Discussion on High Frequency Trading and its Impact on the Markets

[Robert.Boston]

When I was studying at Yale, it was interesting to hear Jim Tobin's point of view on HFT (which was just in its nascence back then). He proposed what's now called a "Tobin tax" on transactions, a tax that is small enough that "real" investors don't care but one that hobbles the profitability of flash trading. As Jim put it, "While I believe we should have efficient markets, sometimes we need to throw some sand in the works to keep things from moving too fast." (or words to that effect)

 

[hershey101]

When I was studying at Yale, it was interesting to hear Jim Tobin's point of view on HFT (which was just in its nascence back then). He proposed what's now called a "Tobin tax" on transactions, a tax that is small enough that "real" investors don't care but one that hobbles the profitability of flash trading. As Jim put it, "While I believe we should have efficient markets, sometimes we need to throw some sand in the works to keep things from moving too fast." (or words to that effect)

I'm not sure what this would accomplish. If you are to believe that HFTs hinder investors, and as Lewis puts it, make you pay a tiny invisible tax, then basically you have moved the issue out of the private sector and into the government sector. Instead of HFTs collecting the money, the government would collect the money. But obviously the government isn't going to motivated in investing in better technology, and without the pressure from a group of companies seeking better latency and faster speeds, neither will the exchanges. I feel like it just ends up causing the industry to use out of date technology (and exchange technology is pretty dated as is) which isn't good for anyone.
Not to mention there is the whole question of how the tax would be collected on products that trade across nations etc. I would rather the money go to the private sector than government any day.

 

[Cosmacelf]

I agree. A tax is a horrible idea. Actually, even regulation isn't the best idea. I really do like what IEX is doing. An open transparent exchange. Let market forces decide what is a problem and what isn't.

 

[The Blue Owl]

I spent some time reading more about HFT. As it turns out, it's complicated.

After reading the links I included below, I've come around to believe that Michael Lewis and Brad Katseyama are most likely wrong when they assert that "the markets are rigged." I thought I'd post this for those in the audience who, like me, are not experts, but are curious about the subject. If you have an opinion that was shaped by the recent debate on CNBC and the 60 minutes piece (like I did), you may be surprised.

I remain a huge Michael Lewis fan, and I am currently reading his book. However, I no longer believe that HFTs are rigging the markets. I now think they are competing with each other to provide liquidity and price discovery, and are being compensated for it. I also think their way of doing it is not the only one, but as it is it, it drastically brought down the costs of trading for the retail investor.

I'm not an expert on this, so I am not going to defend what I just said above, because I'm not the best person to do it. Please read the links and reach your own conclusions.

1) HFTs are not Front-Running
2) A very informative discussion thread about how the markets operate. I found it best to ignore the speculation on motives, and focus on the explanations.
3) A longer piece on the subject, on which the above thread is based (I dislike the racial language at the beginning, but if you ignore that and the sarcastic tone, it makes a strong case for the role of HFTs in the markets)
4) A critical review of Michael Lewis' book on Amazon.

 

[TSLAopt]

I spent some time reading more about HFT. As it turns out, it's complicated.

After reading the links I included below, I've come around to believe that Michael Lewis and Brad Katseyama are most likely wrong when they assert that "the markets are rigged." I thought I'd post this for those in the audience who, like me, are not experts, but are curious about the subject. If you have an opinion that was shaped by the recent debate on CNBC and the 60 minutes piece (like I did), you may be surprised.

I remain a huge Michael Lewis fan, and I am currently reading his book. However, I no longer believe that HFTs are rigging the markets. I now think they are competing with each other to provide liquidity and price discovery, and are being compensated for it. I also think their way of doing it is not the only one, but as it is it, it drastically brought down the costs of trading for the retail investor.

I'm not an expert on this, so I am not going to defend what I just said above, because I'm not the best person to do it. Please read the links and reach your own conclusions.

1) HFTs are not Front-Running
2) A very informative discussion thread about how the markets operate. I found it best to ignore the speculation on motives, and focus on the explanations.
3) A longer piece on the subject, on which the above thread is based (I dislike the racial language at the beginning, but if you ignore that and the sarcastic tone, it makes a strong case for the role of HFTs in the markets)
4) A critical review of Michael Lewis' book on Amazon.

You would be best off finishing the Lewis book first before drawing conclusions about what the book is saying. The state of HFT cannot be argued either way in an article or paper, it needs a book to help explain.
let us know if it changes your viewpoint once your done with the book.

 

[The Blue Owl]

You would be best off finishing the Lewis book first before drawing conclusions about what the book is saying. The state of HFT cannot be argued either way in an article or paper, it needs a book to help explain.
let us know if it changes your viewpoint once your done with the book.

I fully expect to learn more from the book, and my position may evolve. My current position is tentative, and it only reflects my current understanding. The part that changed for me so far relates specifically to the strong assertion I have seen them make on TV that the markets are rigged. It's not that clear cut anymore for me that it's the case.

You're right, though, which is why I'll finish his book.

 

[apvbguy]

You would be best off finishing the Lewis book first before drawing conclusions about what the book is saying. The state of HFT cannot be argued either way in an article or paper, it needs a book to help explain.
let us know if it changes your viewpoint once your done with the book.

it would help if the book was not biased and a bit more factual

 

[TSLAopt]

it would help if the book was not biased and a bit more factual

I thought the book was very fair. HFTs are not evil or necessarily bad in their nature, they are just a product of a ever-more complex financial system with specific loopholes that now can occur within milliseconds.
What the IEX exchange is trying to do now to disrupt the stock market I view similarly to what Tesla is doing to try and disrupt the auto-industry for the better. The other auto-makers are not evil or bad natured either, they are a product of large corporations that rely on an ICE business model that has evolved over many decades.

when they say "the market is rigged" it is true in some context and untrue in others. In the context of what the book is talking about, it IS rigged in that there is this hidden unknown tax occurring on every single trade that 99% of people are completely unaware of.
Michael Lewis gives a great analogy of a casino(exchanges) that has a new poker table it created. It invites a few poker pros (HFTs) to play at the table. The casino explains a couple of unique rules (e.g. there are no Jacks and no 4s in the deck) for this poker table just to those poker pros and then the casino pays tour bus companies (Banks/brokers) to bus in the suckers (investors) who aren't aware that there are no Jacks and no 4s in the deck.
Anyone who has retirement savings in the stock markets (401ks, mutual funds, pension funds) is getting taxed from these unique rules that the investment managers of those funds can't know or compete with unless IEX succeeds, then I think there is a chance.

 

[Cosmacelf]

The WSJ has a front page article tonight talking about how the stocks of the consumer stock brokers (Schwab, etrade, etc) are getting hammered. Analysts have pointed out that they get a lot of their revenue from selling their order flow. There is speculation that the regulators are going to outlaw this entirely. At the very least, they have a reputation problem to sort through.

 

[apvbguy]

I thought the book was very fair
Michael Lewis gives a great analogy of a casino(exchanges) that has a new poker table it created. It invites a few poker pros (HFTs) to play at the table. T

when he makes absurd claims of the markets being rigged that is a bit unfair.
the new casino hasn't been invented, the old one was only modernized, the chairs on the deck were shuffled about and instead of having a centralized transparent marketplace you now have dozens of exchanges, "dark pools" and private deals that limits participation in the transactions.
the modern trading game is different in many ways and it is also an example of there being nothing new under the sun.

- - - Updated - - -

The WSJ has a front page article tonight talking about how the stocks of the consumer stock brokers (Schwab, etrade, etc) are getting hammered. Analysts have pointed out that they get a lot of their revenue from selling their order flow. There is speculation that the regulators are going to outlaw this entirely. At the very least, they have a reputation problem to sort through.

selling order flow is one huge root of corruption in the process of retail trading

 

[TSLAopt]

when he makes absurd claims of the markets being rigged that is a bit unfair.
the new casino hasn't been invented, the old one was only modernized, the chairs on the deck were shuffled about and instead of having a centralized transparent marketplace you now have dozens of exchanges, "dark pools" and private deals that limits participation in the transactions.
the modern trading game is different in many ways and it is also an example of there being nothing new under the sun.

- - - Updated - - -


selling order flow is one huge root of corruption in the process of retail trading

apvbguy, did you read the book from to back yet?

there are a lot of people who did not read it but are saying he's wrong. It's like saying Tesla is not that great of a car without test diving it yourself first.

 

[hershey101]

apvbguy, did you read the book from to back yet?

there are a lot of people who did not read it but are saying he's wrong. It's like saying Tesla is not that great of a car without test diving it yourself first.

True.... But the headline still stands as "stock markets rigged" and 85% of the people will just read that and form an opinion so its important to prevent the headlines from being wrong and mis-informative.

 

[apvbguy]

apvbguy, did you read the book from to back yet?

there are a lot of people who did not read it but are saying he's wrong. It's like saying Tesla is not that great of a car without test diving it yourself first.

did I comment on the entire book or did I comment on his assertions of the markets being rigged?

 

[hershey101]

Not sure if this was posted here but its a good read:
Michael Lewis: shilling for the buyside | Locklin on science

PS:
My masters research involved looking at the VPIN model (Volume-synchronized probability of informed trading), which is a model used by market makers to estimate the probability of informed traders being in the market and adjusting the bid/ask prices accordingly so they are not loosing money. That is what the blog author is referring to, and he makes a good point. How Lewis went from something that complex to "prices move because I tried to place the order, and I think its because they are front-running" is utterly insane.
For those interested, here is the wiki article on VPIN, feel free to PM me if you want to know more:
VPIN - Wikipedia, the free encyclopedia

 

[TSLAopt]

Not sure if this was posted here but its a good read:
Michael Lewis: shilling for the buyside | Locklin on science

PS:
My masters research involved looking at the VPIN model (Volume-synchronized probability of informed trading), which is a model used by market makers to estimate the probability of informed traders being in the market and adjusting the bid/ask prices accordingly so they are not loosing money. That is what the blog author is referring to, and he makes a good point. How Lewis went from something that complex to "prices move because I tried to place the order, and I think its because they are front-running" is utterly insane.
For those interested, here is the wiki article on VPIN, feel free to PM me if you want to know more:
VPIN - Wikipedia, the free encyclopedia

I read this conspiracy theory article Hershey thanks. I know you work for a HFT firm, but do you really feel that trading in micro-seconds or nano-seconds instead of milliseconds or seconds benefits investors somehow?

More than this 30bn+ year 'HFT tax' to every investor exposed to the stock market is the fact that HFTs disappear if things get too volatile such as in the Flash Crash...HFTs are driving electronic market makers out of business and this is a really bad risk as the next market 'glitch' caused by HFTs could be much worse than the Flash Crash.

HFTs are very smart and creative, but we need to look at the bigger picture here. The entire stock market and financial economy is at risk now because of HFTs. It's an arms race between HFTs that will continue until either a massive market meltdown occurs from some HFT algos gone wrong, or until the exchanges and brokers change behavior on how they deal with HFTs...i really hope this IEX exchange succeeds and I think it will as everyone becomes more informed on this topic.

 

[hershey101]

I read this conspiracy theory article Hershey thanks. I know you work for a HFT firm, but do you really feel that trading in micro-seconds or nano-seconds instead of milliseconds or seconds benefits investors somehow?

More than this 30bn+ year 'HFT tax' to every investor exposed to the stock market is the fact that HFTs disappear if things get too volatile such as in the Flash Crash...HFTs are driving electronic market makers out of business and this is a really bad risk as the next market 'glitch' caused by HFTs could be much worse than the Flash Crash.

HFTs are very smart and creative, but we need to look at the bigger picture here. The entire stock market and financial economy is at risk now because of HFTs. It's an arms race between HFTs that will continue until either a massive market meltdown occurs from some HFT algos gone wrong, or until the exchanges and brokers change behavior on how they deal with HFTs...i really hope this IEX exchange succeeds and I think it will as everyone becomes more informed on this topic.

I think that the distinction at the microsecond level is a bit insane. But this distinction is really only made in the equities markets, specifically in the US and european equities markets. That comes from the HFT industry being out of its infancy in these markets and well matured. I think these markets might need some force to be brought into stable equilibrium. However, I still feel there is plenty of value to be added by introducing high-frequency trading/alogrithmic trading to other equity markets, the FX markets, bonds, and derivatives markets. Derivatives markets (eg. options markets, equity options, index options, future options, interest rate options, fx options...) are very complicated to trade algorithmicly. This is where we need to focus the intellectual powers on. US/European equity markets from an HFT stand point are not very profitable anymore for new firms. The old names like Citadel will continue to run strategies to the point of break-even at these markets.
I look at the problem from "what can I do to make money by clever algorithms/automated trading systems". so to me, US equity markets aren't super interesting topic of discussion.
Yea sure, since 2010 I don't think there is much value that HFTs are adding to these markets, but the industry as a whole is shifting focus out of this area because there is more money to be made elsewhere and other in-efficiencies to exploit. The argument of "lets focus on US equities and debate till the sun goes down" is kinda pointless to me. Yea its a decent chunk of money that the old guard (Rennisance, Citadel, Bridgewater etc.) makes on these markets, but not nearly as much as people did pre 2010, and definitely no-where close to pre-2002 when HFT was really introduced in a big way. Let the old guard have its way, its barely noticable to the individual investor, and the institutional investors are finding smarter ways not to be scalped off by the HFTs. I would much rather focus my intellectual powers on newer, less-developed markets.

I guess what I'm saying is, yea after 2010, there isn't much more benefit that HFTs bring to US equities markets, but at the same time, there are more interesting problems to solve, and the HFT overhead so little (even in relation to what the overhead would be if say there were regulations etc.) that I don't see the point in discussing whether HFTs are continuing to do good in these markets.
From my prespective, I would prefer the US lawmakers to not waste their time focusing on this because the harm that the HFTs cause me when I try to trade equities non-existant. Whereas anything that the lawmakers would come up with would surely benefit the insitutational investor and put them in a better place but at my expense..
Sorry this isn't as well thought out as I would like it to be, but I hope you get the point I'm trying to get across.

 

[The Blue Owl]

Not sure if this was posted here but its a good read:
Michael Lewis: shilling for the buyside | Locklin on science

PS:
My masters research involved looking at the VPIN model (Volume-synchronized probability of informed trading), which is a model used by market makers to estimate the probability of informed traders being in the market and adjusting the bid/ask prices accordingly so they are not loosing money. That is what the blog author is referring to, and he makes a good point. How Lewis went from something that complex to "prices move because I tried to place the order, and I think its because they are front-running" is utterly insane.
For those interested, here is the wiki article on VPIN, feel free to PM me if you want to know more:
VPIN - Wikipedia, the free encyclopedia

I read it, and I also posted it in this thread. Notwithstanding the sarcastic (if entertaining) tone, I found it quite informative.

I agree with the argument that liquidity providers must protect themselves against informed traders in the process of providing said liquidity. I don't see why traders of large blocks should expect the market not to move, as long as no standing offer exists that can fill the entire order in one shot. When a big order can only be filled with multiple blocks from many different exchanges, the market should absolutely move, to protect not only the market makers, but also the other natural traders who may take the other side of the trade. This is simply price discovery working very well.

But there is way more than that in Lewis' book.

For instance, there is an example where a guy tries to trade with himself in two different accounts. First, he sends a mid-market buy order at $100.5 from one account. He stares at his offer, which is now sitting at the top of the book, for a few seconds. Then, he crosses the spread with a sell order for $100.1 from a second account. His first order to buy should now have been filled at $100.1, which was the best standing offer. Instead, he sees that the buy was filled at $100.5, and the sell was filled at $100.1. He bought from someone at the higher price, then sold to someone else at the lower price, for a $0.04 loss. That someone was the HFT lurking in the shadows. This happened consistently over hundreds of test trades.

One detail is that the first order was routed to a dark pool. I'm not an expert, obviously, so I don't know how Reg NMS is supposed to affect dark pools. However, it's clear that in this case no liquidity was provided whatsoever. No price discovery in the face of an informed trader took place either, since the orders were tiny and matched each other. I believe this behaviour does qualify as a form of "front-running"; it is wrong, and should be illegal.

Yes, I understand that the official definition of front-running refers to brokers not being allowed to trade in front of their customers, and that this is not that. However, when brokers sell their order flows to HFTs and send customer orders to certain exchanges offering taker rebates in order to provide HFTs with the right signals, that line is blurred. If the brokers did it themselves it would be illegal. However, them benefitting financially from allowing HFTs to do it is somehow ok.

The book is actually very informative, and I haven't seen anyone disputing the facts as it presents them. What's in dispute is the interpretation of those facts. Even if a lot (or most) of what HFTs do is legit and serves a purpose, in my humble opinion there is enough evidence to support the assertion that at least some aspects of the market are, indeed, rigged.

 

[hershey101]

For instance, there is an example where a guy tries to trade with himself in two different accounts. First, he sends a mid-market buy order at $100.5 from one account. He stares at his offer, which is now sitting at the top of the book, for a few seconds. Then, he crosses the spread with a sell order for $100.1 from a second account. His first order to buy should now have been filled at $100.1, which was the best standing offer. Instead, he sees that the buy was filled at $100.5, and the sell was filled at $100.1. He bought from someone at the higher price, then sold to someone else at the lower price, for a $0.04 loss. That someone was the HFT lurking in the shadows. This happened consistently over hundreds of test trades.

One detail is that the first order was routed to a dark pool. I'm not an expert, obviously, so I don't know how Reg NMS is supposed to affect dark pools. However, it's clear that in this case no liquidity was provided whatsoever. No price discovery in the face of an informed trader took place either, since the orders were tiny and matched each other. I believe this behaviour does qualify as a form of "front-running"; it is wrong, and should be illegal.

Yes, I understand that the official definition of front-running refers to brokers not being allowed to trade in front of their customers, and that this is not that. However, when brokers sell their order flows to HFTs and send customer orders to certain exchanges offering taker rebates in order to provide HFTs with the right signals, that line is blurred. If the brokers did it themselves it would be illegal. However, them benefitting financially from allowing HFTs to do it is somehow ok.

The book is actually very informative, and I haven't seen anyone disputing the facts as it presents them. What's in dispute is the interpretation of those facts. Even if a lot (or most) of what HFTs do is legit and serves a purpose, in my humble opinion there is enough evidence to support the assertion that at least some aspects of the market are, indeed, rigged.

In your example, are both limit orders sent to the same exchange? If not, then clearly what happened should happen because its an arbitrage opportunity across the exchanges. If so, then thats 100% illegal in regulated exchanges, and should be illegal in dark pools as well..

 

[The Blue Owl]

In your example, are both limit orders sent to the same exchange? If not, then clearly what happened should happen because its an arbitrage opportunity across the exchanges. If so, then thats 100% illegal in regulated exchanges, and should be illegal in dark pools as well..

Hmm... The first order was sent to a dark pool, the second to a public exchange. Is this arbitrage ok?

 

[hershey101]

Hmm... The first order was sent to a dark pool, the second to a public exchange. Is this arbitrage ok?

I think certain statistical arbitrage algos would pick this up and trade on it.
Eg. for example say 0.1% quotes on the exchanges present this behavior. certainly possible since not everyone has access to dark pools. Say some strategy notices this during backtesting and observes that 65% of the time when such a situation occurs, the quotes stay there long enough that you can trade on it (here long enough means the quotes are there for > the latency time to go to and from the exchanges). Then you can buy X shares at one exchange, and within a few microseconds sell X shares at the other exchange for essentially risk-free profit 65% of the time. Hence arbitrage. Nothing illegal here, simply market makers doing their jobs and making markets more efficient.