along with their HFT paymasters, need to be part of the solution, rather than lawyering up and entering a defensive legal crouch.

And frankly the buy side — which gets a complete pass in Lewis’s book, as the guileless victim — needs to be part of the solution as well. Right now, most investors’ orders are passed to certain broker-dealers not on the basis of which broker offers the best execution, but rather as part of a “soft dollar” system which rewards good research, access to IPO roadshows, and the like. In other words, it’s not traders who decide which brokers to use — it’s portfolio managers.

Most invidiously, soft-dollar fees are paid out of brokerage commissions — which is to say, they’re paid by the investors in the funds. If the system moved to a hard-dollar fee-for-service approach, where traders were incentivized to use the brokers with the best execution, then those fees would be taken out of the management fees which are currently being pocketed by the portfolio managers. And it turns out that portfolio managers are much happier paying commissions out of their investors’ money than they are out of their own income.

All of which is to say that fixing the market will take a lot more than just the FBI coming in with a blunderbuss. It will mean deep reform across a huge swathe of the financial markets, some of it seemingly far removed from HFT. Which in turn means that I’m not holding my breath.

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Comments
23 comments so far

The real issue is that HFT creates risk for the markets as a whole but serves no useful function.

What we need is a $.01 per share transaction tax + 90% capital gains tax on all trades less than one day.

Posted by mfw13 | Report as abusive

Besides the risks created by improperly programmed HFT algorithms, the issue is best defined as “unjust enrichment”. Pennies here and there are not going to hurt either small or large investors very much. Hopefully you’ve made much more on your trade than a few pennies.

However, there is no reason that any firm should be able to game the system and front-run orders in the way that is described in the book. So the problem isn’t so much that small investors are losing pennies as a result of this scheme (and they are), it’s that a few firms are unfairly profiting from rigged exchanges (and exchanges that allow themselves to be gamed).

Posted by MaggiesFarmboy | Report as abusive

“After all, a long sub-plot of Lewis’s book concerns the way in which law enforcement is completely clueless about high-frequency trading, and ends up jailing the innocent rather than doing anything constructive.”

I gather you’re referring to the Aleynikov material here. But Lewis doesn’t see Aleynikov as all that innocent. He was not guilty of what he was accused of, but Lewis tends to see Goldman Sachs as a guilty party, and to see Aleynikov as having been complicit in THAT guilt.

The good guys in his book, he says, were working to attack “the very problem that the Russian computer programmer [Aleynikov] had been hired by Goldman Sachs to create.”

So Lewis seems to be of the view that Aleynikov SHOULD have been prosecuted, just not at the behest of GS — he should rather have shared the defense table with his bosses there.

Posted by Christofurio | Report as abusive

“After all, a long sub-plot of Lewis’s book concerns the way in which law enforcement is completely clueless about high-frequency trading, and ends up jailing the innocent rather than doing anything constructive.”

I gather you’re referring to the Aleynikov material here. But Lewis doesn’t see Aleynikov as all that innocent. He was not guilty of what he was accused of, but Lewis tends to see Goldman Sachs as a guilty party, and to see Aleynikov as having been complicit in THAT guilt.

The good guys in his book, he says, were working to attack “the very problem that the Russian computer programmer [Aleynikov] had been hired by Goldman Sachs to create.”

So Lewis seems to be of the view that Aleynikov SHOULD have been prosecuted, just not at the behest of GS — he should rather have shared the defense table with his bosses there.

Posted by Christofurio | Report as abusive

Here’s a simplification plan: we deal with Wall Street the same way Rome dealt with Carthage.

Posted by Moopheus | Report as abusive

Felix,

Don’t know whether you read your emails from here. BUT you are doing fantastic analysis on this dust up driven by Lewis’s book. You might also spend a bit of time on how exchanges rebate tape revenues to those firms who “print” on an exchange. This is an archaic concept that predated the internet when the market NEEDED a massively expensive technology to speed price reporting to the masses. Those days are long gone. Levitt tried to address this with the Federal Advisory Committee on Market Data (chaired by Seligman) and was shouted down by the industry as his staff called for major reform. You want to kill HFT, then kill soft dollars and kill rebates? The whiners in all this are the big mutual funds trying to pay bills with commissions. Glad you put that in its proper context.

Harold S. Bradley
hsb1957@gmail.com

Posted by HaroldBradley | Report as abusive

It’s insider trading; ie
Trading on material non-public information. It’s non-public because when it reaches the first HFT terminals it hasn’t yet been disseminated to the public at large.

It’s non-public for a few milli-seconds, and during that time a trade is placed.

The crime of HFTs is trading on material non-public information. The crime of the exchanges is selective disclosure of material non-public information.

It’s not obvious because the period under scrutiny is a few milli-seconds, but if the period were a few days, would there be any doubt?

Posted by bakerthebeaut | Report as abusive

Murum Platea delenda est!

Posted by QCIC | Report as abusive

Why not just make the market discrete instead of continuous?

Orders get reconciled every 5 seconds.
Submitted orders cannot be cancelled for the current period.
Unfilled orders are carried over into the next period unless cancelled.
No one can see the book of orders submitted.

There would be no way to “front run” the system.

Posted by QCIC | Report as abusive

Seems to me that this sort of skimming is tailor-made for a class action suit. Good luck to all the exchanges that did it.

http://www.zerohedge.com/news/2014-04-02  /presenting-next-market-rigged-high-fre quency-trading

Posted by MaggiesFarmboy | Report as abusive

This article does not touch on the reality of what HFT is doing that is immoral, and wrong. The rigger, the HFT computer utilizing too big to jail bank hedge fund is able through HFT technology to see a non HFT trade coming, jump in front of it, buy the stock first, then sell it at a profit to the original intended buyer. That is front running, and is illegal when done by a human being, but because of bribery and corruption of our crony capitalist system, it is unlikely to be prosecuted when done through computer technology. Is that…capitalism?

Posted by anotherfakename | Report as abusive

It’s just too shady for a free and open market to be dividing up trading seconds into millionths, and shooting transactions in under the radar on a ‘proprietary basis.’

The markets could easily level the playing field by just saying: make your orders as large as you want, but you get one order per security per second. If that is too restrictive, then you’re just playing with yourself. You’re not really an investor.

Posted by AlkalineState | Report as abusive

I saw the interview with Michael Lewis on The Daily Show last night, very informative. What I was left with was that because this is done with computers, it is not illegal, but if a person was it would be illegal because they would be using information that others did not have access too. But in the world of computer trading, it is not illegal.

I know that is a simplification and it MUCH more complicated then that, but it seems as if you just made it illegal for any computer trading system to have access to information that another computer trading system can not get, problem solved.

Or, as mentioned in interview, another solution would be to make all transactions occur at same time instead of sequentially.

Posted by USAPragmatist2 | Report as abusive

How Ironic.

Wall street loves it when corporations reduce costs through outsourcing and automation, but now describe themselves as “that most endangered of species, the NYSE floor trader” when they themselves are threatened with job loss and extinction.

Now you understand “Main Street” a little better, when you have given up control of your life savings and retirement funds to manipulators who are constantly finding ways to separate you from your hard earned money, and happy to throw you to the curb at the first opportunity to save a buck.

Posted by Timbuk3 | Report as abusive

I’d take MFW13′s suggestion, though I might do a percentage-based tax rather than an absolute number of cents. (Or both. Say, 1 cent for each trade, plus 1 bp on the total volume of trades, payable with your regular annual taxes.)

And, as QCIC says, requiring trading pools to operate as a series of relatively simple auctions, held with a minimum period between batches of trades, could also help. Certainly it eliminates a lot of the advantages people derive from advantageous physical access or superfast hardware.

Posted by Auros | Report as abusive

@ MFW13, where is the “Like” button to commend / like and agree with your comment?

@reuters, your log in utility thinks i want to log in to edit your blog or something…. Offers me a second server log in user interface after i log in to place a comment. Looks like you have your own security issue happening starting yesterday(?).

Posted by Timbuk3 | Report as abusive

mfw13 put it best.

Posted by TFF | Report as abusive

@ Felix … this is one of your best post ever. Thanks for this!

I think MFW13′s first sentence is the most important point. What is the social good provided by HFT? Yes they are spending a large percentage of their on cutting edge IT equipment but INTEL isn’t going to stop R&D if these guys go away.

I don’t buy that their social utility is making a market because I don’t see them doing that… if I see bids and asks and I attempt to hit one that’s the market I want to be in… if bids and asks can get submitted or canceled after mine and get executed ahead of mine then how did they offer me liquidity? I placed an order without their liquidity to begin with… I already had a counter-party (or did I.)

The issue of HFT is probably overblown… but if the public’s confidence in the markets goes up marginally by mostly eliminating HFT then the exercise is worth while.

Posted by y2kurtus | Report as abusive

So… It sounds as if Felix is condoning bad behavior, and potentially illegal activities in financial markets! ‘If you want to fix things’…. Felix: I want to do more than ‘fix things’… I want things to be transparent. I want things to be open for everyone to see. AND, I want people who break the law to go to jail – do not pass go, and DO NOT collect those extra fees for shenanigans which cause the markets to be ‘rigged’ in favor of people with fast computers.

Posted by edgyinchina | Report as abusive

@mfw13…… great idea.

but, take it one step further…….

who gets to profit from the tax?

if the government gets revenue, aren’t they going to try and increase the volume of HF trading?

……we still may not have something that provides a useful function to society.

Posted by Robertla | Report as abusive

NOT JUST FOR THE BIG GUYS:
Following 60 Minutes this Sunday-Stock market with Michael Lewis -
This is Not just for the big guys:
I Know First algorithmic trading system is open to the average investors,
it is not HFT but beat the S&P500 in the last year with +51% average gain.

Posted by DanielRight | Report as abusive

exchanges are the guilty parties and they were very aware what they were creating .
Perhaps their remit of providing “fair and orderly markets ” needs to be taken away and their regulation and governance replaced as currently they are the abuse .

Posted by neilcrammond | Report as abusive

The problem with HFT WHICH everyone is overlooking:
HFT inovolves a lot of CIRCULAR TRADING in between the moments when “real orders” show up, which literally creates/sustains a fake price point. I am NOT convinced of the soundness of price signals in presence of HFT pay for volume games which is a sophist term for circular trading. Entire HFT strategies: Stat Arb, market making etc are irrelevant to absolute price discovery/

They are literally printing the tape like QE prints money in lieu of US Treasuries not having to be repaid on maturity by US govt b/c the fed is returning the principal at maturity back to US gov.

People are bamboozled.

Posted by kiers | Report as abusive
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