Felix Salmon

The HFT debate

Felix Salmon
Apr 1, 2014 21:35 UTC

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.


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.

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Michael Lewis’s flawed new book

Felix Salmon
Mar 31, 2014 21:11 UTC

I’m halfway through the new Michael Lewis book – the one that has been turned into not only a breathless 60 Minutes segment but also a long excerpt in the New York Times Magazine. Like all Michael Lewis books, it’s written with great clarity and fluency: you’re not going to have any trouble turning the pages. And, like all Michael Lewis books, it’s at heart a narrative about a person — in this case, Brad Katsuyama, the founder of a small new stock exchange called IEX.

The narrative is interesting enough — but so far I haven’t seen anything that would qualify as the “lighting in a bottle” he promised Boris Kachka. We were promised scoops, but so far it’s hard to see what the scoops are supposed to be. The most interesting thing I’ve discovered so far is the existence of something called “latency tables” — a way for HFT shops to work out exactly which brokers were responsible for which orders. The trick is to realize that because every brokerage is in a slightly different physical location, each house’s trades will hit the various different stock exchanges in a slightly different order. And so by looking at the time difference between a given trade showing up on different exchanges, you can (or could, at one point) in theory identify the bank behind it.

This vagueness about time is one of the weaknesses of the book: it’s hard to keep track of time, and a lot of it seems to be an exposé not of high-frequency trading as it exists today, but rather of high-frequency trading as it existed during its brief heyday circa 2008. Lewis takes pains to tell us what happened to the number of trades per day between 2006 and 2009, for instance, but doesn’t feel the need to mention what has happened since then. (It is falling, quite dramatically.) The scale of the HFT problem — and the amount of money being made by the HFT industry — is in sharp decline: there was big money to be made once upon a time, but nowadays it’s not really there anymore. Because that fact doesn’t fit Lewis’s narrative, however, I doubt I’m going to find it anywhere in his book.

Similarly, Lewis goes to great lengths to elide the distinction between small investors and big investors. As a rule, small investors are helped by HFT: they get filled immediately, at NBBO. (NBBO is National Best Bid/Offer: basically, the very best price in the market.) It’s big investors who get hurt by HFT: because they need more stock than is immediately available, the algobots can try to front-run their trades. But Lewis plays the “all investors are small investors” card: if a hedge fund is running money on behalf of a pension fund, and the pension fund is looking after the money of middle-class individuals, then, mutatis mutandis, the hedge fund is basically just the little guy. Which is how David Einhorn ended up appearing on 60 Minutes playing the part of the put-upon small investor. Ha!

Lewis is also cavalier in his declaration that intermediation has never been as profitable as it is today, in the hands of HFT shops. He does say that the entire history of Wall Street is one of scandals, “linked together trunk to tail like circus elephants”, and nearly always involving front-running of some description. And he also mentions that while you used to be able to drive a truck through the bid-offer prices on stocks, pre-decimalization, nowadays prices are much, much tighter — with the result that trading is much, much less expensive than it used to be. Given all that, it stands to reason that even if the HFT shops are making good money, they’re still making less than the big broker-dealers used to make back in the day. But that’s not a calculation Lewis seems to have any interest in.

In his introduction to the book, Lewis writes this:

The average investor has no hope of knowing, of course, even the little he needs to know. He logs onto his TD Ameritrade or E*Trade or Schwab account, enters a ticker symbol of some stock, and clicks an icon that says “Buy”: Then what? He may think he knows what happens after he presses the key on his computer keyboard, but, trust me, he does not. If he did, he’d think twice before he pressed it.

This is silly. I’ll tell you what happens when the little guy presses that key: his order doesn’t go anywhere near any stock exchange, and no HFT shop is going to front-run it. Instead, he will receive exactly the number of shares he ordered, at exactly the best price in the market at the second he pressed the button, and he will do so in less time than it takes his web browser to refresh. Buying a small number of shares through an online brokerage account is the best guarantee of not getting front-run by HFT types. And there’s no reason whatsoever for the little guy to think twice before pressing the button.

HFT is dangerous, I’d like to see less of it, and I hope that Michael Lewis will help to bring it to wider attention. But my tentative verdict on Flash Boys (I’ll write something longer once I’ve finished the book) is that it actually misses the big problem with HFT, in the service of pushing a false narrative that it’s bad for the little guy.


THE BOOK IS GREAT. MY Best friend worked for Ken Griffin at Citadel, hasn’t read the book, but was practically quoting verbatim many of Lewis’s points. “It’s simply legal front running”. And the liquidity argument, with miniscule bid/offer spreads now, is only true if the prices are real”.

HFTs simply beat your orders into the now numerous exchanges, but activity learned elsewhere, and steal your money by front running you. Just a high tech way of the oldest investment scam known. Now Felix might say, it they only steal a little, your still better off than the old days. Hmmm…

So the big Investment Banks get an excuse to “protect there customers” by channelling their trades into “dark pools”. Then they can front run you themselves with their prop desks! And only sell access to their exchange to only a few HFT firms.

Stealing money is wrong.

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The SEC’s important case against Stevie Cohen

Felix Salmon
Jul 21, 2013 12:43 UTC

Stevie Cohen is one of the greatest stock-market traders of all time. Indeed, there’s a strong case to be made that he’s the greatest. Cohen is not the greatest investor — he doesn’t really go in for buy-and-hold positions which steadily accumulate enormous value over decades. He’s not even the greatest hedge-fund manager: he doesn’t go in for the big macro bets (Soros vs. the pound, Paulson vs. mortgage-backed securities) which are the stuff of legend. Instead, he’s a trader, and while normal people pretty much understand what someone like Warren Buffett does, or what someone like John Paulson does, it’s much harder to understand what a trader does, or what differentiates a good trader from a bad trader.

Trading isn’t usually about making bets, and then cashing them in when things go as you thought they would. It’s more about understanding probabilities, seeing when securities are mispriced, taking advantage of fleeting arbitrage opportunities, being paid for providing liquidity to the markets (selling when others are buying, buying when others are selling), and, most importantly, “reading the tape” — understanding the way that money is flowing around the market, and how those flows are going to manifest themselves in securities prices.

Being a great trader is hard work: you’ve got to be constantly aware of subtle price actions in dozens of different markets and thousands of different securities. (Jim Cramer is a great example of a trader: he doesn’t have a deep understanding of any particular stock, but he knows where thousands of them are trading, and how their movements relate to each other.) What’s more, trading is hard to scale effectively. You need to be a certain minimum size in order to be effective, but there’s a maximum size too: you have to be able to get in and out of positions without moving the market so much in doing so that you end up erasing all of your profits.

Being a great trader is also increasingly difficult. 30 years ago, for instance, you could make surprisingly good money with very, very basic strategies. You could buy convertible bonds at issue, for instance, and hedge by shorting the underlying stock; or, even more simply, you could just pick a set of stocks and buy consistently at the bid while selling consistently at the ask. The buyers and sellers would pretty much cancel each other out, and you’d pocket the bid-ask spread, which, in the years before decimalization, was often substantial.

Today, however, all of those strategies have been arbitraged away by algorithms, and the result is that markets are faster and more treacherous than ever. Strategies which seem as though they’re work very well often have enormous and unforeseeable fat tails: look at the monster losses during the quant meltdown of 2007, for instance, or JP Morgan’s crazy London Whale trade.

And yet there’s still one thing which can scale, and which will never be competed away by algorithms, and where the upside is much larger than the downside: black edge.

Cohen has never been easy to invest with. He deliberately charges some of the highest fees in the industry — his 3-and-50 makes the standard 2-and-20 seem downright generous. And even then it has historically been very hard to get him to agree to manage your money. Cohen makes his fund inaccessible for a reason: he knows how hard it is to scale the astonishing results he’s been posting, year after year, and that at the margin, the bigger he gets, the lower the returns he’s likely to see.

But at the same time, there’s no way that he can run a $15 billion trading book on his own. He has roughly 1,000 employees, of which about 300 are investment professionals. And if you’re one of those professionals, you have one of the hardest jobs in the business.

The way that SAC works is that Cohen gives his individual traders, and teams, their own trading accounts, with millions or billions of dollars: the traders who make the most money get the biggest allocations. Traders get paid a percentage of the profits they make, which makes them compete against each other: in order to be successful at SAC it isn’t good enough to make good profits. Instead, you have to make better profits than any of the other traders — who themselves are some of the best in the business. If you can’t do that, you get fired. If you can do that, you get to manage ever-increasing amounts of money — plus, Cohen will mirror your positions in his own account, the largest at the firm, giving you a shot at extra profits over and above the ones generated by your own positions. In the immortal words of David Mamet, first prize is a Cadillac El Dorado. Second prize is a set of steak knives. Third prize is you’re fired.

While Cohen does still generate his own ideas, then, most of the time he outsources that function to his employees. There’s a relatively static allocation of capital between the various traders, but then there’s a dynamic overlay as well: Cohen “tags” the positions in his own account with the names of the traders whose trades they are, thereby giving every trader the opportunity to see his positions multiplied in size at any time. While his traders are moving money in and out of stocks, Cohen can be thought of moving his money in and out of his own traders’ positions. He’s not betting on stocks so much as he’s betting on individual employees, in one big zero-sum game.

As such, Cohen is much more than a simple employer/supervisor. He’s constantly sending clear and public messages to his traders, about what he likes, what he approves of, and what he disapproves of — and he’s sending those messages in the most unambiguous way possible, in the form of extraordinarily large sums of money. If he wanted to, he could withhold money, and even employment, from anybody who was working with black edge. Alternatively, he could manufacture a spurious layer of deniability, while actively encouraging, in terms of financial incentives, the one kind of trade which has the very best risk-adjusted returns.

The SEC’s decision to charge Cohen with failing to supervise his employees is, yes, a clever way to try to put together the most winnable case before the statute of limitations runs out. But it’s also a serious charge which goes straight to the main way in which Cohen makes his money. Cohen’s returns come directly from the way that he supervises and incentivizes his employees, and once you’ve read the complaint, it’s pretty clear that Cohen loves any trade which makes money, and has no particular compunctions when it comes to whether or not the trader in question is behaving in an entirely legal manner.

It’ll be interesting to see Cohen’s defense to these charges, but he has an uphill task ahead of him — especially given that the hearing will be held in front of the SEC’s own judge. The SEC has home-field advantage, here, while Cohen oversees a firm which has seen four different traders already plead guilty to criminal insider-trading charges. It’s good that the SEC has finally managed to charge Cohen personally, rather than just his traders. The only pity is that we’re still a long way from a criminal case. That might yet come, but I’m not holding my breath.


While the government can show a clear pattern of abuse by at least 3 of his 300 investment professionals, he can dump reams of legally justifiable securities research of why they entered and exited every one of tens of thousands of positions.

In my view this gets back to the difference Felix often points out between US and UK laws:

Did Cohen violate the spirit of the law by hiring well connected individuals, strongly encourage them to use and even create expert networks which by their nature were on the edge of the law while at the same time force them to sign ironclad code of conduct contracts swearing never to use insider information. Absolutely he violated the spirit of the law.

When you get to the technicalities none of it sticks to him. After reading the complaint I think he’ll walk if he is tried by a jury of his peers.

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Why there’s less high-frequency trading

Felix Salmon
Oct 15, 2012 16:50 UTC

Nathaniel Popper arrives today with something that looks like good news on the high-frequency trading front: there’s less of it!

Profits from high-speed trading in American stocks are on track to be, at most, $1.25 billion this year, down 35 percent from last year and 74 percent lower than the peak of about $4.9 billion in 2009, according to estimates from the brokerage firm Rosenblatt Securities…

The firms also are accounting for a declining percentage of a shrinking pool of stock trading, from 61 percent three years ago to 51 percent now, according to the Tabb Group, a data firm.

This is all true, and in fact it probably is good news, at the margin. But it’s not very good news, and it’s not as good news as it might look at first glance. Because while the number of trades is indeed going down, the number of orders is going through the roof. Here’s how I put it in my Radio 3 essay:

One 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.

Call it the Stalemate of the Spambots: the HFT algos are all so sophisticated, now, that they just ping each other with order spam, rather than actually trading shares. Naturally, if you don’t trade shares, you can’t make money. But at the same time, anybody who does trade shares risks getting picked off by the very algorithms which are increasingly circling each other like prizefighters who never land a punch.

All of which is to say that just because HFT algobots aren’t trading as much any more, doesn’t mean that the waters are any safer for real-money accounts to re-enter. Indeed, the exact opposite is more likely: that the bots have poisoned the stock-trading waters so much that even the bots themselves fear to go in.

As a result, market regulators still have a huge amount of work to do, starting with a serious attempt to cut down on quote-spam. There’s no reason why regulators shouldn’t effectively ban the practice of putting in non-serious orders which disappear in the blink of an eye — although the risk, of course, is that if the algobots are banned from confusing each other with quote spam, then they’ll just revert to dominating trading instead. Which is why I still like the idea of a financial-transactions tax.

Popper says that “now that the high-speed firms are shrinking from the market, there are some indications that trading costs may again be rising.” This might be true, but it’s negligible: we’re talking here about a tiny uptick from 3.5 cents per share to 3.8 cents per share, after a long fall from a level of 7.6 cents in 2000. There’s no indication that this is either a trend or anything to be worried about.

In any case, let’s not assume that rising trading costs are always and necessarily a bad thing. Trading costs right now are incredibly low — low enough that they can, actually, rise a little bit without doing any visible harm. Fear of rising trading costs must not prevent us from continuing to prosecute the war on HFTs — especially if there are indications that we’re slowly beginning to win it.


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.

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HFT charts of the day, trading-cost edition

Felix Salmon
Aug 14, 2012 15:33 UTC

14speed-articleInline.jpg The Nanex HFT chart I posted last week went viral, becoming by far my most popular post of the year; I even did a version of it for Buzzfeed. In the comments to that post, Kid Dynamite defended high-frequency trading by saying that spreads have tightened in substantially for everyone as a result of HFT. But neither of us really had the numbers — until now.

The NYT’s Nathaniel Popper, today, runs this pair of charts, which basically tells us everything we need to know. The main thing you need to notice is that the x-axis is the same on both charts, running from 2000 to the present day; my HFT chart from Nanex ran from 2007 to the beginning of 2012.

What’s clear from the top chart in the NYT (and from my Nanex chart) is that the explosion in HFT took place from 2007 onwards. And what’s clear from the bottom chart in the NYT is that benefits to small investors more or less stopped at that point.

First, let’s be clear about what these charts are showing. HFT is maybe a bit misnamed, since what we’re seeing here is two separate eras. From 2000 to 2006, trading got faster and cheaper. From 2007 to date, trading itself hasn’t actually risen much, or got faster. the huge spikes are in quotes, rather than trades, and it’s not uncommon for certain stocks to see more than a million quotes over the course of a single day, even when they are only traded a couple of dozen times.

You know the track cycling at the Olympics, where the beginning of the race is entirely tactical, and the trick is not to go fast but to actually position yourself behind the other person? HFT is a bit like that: the algorithms are constantly putting up quotes and then pulling them down again, in the knowledge that there’s very little chance they will be hit and traded on. The quotes aren’t genuine attempts to trade: instead, they’re an attempt to distract the rest of the market while the algo quietly trades elsewhere.

As such, the vast number of quotes in the market is not a genuine sign of liquidity, since there really isn’t money to back them all up. Instead, it’s just noise. But don’t take my word for it. Here’s Larry Tabb, the CEO of Tabb Group, and a man who knows vastly more about HFT than just about anybody else:

Given the events of the past six months, the SEC should think hard about the market structure it has created, and do its utmost to rein it in. While the SEC can’t stop computers from getting faster, there is no reason it can’t reduce price and venue fragmentation, which should slow the market down, reduce message traffic and lower technology burdens.

Until we can safely manage complex and massive message streams in microseconds, fragmentation is making one of the greatest financial markets of all time about as stable as a McLaren with its RPMs buried in the red.

HFT causes stock-market instability, and stock-market instability is a major systemic risk. No one’s benefitting from the fact that the entire market could blow up at any second. So why isn’t anybody putting a stop to it?


It hardly worth considering the facile size of the spread without considering how much one might transact at that price as well as the cost of transacting orders of increasing size. One needs to ruminate upon such a chart in (at least!!) three dimensions – the third being size. For what is the utility of a tighter inside spread if HFT creates a feedback loop from initial transaction/quote-change information that elevates the ultimate cost of completing one’s transaction? I’m not saying it definitively does increase the cost, and comparatively specialists of old and NASDAQ mmkers were no angels or altruists, but it serves little purpose outside positive PR for HFT to make less-than-sensical definitive and categorical statements about HFTs relative and absolute virtue without a little more substantiation.

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Dennis Kelleher, Libor, and high-frequency trading

Felix Salmon
Aug 8, 2012 06:03 UTC

Dennis Kelleher of Better Markets has responded to my post in which I said, inter alia, that he was wrong about high-frequency trading. He, of course, says that I’m wrong — indeed, that I’m “over the top and just plain wrong in many ways”, and that the post is “self-discrediting”. Blogfight! So, fair warning: this post is my response to his response to my post; if you’re not into that kind of thing I fully understand, and you’re probably much more grown-up than either of us. Anyway.

First, Felix totally overlooks the fact that some of the biggest banks in the world knowingly committed multiple very serious crimes by rigging the Libor rate.

It’s true I didn’t dwell on this, because it really wasn’t the subject of my post. My point was that whenever something scandalous or unacceptable happens in the financial markets, it’s not enough that the activity is scandalous or unacceptable: the financial press also feels the need to demonstrate that the little guy was being ripped off somehow. Even if he wasn’t. In this case, I’m perfectly happy to agree with Kelleher that rigging Libor was a very serious crime.

Kelleher accuses me of ignoring other things, too, like the difference between the two separate parts of the Libor-rigging scandal. Again, yes, I didn’t mention that. I also didn’t mention Standard Chartered, or HSBC money-laundering, or, for that matter, the Olympics badminton scandal. Kelleher has made it his life’s work to rail against such things, so maybe he feels that I should mention them in every post I write. But I can hardly be wrong about something if I didn’t even mention it.

He does, however, say that I’m “dead wrong that no one was harmed by the banks rigging the Libor rate”. This is a bit of a nasty accusation, because if I’d said that no one was harmed by the Libor rigging, then indeed he would be quite right to call me wrong. But I never said anything like that. He also says that I don’t understand interest-rate swaps, and proceeds to give a perfectly accurate explanation of how they work. And again, his explanation doesn’t contradict anything I said. But I do think he misses my point, so let me try again.

Kelleher uses an example of a municipality which has entered into an interest rate swap and is paying a fixed rate while receiving a floating rate linked to Libor. Such swaps are designed to protect borrowers from rising interest rates; the flipside of the deal is that if rates fall, then the borrower will end up losing money. And as it happened, rates fell, and the borrowers ended up losing money.

Now here’s the thing: the municipalities didn’t insist on linking the interest-rate swap to Libor because their borrowing costs are particularly bank-like. They just used Libor because it was the market standard, a proxy for interest rates more generally. The Libor scandal — and, yes, it is a scandal — is that the banks ended up printing a rate for Libor which was closer to prevailing interest rates than it should have been. Because Libor is tied to the interest rate on unsecured bank debt, it can actually rise when interest rates are falling, if the credit spread on bank debt rises fast enough. From the point of view of borrowers engaging in interest-rate swaps, that’s a bug, not a feature. What they want is a simple proxy for interest rates; they don’t want a proxy for interest-rates-plus-financial-sector-credit-spreads.

So Kelleher is right, in a narrow sense, when he says that if you were receiving floating-rate interest payments linked to Libor, then you got less money than you should have got. Because according to the contract, your payments should have included that extra bank-credit-spread component, on top of the interest-rate component. But my point is that no one ever entered into an interest-rate swap because they were making a bet on bank credit spreads rising. As a result, the losses here are losses of windfall, unexpected revenues. And of course there are just as many borrowers who entered into floating-to-fixed interest-rate swaps: they ended up winning just as much as the fixed-to-floating borrowers ended up losing.

It’s worth taking a step backwards here. In the grand scheme of things, borrowers gained rather than lost from the Libor manipulation, because it meant that they paid less interest on floating-rate debt. The real losers here are investors who bought floating-rate debt, and who should have been paid more than they were. My point is that if you’ve found someone claiming to have lost money as a result of the Libor manipulation, and they’re a borrower rather than an investor, you’re pretty much scraping the barrel. The Libor scandal is scandalous for many reasons, first and foremost that it involved banks lying in order to manipulate a hugely important interest rate. You don’t need to show borrowers losing money in order for there to be a scandal here: there would be a huge scandal even if no borrowers lost any money at all.

Kelleher then moves on to the main subject of my post, which was high-frequency trading. I said he was wrong when he said on a TV show we were on that shops like Knight rip off small investors. He replies:

Mr. Kelleher distinguished between high speed trading (really high speed market making) and predatory high frequency trading (HFT). Maybe not the most precise way to talk about these activities, but not too far off the mark for a general audience. It was the later practice not the former that Mr. Kelleher said rips off small investors, frequently referred to in the market as dumb money. (Not mentioned was that, because shops like Knight pay for order flow from retail brokers and pick off what they want, there are fewer natural buyers and sellers in the market and only professional or toxic retail flow actually gets to the market.)

OK, let’s make a distinction between high-speed market-making, on the one hand, and HFT, on the other. If you’re making that distinction, then Knight absolutely falls into the former category: it’s one of the helpful market-makers, rather than one of the predatory algobots. This part of the show hasn’t made it onto the internet, but I can assure you that Kelleher never explained that his distinction, at the margin, actually makes Knight look better rather than worse.

But in any case, the high-frequency algobots don’t rip off small investors, because the two never come into contact with each other. If a small investor puts in a stock trade, it ends up being filled by Knight, or one of the other high-speed market-makers. The algobots are whale-hunting: they’re looking for big orders from institutional investors, which they can game and front-run and otherwise prey upon. If small investors ever found themselves naked in the open oceans of the markets, the same thing might happen to them, but they don’t: they’re protected from those waters by companies like Knight, which will give them exactly what they want at the national best bid/offer price.

You’d think that Kelleher, having made the distinction, would be happy that small investors don’t end up being picked off by predators, but he’s not: he reckons that because they’re not out in the open ocean, that means “there are fewer natural buyers and sellers in the market”. Well, you can’t have it both ways. And frankly if retail investors did return to the market, it wouldn’t help matters: there wouldn’t be more volume or more liquidity or any visible positive effect.

So why did Kelleher even make his distinction in the first place? Just so that he could then come out and say that “HFT is a liquidity taker, not a liquidity provider”. In order to say that, he needs to exclude high-speed market-makers like Knight, who clearly do provide liquidity to retail investors. When I said that high-frequency shops provide liquidity to the market, I was very much talking about Knight, and I can assure Kelleher that everybody who was watching TV on Monday night thought that he was talking about Knight as well. After all, it’s Knight that’s in the news right now.

Finally, Kelleher pushes back against my “anti-regulation stance”, which is quite hilarious; he also informs his readers that “Felix also sees HFT as nothing but a force for good.” Maybe he didn’t see my post on Monday, where I talked about how HFT is “quite literally out of control”. I concluded that post by saying that “the potential cost is huge; the short-term benefits are minuscule. Let’s give HFT the funeral it deserves.” So obviously I don’t consider HFT to be “nothing but a force for good”.

The fact is, however, that I don’t need to go back to Monday’s post to demonstrate my anti-HFT bona fides. In the very post that Kelleher’s responding to, I write this:

I do think that the amount of HFT we’re seeing today is excessive, and I do think that we’ve created a large-scale, highly-complex system which is out of anybody’s control and therefore extremely dangerous.

Kelleher, then, is a man who, immediately after reading those words, can turn around and describe me as someone who sees HFT as nothing but a force for good. It’s very hard to know how to respond to such a person, but I guess that does at least explain why he thinks I said so many things I never said. He might think he’s responding to me, but in fact he’s just creating a straw man and putting my name on it. Which, frankly, is a little bit annoying.


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

Small investors vs high-speed traders

Felix Salmon
Aug 7, 2012 15:02 UTC

One of the problems with financial journalism is its rather kludgy attempts to appeal to a general audience. If something bad happens, for instance, it has to be presented as being bad for the little guy. This was a huge problem with the Libor scandal, since anybody with a mortgage or other loan tied to Libor ended up saving money as a result of it being marked too low.

But don’t underestimate the imagination of the financial press. For instance, what if there was a New York county which put on Libor-linked interest rate swaps to hedge its bond issuance? In that case, if Libor was understated, then the hedges would have paid out less money than they should have done — and presto, the Libor scandal is directly responsible for municipal layoffs and cuts in “programs for some of the needy”.

This is all a bit silly. The Libor understatements actually brought it closer to prevailing interest rates; the fudging basically just served to minimize the degree to which the unsecured credit risk of international banks was embedded in the rate. And in any case, the whole point of a hedge is that it offsets risks elsewhere: it’s intellectually dishonest to talk about losses on the hedge without talking about the lower rates that the municipality was paying on its debt program as a whole.

We’re seeing the same thing with the fiasco at Knight Capital, where a highly-sophisticated high-frequency stock-trading shop lost an enormous amount of money in a very small amount of time, and small investors lost absolutely nothing. On the grounds that we can’t present this as news without somehow determining that it’s bad for the little guy, it took no time at all for grandees to weigh in explaining why this really was bad for the little guy after all, and/or demonstrates the need for strong new regulation, in order to protect, um, someone, or something. It’s never really spelled out.

The markets version of the Confidence Fairy certainly gets invoked: Arthur Levitt, for instance, said that recent events “have scared the hell out of investors”. And Dennis Kelleher of Better Markets goes even further: I was on a TV show with him last night, where he tried to make a distinction between “high-frequency trading” and “high-speed trading”, and said that shops like Knight rip off small investors. He’s wrong about that: they absolutely do not. Yes, Knight and its ilk pay good money for the opportunity to take the other side of the trade from small investors. But those investors always get filled at NBBO — the best possible price in the market — and they do so immediately. Small retail investors literally get the best execution in the markets right now, thanks to Knight and other HFTs. And those investors want companies like Knight to compete with each other to fill their trades as quickly and cheaply as possible. If Knight loses money while doing so, that’s no skin off their nose.

So Andrew Ross Sorkin is right to treat such pronouncements with skepticism. The argument that “investors are worried about high-frequency trading, therefore they’re leaving the market, therefore stocks are lower than they would otherwise be, therefore we all have less wealth than we should have” just doesn’t hold water at all. Sorkin has his own theories for why the stock market doesn’t seem to be particularly popular these days, which are better ones, but the fact is — he doesn’t mention this — that the market is approaching new post-crash highs, and that if investors follow standard personal-finance advice and rebalance their portfolios every so often, they should probably be rotating out of stocks right now, just to keep their equity holdings at the desired percentage of their total holdings.

The calls for more regulation are a bit silly, too. Bloomberg View says that “if any good comes out of the Knight episode, it will be a commitment by Wall Street’s trading firms to help regulators design systems that can track lightning-speed transactions” — but regulators will always be one step behind state-of-the-art traders, and shouldn’t try to get into some kind of arms race with them. More regulation of HFT is not going to do any good, especially since no one can agree on the goals the increased regulation would be trying to achieve. If what we want is less HFT, then a financial-transactions tax, rather than a regulatory response, is the way to go.

I do think that the amount of HFT we’re seeing today is excessive, and I do think that we’ve created a large-scale, highly-complex system which is out of anybody’s control and therefore extremely dangerous. Making it simpler and dumber would be a good thing. But you can’t do that with regulation. And let’s not kid ourselves that up until now, small investors have been damaged by HFT. They haven’t. The reasons to rein it in are systemic; they’re nothing to do with individuals being ripped off. Sad as that might be for the financial press.


I agree with another post futher up the thread,HFT’s do not always hold on to postions for just seconds scalping the market ,it can be minutes ,it all depends on the trading system they are using.Some traders open between 15-20 position at a time and can remain open for hours if the market volumes are low. Nidal Saadeh UK

Posted by SAADEH | Report as abusive

Chart of the day, HFT edition

Felix Salmon
Aug 6, 2012 15:37 UTC


This astonishing GIF comes from Nanex, and shows the amount of high-frequency trading in the stock market from January 2007 to January 2012. (Which means that the Knightmare craziness of last week is not included.)

The various colors, as identified in the legend on the right, are all the different US stock exchanges. You might think there are only two stock exchanges in the US, but you’d be wrong: there are only two exchanges where stocks are listed. There are many, many more exchanges where stocks are traded.

What we see here is relatively low levels of high-frequency trading through all of 2007. Then, in 2008, a pattern starts to emerge: a big spike right at the close, at 4pm, which is soon mirrored by another spike at the open. This is the era of traders going off to play golf in the middle of the day, because nothing interesting happens except at the beginning and the end of the trading day. But it doesn’t last long.

By the end of 2008, odd spikes in trading activity show up in the middle of the day, and of course there’s a huge flurry of activity around the time of the financial crisis. And then, after that, things just become completely unpredictable. There’s still a morning spike for most of 2009, but even that goes away eventually, to be replaced with sheer noise. Sometimes, like at the end of 2010, high-frequency trading activity is very low. At other times, like at the end of 2011, it’s incredibly high. Intraday spikes can happen at any time of day, and volumes can surge and fall back in pretty much random fashion.

It’s certainly fair to say that if you take a long, five-year view, then you can see a clear rise in trading activity. But it’s also fair to say that there’s something quite literally out of control going on here. Just as the quants at Knight found themselves unable to turn off their machines for 30 long minutes last week, the HFT world in aggregate seemingly has a mind of its own when it comes to trading patterns. Or, to put it another way, if there’s a pattern here, it’s one incomprehensible to human minds.

Back in 2007, I wasn’t a fan of a financial-transactions tax; today, I am. And this chart shows better than anything why my opinion has changed. The stock market is clearly more dangerous than it was in 2007, with much greater tail risk; meanwhile, in return for facing that danger, society as a whole has received precious little utility. Are spreads a tiny bit tighter than they might be otherwise? Perhaps. But that has no effect on stock-market returns for long-term or even medium-term investors.

The stock market today is a war zone, where algobots fight each other over pennies, millions of times a second. Sometimes, the casualties are merely companies like Knight, and few people have much sympathy for them. But inevitably, at some point in the future, significant losses will end up being borne by investors with no direct connection to the HFT world, which is so complex that its potential systemic repercussions are literally unknowable. The potential cost is huge; the short-term benefits are minuscule. Let’s give HFT the funeral it deserves.


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

When large-scale complex IT systems break

Felix Salmon
Aug 1, 2012 22:33 UTC

It’s rogue algo day in the markets today, which sounds rather as though the plot to The Fear Index has just become real, especially since the firm at the center of it all is called The Dark Knight, or something like that. At heart, however, is something entirely unsurprising: weird things happen when you get deep into the weeds of high-frequency trading, a highly-complex system which breaks in entirely unpredictable ways.

In fact, it’s weirder than that: HFT doesn’t just break in unpredictable ways, but works in unpredictable ways, too. Barry Ritholtz has an excerpt from Frank Partnoy’s new book, Wait, all about an HFT shop in California called UNX:

By the end of 2007, UNX was at the top of the list. The Plexus Group rankings of the leading trading firms hadn’t even mentioned UNX a year earlier. Now UNX was at the top, in nearly every relevant category…

Harrison understood that geography was causing delay: even at the speed of light, it was taking UNX’s orders a relatively long time to move across the country.

He studied UNX’s transaction speeds and noticed that it took about sixty-five milliseconds from when trades entered UNX’s computers until they were completed in New York. About half of that time was coast-to-coast travel. Closer meant faster. And faster meant better. So Harrison packed up UNX’s computers, shipped them to New York, and then turned them back on.

This is where the story gets, as Harrison put it, weird. He explains: “When we got everything set up in New York, the trades were faster, just as we expected. We saved thirty-five milliseconds by moving everything east. All of that went exactly as we planned.”

“But all of a sudden, our trading costs were higher. We were paying more to buy shares, and we were receiving less when we sold. The trading speeds were faster, but the execution was inferior. It was one of the strangest things I’d ever seen. We spent a huge amount of time confirming the results, testing and testing, but they held across the board. No matter what we tried, faster was worse.”

“Finally, we gave up and decided to slow down our computers a little bit, just to see what would happen. We delayed their operation. And when we went back up to sixty-five milliseconds of trade time, we went back to the top of the charts. It was really bizarre.”

Partnoy has a theory about what’s going on here — something about “optimizing delay”. But that sounds to me more like ex-post rationalization than anything which makes much intuitive sense. The fact is that a lot of the stock-trading world, at this point, especially when it comes to high-frequency algobots, operates on a level which is simply beyond intuition. Pattern-detecting algos detect patterns that the human mind can’t see, and they learn from them, and they trade on them, and some of them work, and some of them don’t, and no one really has a clue why. What’s more, as we saw today, the degree of control that humans have over these algos is much more tenuous than the HFT shops would have you believe. Knight is as good as it gets, in the HFT space: if they can blow up this badly, anybody can.

I frankly find it very hard to believe that all this trading is creating real value, as opposed to simply creating ever-larger tail risk. Bid-offer spreads are low, and there’s a lot of liquidity available on a day-to-day basis, but it’s very hard to put a dollar value on that liquidity. Let’s say we implemented a financial-transactions tax, or moved to a stock market where there was a mini-auction for every stock once per second: I doubt that would cause measurable harm to investors (as opposed to traders). And it would surely make the stock market as a whole less brittle.

It’s worth recalling what Dave Cliff and Linda Northrop wrote last year:

The concerns expressed here about modern computer-based trading in the global financial markets are really just a detailed instance of a more general story: it seems likely, or at least plausible, that major advanced economies are becoming increasingly reliant on large-scale complex IT systems (LSCITS): the complexity of these LSCITS is increasing rapidly; their socio-economic criticality is also increasing rapidly; our ability to manage them, and to predict their failures before it is too late, may not be keeping up. That is, we may be becoming critically dependent on LSCITS that we simply do not understand and hence are simply not capable of managing.

Today’s actions, I think, demonstrate that we’ve already reached that point. The question is whether we have any desire to do anything about it. And for the time being, the answer seems to be that no, we don’t.


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