In a recent episode, the ever-brilliant Planet Money podcast looked at the arcane world of high-frequency trading. The usual clarity of exposition was further enhanced by something of a Mule theme. It seems that Planet Money host Chana Joffe-Walt is, like me, a Tom Waits enthusiast and she found a way to fuse “Whats He Building in There?” from the Mule Variations album with the otherwise non-musical subject of the podcast. An inspired choice.
So, what is high-frequency trading? Here is how Planet Money describes it.
In high-frequency trading, people program computers to buy and sell stocks in quick succession under certain, pre-defined circumstances. The idea is to profit from fleeting changes in the price of a stock.
This type of trading is made possible by the increased use of electronic trading platforms for financial markets around the world and is a special case of so-called “algorithmic trading” (or “algos”). It has been estimated that as much as 75% of the trades on the New York stock exchange were generated by algos and perhaps 50% on some European markets.
High-frequency trading has been generating some controversy in recent years:
High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.
Critics of high-frequency trading argue that it is a form of front-running, a practice which is illegal in most jurisdictions. The counter-argument in defence of the algos is that it increases the efficiency of the market. As Steve Rubinow of NYSE Euronext explains to Planet Money:
Every innovation of this type makes the market more efficient. … The faster we trade, and the more people you have trading, any aberrations that exist in the market are taken out of the market really really quickly, which makes for a fairer market for all participants … Those prices are about as fair as they could be.
Efficient markets are a good thing and I have used a similar argument here on the blog to defend short-selling. Nevertheless, there has always been something about high-frequency trading that makes me uneasy. In an interview with Edge, Emanuel Derman seems to put the finger on the source of this unease:
Also, people who benefit from it tend to over-accentuate the need for efficiency. Everybody who makes money out of something to do with trading tends to say, oh, we’re got to do this because it makes the market more efficient. But a lot of the people who provide this so-called liquidity and efficiency are not there when you really need it. It’s only liquidity when the world is running smoothly. When the world is running roughly, they can withdraw their liquidity. There is no terrible need to be allowed to trade large amounts in fractions of a second. It’s kind of a self-serving argument. Maybe a tax on trading to insert some friction isn’t a bad idea, just as long term capital gains are taxed lower than short term gains.
Derman started working as a “quant” in financial market around 25 years ago and had a long stint at Goldman Sachs. His response is not likely to be one of knee-jerk suspicion, but rather the considered voice of experience.
Joffe-Wolt’s reinterpretation of Waits conjured up an atmosphere of mystery and fear when exploring NYSE Euronext’s new data centre. Perhaps a bit of fear of high-frequency trading is healthy.
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It’s the “making money while making nothing” argument that sways the guts of most people. For most people, profit is justified by producing something useful. These guys seem to just be profiting from rounding errors and slight aberrations in prices. Whether the market is more “efficient”, and by what measures, as a result is a matter for debate.
The simplest, and probably most efficient, way to shut it down would be to insert a random 1-15 second delay in all trades. Now that’d mess up the arbitragers.
Simon: given that there is supposedly minutes in microseconds, even a fixed 1 second delay would probably suffice. Still, the exchanges would resist that as they benefit from increased turnover.
Algo trading is fine. A fair portion of the volume derives from ordinary fund managers getting positions set in an efficient manner.
HFT is not arbitrage. And true arbitrage profits are rare, and not evil.
Finally, has this HFT anything to do with the Flash Crash last May? And what about the 1987 crash?
And what about those proposals (backed even by Buffett and Soros, plus a host of economists) of a Robin Hood tax? Have you heard about them?
Simon: how is HFT different from day-trading (or even “buy and hold”) when it comes to making money for doing nothing?
The “mug punters” most likely to get hurt by HFT (or other forms of “bot trading) are the ones who are trying to do the same thing on a smaller scale, with fewer resources…
Paddy: I don’t object to true arbitrage either: it plays a clearer role in ensuring efficiency of the market. My discomfort with HFT comes from the sense that there is something other that arbitrage going on. Even if there is some form of efficiency gain, I am not convinced of the importance for the market of ironing out an “inefficiency” that exists at the scale of a microsecond but not a second (or even a minute). I don’t object to algo trading in general either.
Marco: it’s hard to know exactly the role algo and/or high-frequency trading had in the flash crash. Once again, Planet Money has something interesting to say on the topic.
The efficiency argument, in my mind, is similar to that for the finance sector “greasing the wheels of industry”, because with too much grease, there is too little friction and not enough traction to get work done. I’ve long thought that forcing “inefficiency” through disallowing rapid movements in and out of a stock would increase stability by forcing greater deliberation about the value and risk, a deliberation that underpins most of the arguments favoring a market system. (How much more carefully do people look at value when considering fixed term deposits?)
Well, what I could gather from those interviews is that for Robert Greifeld (NASDAQ OMX) it was all NYSE’s fault. For Duncan Niederauer (NYSE Euronext), it was all the smaller electronic markets’ fault. Thank goodness, nobody asked the latter: who knows who they would blame.
Greifeld says that the problem appeared when NYSE stopped trading P&G and 3M, due to their individual circuit breakers. Niederauer says that it’s a good thing they have individual stock circuit breakers, unlike NASDAQ, that has a market-wide one.
However, everybody is doing their best to fix the situation, but nobody knows exactly what happened. This, naturally, make us all very confident it’s never gonna happen again.
They mention that the SEC will fix the problem (although they themselves were already at it). The SEC woman (can’t remember her name), last I knew, didn’t know exactly what happened either.
The English guy interviewing Niederauer (Simon something, extreme right on the screen, looking like a funeral director) suggested the problem was created by LFT and algorithmic trading.
There was talk of a “fat finger” (I am thinking it might have been a fat middle finger), then there was talk that it all started at the Chicago Mercantile Board. The conspiracy theorists blamed Goldman Sachs…
It’s mid June; does anyone know how trades made during those 15 minutes were actually settled? (Not that it actually affects me: there is something good in being poor).
The computers have remained suspiciously silent about the whole episode. Maybe a tacit admission of responsibility?
The good thing is that I’m starting to believe the whole thing never actually happened! Thus, it couldn’t possibly happen again.
I don’t think all algo trading is abnormal trading. I have done some small algo trading, not typically same day stuff, but same week stuff.
John: Agreed. The mere fact that computers can be used to generate trades does not bother me. High-frequency trading does because, although I’m certainly not au fait with all the strategies used, I have the suspicion that at least some of it amounts to some form of market-manipulation or front-running. I can only say suspicion, because I certainly can’t prove any of that. It’s just what I have read about it makes me uneasy. The fact that Derman is dubious reinforces that feeling.
My thinking….aside from possible liquidity and market efficiency arguments & in simple terms….Assume we are aiming to get to Brisbane from Sydney, there are many ways to get there and some people will use one transport medium over other. It will also depend on the traveler’s spending capacity and ability to go from A to B to make the trip. The plain and distance from A to B is equal for all travelers – but some will go faster (or slower) than others and everyone is aware of the advantages….or disadvantages of choices. Isn’t HFT pretty much the same, some will use a Ferrari or a plane, others will walk or use a bus, horse or a mule….to get there – HFT invest (note the word invest) a lot of effort, people, technology and money in getting this systems right – it is there to make profits and these ‘advantages’ are open to all (equally) – no preferential treatment is given. HFT companies just chose to make things better, quicker and faster (they invest). At the high end, it creates good competition, and if other (high end) firms complain that this is bad or not fair, so what is it that needs to be good and fair? The fact that an institutional competitor (or retail private investor) cannot compete or does not want to compete does not necessarily translate into ‘unfair’ or does it? – As our traveler friend above can show, I think it just means that some don’t have the capacity or ability to compete because they have decided not to or don’t have the ability to invest as much – but why is this bad, unfair or negative? Isn’t this their problem and not the HFT firms? Wouldn’t it be like saying, well everybody gets to Brisbane by plane very fast, and because I cannot afford to travel by plane I need to catch the bus, then I tell my government that this is unfair and I claim that all travelers should be able to travel by plane and get all the perks with it! anything else is unfair. If you don’t invest (as the HFT firms have) you don’t get a reward (with or without risk). And in relation to ‘flash orders’, etc…Recall the outcry markets, flash order are just that, a guy screaming in the trading pit for a buy or sell order while imputing the trade into the ‘system’ – was that front-running or unfair?
Harold: it is a tricky issue. I am torn between feeling there’s something not quite right about it and thinking that it is all about efficiency. Interestingly, I remember being told once by a Swiss guy who claimed that Switzerland had no insider-trading restrictions. The logic was that it was better to allow insiders to trade on the basis of the information they have and allow the information to be rapidly priced into the stock. In this sense, allowing insider-trading is more efficient. Now most countries do not take this approach and draw the line somewhere. The question of HFT feels similar, particularly if the exchange is allowing some businesses to tap right into their networks at the source, to shave off the last millisecond.
If it interests you, I happen to know that there are a number of HFT companies active on the ASX, but the bigger ones typically call themselves Market Makers and they primarily trade in derivatives.
There is certainly no preferential access system on the ASX, but it is relatively costly to trade from the Exchange’s Colocation facility compared to other access methods, but importantly it is open to any full participant in the market. Some companies also offer shared access to Colocation facilities to 3rd parties who do not have their own setup within the facility because they are foreign firms or are not a full participant. They are still able to gain access to the same facility and the same systems however.
It is true though that liquidity is only offered when it’s beneficial to the trader, quotes can be withdrawn or priced out of a reasonable value very quickly if there is too much uncertainty, and any bids or offers are traded only when it’s profitable to do so – they are of course a business like any other.
Mostly the arms race to the millisecond is played out between a set of HFT companies, all who have access to the same systems. If these companies beat another institution to a trade that they wanted, it is precisely because they have invested a lot of time and effort into having this ability, not because they have unfair access that only a few can obtain. If the costs are too high to have access to the Colocation facility, such that these institutions or other investment houses choose not to enter the facility, they have made the choice – that they don’t see a profitable business case to pay the extra fees associated with the access, and therefore are much more likely to miss trades that they otherwise would have a competitive chance at winning. Either that, or they are ignorant of the facilities availability and/or the companies that provide access to it.
Although there are a few of cases of market manipulation by some of these firms in other overseas markets, I do not believe it is common practice amongst the HFT companies. Market Manipulation is dangerous because the company’s only business interest can be completely taken away from them if they are discovered – eg, being banned from the market means they would have to shut up shop or move to another country and always comes with a reputational cost to the business. In any case, you do not need millisecond access to manipulate the market, there are probably far more cases of non HFT traders doing this than there are HFT traders – bad apples are bad apples no matter what basket you put them into. Granted some strategies appear opaque, and behavior mysterious when viewed only through the narrow focus of an investment house processing market data, but it is a leap to say that because it is not understood by the observer that it is illegal.
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