« Interview with Kenneth Arrow | Main | Identifying and Popping Bubbles: Evidence from Experiments »
High-frequency trading
A few MR readers ask about high-frequency trading. Senators are calling it unfair because some traders have access to more powerful computers,and better quants, than do others. The traders with the most powerful aids get there first and make more money. Here is a typical critique. Felix Salmon is also skeptical.
I do not worry about high-frequency trading. Telegraphs and telephones also brought their own, earlier versions of high-frequency trading. As did stock index futures. There are second-best arguments relating to hockey helmets and the like but that is the case with most forms of progress and greater economic speed. You don't have to think that the current profits measure the current social value of high-frequency trading to argue that the overall trend should be allowed. The correct judgment of efficiency occurs at the system-wide level, not at the level of the individual trading strategy. The short-run story is that private profits exceed social returns but in the longer run the trading activity and liquidity brings increasing social returns and better communication of information.
I'm not a believer in the strong versions of efficient markets hypotheses, so I do admit that high-frequency trading, like just about every other trading strategy, can bring short-run "whiplash" effects on market prices. But if you don't like it, you can trade yourself at much lower frequencies, which is probably what you should be doing anyway. At the same time high-frequency trading smooths out or shortens many other cases of price whiplash. High-frequency trading brings more liquidity into the market. Call it "low quality liquidity" if you wish, but it still looks like net liquidity to me.
The complaint is that this liquidity sometimes vanishes. Maybe high-frequency trading can scare other traders out of the market; that charge has been leveled against every method of informed trading. In the short run it is sometimes true but markets respond by upping the general requirements for quality trading and many market participants rise to meet the new standard or else switch to longer time horizons.
On the critical side there is lots of talk of "unfairness" and "manipulation," combined with snide references to the financial crisis. I'd like to see a serious efficiency argument against high-frequency outlined and defended, without the polemics. That would include a case that regulation will prove workable and catch only the "bad liquidity," while at the same time avoiding capture by envious and inferior competitors.
If high-frequency trading is used to trick other traders into revealing their demand schedules, and then canceling orders, I can see a case for regulating that particular practice. On that issue, here is background, from a critic, but note that these charges seem to be unverified.
The philosophical question is why it might possibly be beneficial to have market prices adjust within five seconds rather than within fifteen. One second rather than five? 0.25 rather than one? If you had been writing in the year 1800, what comparisons would you have chosen?
Remember that old comic book where they had Superman race against The Flash? The Flash won. Someone had to, just keep that in mind.
Posted by Tyler Cowen on July 29, 2009 at 03:48 AM in Economics | Permalink
Comments
i like these posts where you give us a clear, well-laid-out position on an economic issue.
Posted by: sean at Jul 29, 2009 3:59:29 AM
Your blog's theme is "small steps toward a much better world." I see your efficiency argument, but how does high-frequency trading lead us toward a better world? Doesn't it just benefit the traders?
Posted by: Andrea at Jul 29, 2009 4:21:44 AM
i think that's what he was addressing with this paragraph:
"The philosophical question is why it might possibly be beneficial to have market prices adjust within five seconds rather than within fifteen. One second rather than five? 0.25 rather than one? If you had been writing in the year 1800, what comparisons would you have chosen?"
Posted by: sean at Jul 29, 2009 4:29:25 AM
High-frequency trading makes the world a better place, just as finding a house in the housing market twice as fast as you would have found it otherwise makes the world a better place. I think the term "high-frequency" might be better understood as "higher-than-before frequency".
Posted by: mpkomara at Jul 29, 2009 4:31:31 AM
The argument against HFT is essentially the argument against insider trading and front running. Both of those arguably increase efficiency by quickly moving price, but hurt the market because of unfairness.
Posted by: fusion at Jul 29, 2009 5:05:40 AM
Is high-frequency trading just restricted to high-speed stock trading?
Posted by: Andrea at Jul 29, 2009 5:10:23 AM
I see this as being trader vs. trader with no real impact on the average shareholder or the company. I would hope that traders could work things out among themselves without govt regulation.
I see no reason to scare us with another "crisis". This crisis became a global event once millions of Americans found themselves in a worthless home, unemployed and with their savings wiped out. HFT trading won't do that.
Posted by: places to visit in Boston at Jul 29, 2009 5:15:29 AM
"I see this as being trader vs. trader with no real impact on the average shareholder or the company."
My finance professor devoted sometime talking about HFT, but I didn't really learn anything. Because all I took from that lesson is: keep your eyes on that screen.
But I just read a NYT op-ed article on HFT (http://www.nytimes.com/2009/07/29/opinion/29wilmott.html), and the author says HFT is based on computer algorithms.
Anyways, what is bothering me is HFT opposes to what I have been taught: for an average shareholder, or just someone who is interested in a company's stock, you really take time to study that company and then make a decision. HFT takes the studying and decision-making out. What fun is left in stock-trading?
If HFT adds more liquidity to the securities market, and if the stock is priced "correctly," how can the average stockholder /not/ be affected?
Posted by: Andrea at Jul 29, 2009 5:51:33 AM
It benefits some traders at the expense of other traders. So what? We don't have to speculate. We can follow the teaching of Warren Buffett who only uses his computer to play bridge with Bill Gates.
Posted by: Andrew at Jul 29, 2009 6:26:41 AM
If the blogger's blog content were scooped up electronically by a large media conglomerate and published ahead of the blogger, then society would benefit from the rapid dissemination of economic analysis. Others could then blog about the stupidity of any objections he might raise, since he would merely be objecting to big media's having access to big computers.
Posted by: dwinds at Jul 29, 2009 6:55:14 AM
High frequency trading is certainly not just US stock trading. Equities trading, however, is heavily regulated already--see in particular Regulation NMS. I do not think these regulations have the intended effect of protecting customers (I also do not believe the net effect of "high-frequency trading" is to harm customers). Dealing with these regulations is a large part of the job of a high-frequency equities trader.
Posted by: keikobad at Jul 29, 2009 7:23:55 AM
Sounds like a bunch of priests telling each other that predation on choir boys is really "efficient" and "utilitarian" and "consistent with the great ideas of our times, and personal freedom of choice."
"Envious and inferior competitors?" That sounds like serious economic analysis, all right. Yah, let's just applaud all those people who already have figured out ways to make present-value "profit" and "bonus" and "bailout" dollars out of mortgaging the future Real Wealth that has to pay for the bubble-blowing of today. After all, some day WE might get invited to learn the secret handshakes and Join The Club.
Hey, Warren Buffett has "people" to use computers to do stuff other than play chess with Mr. Bill. A big FAIL on that analogy.
You ASSUME that "liquidity" and "efficiency" are present in program trading, and it's all just about who has the fastest computer. These sound more like matters of faith than what might, very very charitably, be called economic science. This ain't an e-bay auction, and pray tell where does the "wealth" represented by trillions in program-trading-generated, virtually risk-free "investment" come from? It's just another face of the rip-off of the future that passes for High Finance these days.
Maybe your Goldman-Sachsers know that all of us have actually suffered the burst of sterilizing radiation you blogged earlier. They sure as heck appear to be living that self-gratifying, screw-the-can't-touch-ME future, wet dream. How pleasing to be able to live without consequences or restraints, with lots of Really Smart People happy to take a big salary to justify and if need be defend against the whining and pawing of the lesser orders.
Posted by: Jon at Jul 29, 2009 7:27:59 AM
Other very good firms are making hundreds of millions of dollars, but somehow Goldman is making 10's of billions. I don't see how the numbers add up. I know from friends at other feared HF firms that they are making tons of money, but not billions. These are firms that other people in the HF space fear and are also a significant percentage of stock and futures trading in the US. They are not making 10's of billions or even a billion. I can assure you their technology and well, everything about their firms is state of the art. We are talking NASA level quants and millions in technology for these other firms.
Goldman's HF operation was an offshoot of the Blair Hull trading firm purchase. They paid 900 million, I think. The word on the street 6 months later was that they overpaid. I don't see how they make a few billion unless they are frontrunning an order book.
Posted by: mickslam at Jul 29, 2009 7:31:06 AM
I've noticed a lot of people discussing "high frequency trading" getting incredibly angry over something they don't understand even slightly. Also, angry at Goldman specifically, as if Goldman does something unique in this space. Why?
From Tyler:
"You don't have to think that the current profits measure the current social value of high-frequency trading..."
I have no idea what the social value of high-frequency trading is, but you can ask the same question (private profit vs. social value) about trading in general. High frequency trading is not a high percentage of average annual trading profits across the banking and hedge fund world. Also, high frequency trading profits are declining significantly in 2009 on lower volatility.
Posted by: keikobad at Jul 29, 2009 7:40:38 AM
great post
Posted by: nate at Jul 29, 2009 8:26:10 AM
keikobad
All big Wall St firms and many hedge funds have algorythmic trading "desks" (racks?), but Goldman is able to make vastly more money than all the others even though all have similar input. The thought is that Goldman is most likely sniffing institutional orders (illegal) rather than just noticing trading patterns and acting (legal). A scenario is something like this: institution sends order to broker who transmits it to the NYSE, but while it is in transit, Goldman's computer reads the message and matches the trade the institution is doing then reselling (buying back) the shares it just bought (or sold) at a higher (or lower) price.
Posted by: nelsonal at Jul 29, 2009 8:52:41 AM
Tyler rather misses the point. There's nothing wrong with a technology that lets the market incorporate information faster. But we're really talking about an institutional rule that allows the HFTrader to see other people's orders before they buy the stock, and make trades on that basis:
http://www.nytimes.com/imagepages/2009/07/24/business/0724-webBIZ-trading.ready.html
The NADQAQ lets HFTraders see other people's orders before they're made.
So using the poker analogy, we're not talking about a new technology that allows players to calculate probabilities based on the visible cards; we're talking about a rule that lets some favored players look at the hands of other players.
"But hey," some people say, "it's not about fairness between traders. It's about efficiency."
Those people got it all wrong. Efficiency depends on fairness between traders. Markets converge to a collectively true probability estimate because anybody willing to bet money on their belief can participate. But if you give some players an institutional advantage, then other players realize a lower return from participation, and your market then reflects a narrower slice of beliefs. This is especially true if that narrow group of advantaged traders all reside and work in close proximity to one another, and face similar institutional and social incentives to hold similar beliefs.
Posted by: Keith at Jul 29, 2009 9:34:40 AM
I'm a high-frequency trader so take my comments on that basis. Prior to high-frequency trading and fully-electronic markets, the most trading profits went to the physically largest and most charismatic traders on the trading floors. By being large or gregarious they were more easily able to get the attention of brokers and get filled on their orders first, effectively front-running the other traders on the floor. On the NYSE, the specialist in charge of the book also could also extract profits at will. Since the advent of HFT, profits have moved from these traders to the ones with the best computer scientists. You can argue whether the new market is more efficient or fair, but you can't claim that the old one was somehow perfect and impossible to manipulate.
On the topic of flash orders, they do not allow HFTers to see orders before everyone else unless the customer placing the order chooses to allow it. There is nothing forcing your mutual fund provider to send a flash order and advertise the price the are willing to pay. They can continue to use the same limit orders they are using currently. the RegNMS rules state that you can't post a bid on your stock exchange better than an offer on some other exchange. Flash orders allow a trader to post such a bid on the NASDAQ without violating RegNMS.
Posted by: Matt at Jul 29, 2009 9:49:06 AM
"The philosophical question is why it might possibly be beneficial to have market prices adjust within five seconds rather than within fifteen. One second rather than five? 0.25 rather than one? "
The social benefit is the net present value of having "accurate" prices a few fractions of a second earlier. This benefit is a function of the discount rate, which is customarily expressed in annual terms, and the value of the changes in decision-making that might result under the new, more "accurate" prices.
I submit that the social benefit is trivial.
The private benefit is in the billions, but that is almost 100% rent-seeking. It is gained almost entirely at the expense of another party who's computer or trading algorithm might be fractionally slower.
This is an nice example of almost pure rent-dissipation. It's a case where the invisible hand of the market does more harm than good, by directing enormous capital resources and some of our most brilliant minds toward an activity that creates essentially zero value.
We should set up the rules of the game to maximize incentives for value creation and minimize incentives for rent dissipation. That suggests banning or heavily taxing HFT.
Posted by: a student of economics at Jul 29, 2009 9:53:42 AM
Are people really so sanguine about the future that they have nothing better to do than complain about high-frequency trading?
We're not out of the woods yet as far as systemic failure of the global financial system is concerned. There are still a number of shoes left to drop, and HFT is simply not one of them. Even if it were illegal frontrunning (which it is not), it would be the equivalent of stealing a penny from a billion bank accounts: not a threat at all to anyone in particular or to the system as a whole.
As the second wave of the long crisis washes over us over the next few years, people clinging to confabulated "protocols of the elders of Goldman" conspiracy theories are not being particularly helpful.
Posted by: anonymous at Jul 29, 2009 10:02:36 AM
"Hey, Warren Buffett has "people" to use computers to do stuff other than play chess with Mr. Bill. A big FAIL on that analogy."
So, you think Warren Buffett became the richest and best investor in the world by trading strategies? No. You are wrong. A big FAIL on any credibility you have for anything else you say. That's fine, most people don't understand it. He makes money buying ongoing businesses. He's made money on finance business probably none of which use trading to make their major profits. Maybe Goldman Sachs, but I doubt it.
Posted by: Andrew at Jul 29, 2009 10:12:56 AM
Hi Matt,
I don't think anyone in the space or that has been around it for a while thinks that HF is necessarily bad. I think people are beginning to question how Goldman makes an order of magnitude more money than anyone else in the space. I know people at firms where there are former Goldman top level people (for instance, the former head of technology for the goldman HF operation), and those firms are not making as much as goldman.
Why are these firms only making a few hundred million a year (or less!), but Goldman is able to pull 10X as much money out of the same market? It doesn't add up. Goldman must pay their people less money due to the structure of a company than a Chicago HF shop can...
Posted by: mickslam at Jul 29, 2009 10:14:20 AM
Sounds like high tech "front running" to me. I think the SEC has taken strike three: Madoff, naked shorting and now legalized front running. Time to terminate the SEC with extreme prejudice.
Posted by: Thomas Mullaney at Jul 29, 2009 10:15:44 AM
For a more skeptical take on the value of high-frequency trading and liquidity, I highly recommend economic sociologist Peter Levin's take on things. He always references the folks at socfinance, who have been discussing this issue.
Posted by: Dan Hirschman at Jul 29, 2009 10:34:43 AM
most high frequency traders are not attempting to move the market towards a true price. There are definitely some algorithms that do stuff that, but most of them are just attempting to trade against order flow and earn the bid/ask. Prior to decimilization in 2000 it made sense to do this manually, but now that you are fighting for a penny rather than an eighth, you have to be a little more sophisticated, and you have to trade a lot more and take on more risk to generate the same revenue. What we saw after decimilization was a huge decrease in the profits of equity market makers. Now, after 8 years they have figured out new ways to make that money and are doing well. In order to do well again they have had to trade a lot more so now we see much more volume and liquidity in US equities than even a couple years ago. The net result for institutional and retail investors is substantially lower net transaction costs.
The discussion on HFT seems to assume that you need enormous resources to do this stuff or compete in this space. That is just untrue. There are tons of small companies doing this kind of trading. The technology component (having co-located servers and the best datafeeds) costs around 5-50K/month depending on the exchange. Not exactly a domain that is reserved for only the biggest players. If you aren't willing to pay for that level of access, then you are presumably making the judgement call that it is not worth it.
I do HFT for a living (in futures, not equities, though I traded equities for years) and I have very little knowledge of what other successful high frequency shops are doing. I am always trying to figure it out, but no one is going around explaining the details of these algorithms. So, it is a little ridiculous for people who have much less involvement in the markets to think that they have this stuff all figured out and they know what the consequences would be to banning this activity.
Posted by: Joe Teicher at Jul 29, 2009 10:42:51 AM
[I'm not a believer in the strong versions of efficient markets hypotheses, so I do admit that high-frequency trading, like just about every other trading strategy, can bring short-run "whiplash" effects on market prices]
in other words, you're not a believer in the weak versions of the efficient markets hypothesis either.
Posted by: dsquared at Jul 29, 2009 10:53:29 AM
Putting ethics aside, HFT will be the next financial tower of Babel to fall in grand fashion. See portfolio insurance of 1987 and the smartest guys in the room at LTCM. To paraphrase Charlie Munger, having a bunch of smart finance guys compete with each other isn't quite the same as having a bunch of restaurant guys compete with each other.
Paul Wilmott weighs in: http://www.nytimes.com/2009/07/29/opinion/29wilmott.html
Posted by: Publius at Jul 29, 2009 10:55:00 AM
I work as one of these computer scientists in a lower tier electronic trading firm. Our problem with HFT is its predatory nature. the Getco's of world make most of their money prowling the market looking for split seconds mistakes and then exploiting them. That provides zero social benefit, and in fact, causes social harm. When market making firms know that there are sharks in the water, they tend to widen their spreads to compensate for the newly added risk. As such, the prices that consumers get filled at will be worse than what could have been achieved in a non predatory environment. The net result is that the HFT are extracting money from the investing public at large, so you should care.
But this brings up an important distinction between the normal HFT, this seems to be what Joe Teicher is doing, and the predatory HFT.
One of the proposed solutions to the predatory HFT is to force all order submitted to exchanges to remain live for a half second. This doesn't seem like much, but that half second is an eternity and would virtually stop the wave of predatory orders.
Posted by: Beerman at Jul 29, 2009 10:58:55 AM
Andrew, your implication was that Mr. Buffett eschews the use of computers except to play a particular computer game, and that QED it doesn't take computers to garner a lot of wealth. I would hazard a guess that Berkshire Hathaway has a lot of staff and silicon doing the fundamentals analyses. I was not in any way saying that Buffett and B-H are involved in program trading, just highlighting what looks like apples and oranges to me in your exemplar.
Posted by: Jon at Jul 29, 2009 11:35:19 AM
"One of the proposed solutions to the predatory HFT is to force all order submitted to exchanges to remain live for a half second. This doesn't seem like much, but that half second is an eternity and would virtually stop the wave of predatory orders."
This exists in certain markets. For instance, it exists in the cash gold market on EBS. It is favored by the old-school brokers and banks that don't want to compete with more sophisticated traders. It makes the market much less liquid. Making a tight market in that product is suicide because on a fast move you are going to get picked off every time.
I have serious doubts that a big company like Getco makes most of its money "prowling the market" looking for mistakes. Markets are just not that inefficient. That is not to say that if you do make a mistake they won't jump on you, but just that that is not their main business.
Here is a quote from their website:
"GETCO is a registered market maker. We provide continuous two-sided markets, by posting both buy and sell orders, in thousands of securities on major exchanges around the world.
Market makers serve a vital function in our capital markets. Through their quoting activity, they facilitate price discovery and help maintain orderly, liquid, transparent markets for investors.
Electronic market makers use technology to create efficiencies and reduce trading costs for investors.
Today’s electronic market makers risk their own capital with every trade, and succeed only if they provide accurate, competitive markets for investors."
Posted by: Joe Teicher at Jul 29, 2009 11:36:46 AM
Wait, why are you so dismissive of the "talk of "unfairness" and "manipulation?"
That's precisely the issue! It is an unfair advantage!
You reference telephones, but telephones quickly became cheap enough for everyone to use and so it very quickly afforded NO unfair advantage to the very wealthy.
However, I really do not think these crazy machines are going to be accessible to the average trader any time soon. So until it DOES become accessible, why not ban it? And when, like telephones, it to becomes common, you can unban it.
And, since you yourself are wondering what actual social benefit having these supercomputers trade brings, it seems that banning this practice would have no net costs to society, while all the time ensuring an equitable and just trading floor.
How am i wrong?
Posted by: C at Jul 29, 2009 11:42:41 AM
What is the evidence for the claim that Goldman is making tens of billions on high frequency? Is it that Goldman is having a strong 2009? Lots of traders doing lots of trades are having a good 2009, and in general high-frequency trading is much less juicy than in 2008.
Posted by: keikobad at Jul 29, 2009 12:00:33 PM
I'm a daytrader, and with Keith I don't see any problem with computerized trading except in two cases.
First, if the boxes (or their operators) screw up and their owners get crushed, I don't want to see those trades broken, but I see these trades broken every time. If the computer crushed you, that's your loss, just as if I have a keystroke error and give up $2/share on a big spread I have to take that loss.
Second, quote availability should be uniform for everyone. It's fine if your computer/connection is faster and therefore you are able to access that quote more quickly, but if you get privileged access to flash orders this is a problem.
Other than that, keep up the good work, HF traders!
Posted by: John at Jul 29, 2009 12:26:07 PM
What is the evidence for this: "High-frequency trading brings more liquidity into the market."
Volume and liquidity are very different things. The fact that traders who need to deal in mid and large size transactions find that they get better prices in "dark pools" tells you everything you need to know about the "liquidity" of our stock exchanges.
Since you've chosen to assume your result, it's not surprising that you think that high frequency is good for markets.
Posted by: m at Jul 29, 2009 12:28:42 PM
A reader sent me this very excellent comment, for some reason he could not post it himself:
"Is it possible to stop talking about front-running in a context of "flash" orders? It's an _additional_ order type available to the party entering order, so by deciding to use flash order the submitting party _prefers_ it to the traditional one. What is the problem with optional functionality which doesn't remove an ability to send regular limit orders?
First it was GS reported profit which seemed unjustified to some people, then someone noticed Program Trading numbers on NYSE and decided that GS made profit only on that exchange (although even firms with, say 20 people, trade globally), then where are "program" there is "speed" which is HFT and where there is a speed there are front-runners :)
My company is a software vendor in algo trading business and I'm looking at all this stuff around HFT as on typical reaction of people who need someone to blame, while these people don't understand how the world is actually work.
First, people confuse Program Trading (PT), Algorithmic Trading (AT), High-Frequency Trading (HFT) and Front-running (FR).
And really, HFT/Algo systems is not THAT expensive, so they are
available for "elite" participants only. The prices quotes above are correct for off-the-shelf systems.
I'm not very familiar with the US regulatory definition of PT, but I always thought that the Wiki explanation is correct:
"Program trading is casually defined as the use of computers in stock markets to engage in arbitrage and portfolio insurance strategies. However, the New York Stock Exchange (NYSE) defines the term as "a wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more" without any direct reference to the use of computers[1]."
So, let's say I want to buy a basket - this will be regarded as PT from this POV and included into widely quoted GS numbers. And imagine arbitrage between S&P basket and index fund like SPDR. But even forgetting about ETF arbitrage - almost any basket purchase/sell will be considered as PT.
Algorithmic Trading - this is trading involving computer system and it's really a lot of different stuff, for example:
* Order execution. People typically don't send huge orders to the market to avoid moving it (which leads to huge transaction cost). Instead they use strategies to execute these orders, be it VWAP/TWAP or something more complex, especially involving buying stocks traded on multiple venues. Noone really manages such orders manually.
* Arbitrage (stocks, options, ADRs, indexes, baskets etc)
* Hedging - similar to order execution. Hedging with huge orders is quite expensive...
* Market making in broad definition (not only option MM, but, say, MM in ADRs or original stock). This overlaps with arbitrage in some sense, since arbitragers act as market maker for the instrument they quote.
* Automatizing day-to-day operations. For example, you might get an FX exposure which you don't understand and want to get rid of it (similar to hedging).
HFT - this is a part of Algo Trading, since not all parties using algo trading systems care so much about _speed_. Especially if they trade on slow markets, if they automate their operations, like FX hedges etc. However, most algo trading vendors to promote speed as a key feature of their products, although few of them really say what speed do they have.
Front-running. I would say this is a small part of trading (I don't remember anyone doing this, but maybe they just don't talk about this). It's something with unknown social value (I personally doubt that there is any) and is always around anticipating future order flow and taking advantage of it. Front-running doesn't have to be HFT - it can be done even manually if someone enters, say, huge buy order which is visible to everyone.
However, not all order flow anticipation and not all algos doing "pinging" the market are bad things:
* Market makers do need to anticipate order flow so they can balance their quotes to not take large speculative positions against more informed participants.
* Order execution strategies, run for, say, institutional investors like pension funds may need to "ping" markets in order to discover hidden liquidity in them. The problem with the hidden liquidity is that a lot of parties do want to trade, but they don't want to reveal information to all participants to avoid front-running of their orders, that's why a lot of dark pools appeared and different venues like Turquoise have added "dark" functionality to their systems."
Posted by: Tyler Cowen at Jul 29, 2009 1:54:18 PM
The electronic US equities market is not set up optimally for institutions trying to do big size by hand, certainly. I'm not sure that's the right public policy goal (certainly it's not the goal of the exchanges, which are trying to increase volume), but if it were, I'd think increasing the tick size from a penny and switching to a pro rata matching algorithm over time priority would be logical steps. And these steps wouldn't eliminate high-frequency trading; you see futures exchanges trying to strike this same balance.
Getco certainly picks off other participants and, particularly, annoys less tech-savvy options market makers, but they overwhelmingly provide liquidity (are the passive party in a trade) on equities.
Posted by: keikobad at Jul 29, 2009 1:59:12 PM
I see the comparison to insider trading and remember that not everybody is against insider trading ( but most people are).
It isn't about making a lot of trades, it's about Goldman Sachs and others seeing Bids/Asks before everybody else and making can't lose arbitrage trades that "skim" the entire market. It IS front running, it IS insider trading, and they ARE making billions of risk free dollars off of other investors.
Tyler Durden on Seeking Alpha seems to be leading the war cry against GS and the other HF traders while CNBC takes pot shots at him and "bloggers" on Seeking Alpha. Jul 29 01:58 PM |Report abuse| Link | Reply +10
Posted by: John Galt at Jul 29, 2009 1:59:42 PM
The thing that I don't like is the physical advantages of "co-location". Co-location means you physically stick your servers next to the exchange's trading servers. This gives you a time advantage of several milliseconds over other traders that can be exploited by automated trading strategies. You make a few bux per trade doing this, multiply it over a year, and you've made billions.
Obviously, only a small number of players can do this, so it isn't "a level playing field".
Posted by: Foobarista at Jul 29, 2009 3:26:42 PM
Many, many firms have servers in the optimal co-location facilities. Only a few of those firms make anything like a billion at high frequency trading.
Posted by: keikobad at Jul 29, 2009 3:34:23 PM
I don't think high-frequency trading is a crime, but I do think it's as sinful (and addictive) as alcohol and tobacco. So it's my opinion that we should slap a huge sin tax on high-frequency trading, just like we do on alcohol and tobacco!
Posted by: Cynthia at Jul 29, 2009 4:21:52 PM
I take back the statement that Getco makes "most" of their money prowling the markets. That was emotion getting in the way of logic. But its pretty well known that they bribe exchanges to receive preferential access and execution. Thats crossing the line.
Posted by: Beerman at Jul 29, 2009 5:10:51 PM
"Andrew, your implication was that Mr. Buffett eschews the use of computers except to play a particular computer game, and that QED it doesn't take computers to garner a lot of wealth. I would hazard a guess that Berkshire Hathaway has a lot of staff and silicon doing the fundamentals analyses. I was not in any way saying that Buffett and B-H are involved in program trading, just highlighting what looks like apples and oranges to me in your exemplar."
What I was saying is that if you don't like the rules of this game, then don't play. That is always true. There are a handful of people doing analysis within his company I believe and he might participate passively, if at all, in some profits if a subsidiary uses technical trading. Buffett does satisfactorily buying and holding almost forever. This is not just the best way to invest, this is the right way to invest. There are better reasons than high frequency traders eating your eighths to avoid short-term trading.
"The discussion on HFT seems to assume that you need enormous resources to do this stuff or compete in this space. That is just untrue."
I would think enormous resources would defeat the purpose if you moved the market while attempting to make money off fractions. From where comes this idea that people can just sit back and the market will deliver outsized returns to their doorstep? And why is it when speculators have gotten killed (aside from GS and a few others) we worry about all the speculators making ill-gotten gains?
Posted by: Andrew at Jul 29, 2009 5:15:02 PM
I think you should talk to a control theorist about this. I will at least.
We can view the markets as a control system which attempts to equilibriate price to value. In those sorts of systems there is always a trade off. If you get speed of reaction, you might lose bandwidth, or get steady state errors. The financial markets are far more complicated than the PID systems I am used to and have the disadvantage of imperfect information - if I am running an experiment I know what temperature my device should be; I don't know how much a stock should really be worth, and even if I did there a lot of idiots out there doing things like... investing in Lucent in the 90's.
Posted by: David Brown at Jul 30, 2009 3:10:01 AM
Is it possible to stop talking about front-running in a context of "flash" orders? It's an _additional_ order type available to the party entering order, so by deciding to use flash order the submitting party _prefers_ it to the traditional one. What is the problem with optional functionality which doesn't remove an ability to send regular limit orders? I think it's time to close this topic since for an individual order sender there is no problem with it.
First it was GS reported profit which seemed unjustified to some people, then someone noticed Program Trading numbers on NYSE and decided that GS made profit only on that exchange (although even firms with, say 20 people, trade globally), then where are "program" there is "speed" which is HFT and where there is a speed there are front-runners :)
My company is a software vendor in algo trading business and I'm looking at all this stuff around HFT as on typical reaction of people who need someone to blame, while these people don't understand how the world is actually work.
First, people confuse Program Trading (PT), Algorithmic Trading (AT), High-Frequency Trading (HFT) and Front-running (FR).
And really, HFT/Algo systems is not THAT expensive, so they are available for "elite" participants only. The prices quotes above are correct for off-the-shelf systems.
I'm not very familiar with the US regulatory definition of PT, but I always thought that the Wiki explanation is correct:
"Program trading is casually defined as the use of computers in stock markets to engage in arbitrage and portfolio insurance strategies. However, the New York Stock Exchange (NYSE) defines the term as "a wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more" without any direct reference to the use of computers[1]."
So, let's say I want to buy a basket - this will be regarded as PT from this POV and included into widely quoted GS numbers. And imagine arbitrage between S&P basket and index fund like SPDR. But even forgetting about ETF arbitrage - almost any basket purchase/sell will be considered as PT.
Algorithmic Trading - this is trading involving computer system and it's really a lot of different stuff, for example:
* Order execution. People typically don't send huge orders to the market to avoid moving it (which leads to huge transaction cost). Instead they use strategies to execute these orders, be it VWAP/TWAP or something more complex, especially involving buying stocks traded on multiple venues. Noone really manages such orders manually.
* Arbitrage (stocks, options, ADRs, indexes, baskets etc)
* Hedging - similar to order execution. Hedging with huge orders is quite expensive...
* Market making in broad definition (not only option MM, but, say, MM in ADRs or original stock). This overlaps with arbitrage in some sense, since arbitragers act as market maker for the instrument they quote.
* Automatizing day-to-day operations. For example, you might get an FX exposure which you don't understand and want to get rid of it (similar to hedging).
HFT - this is a part of Algo Trading, since not all parties using algo trading systems care so much about _speed_. Especially if they trade on slow markets, if they automate their operations, like FX hedges etc. However, most algo trading vendors to promote speed as a key feature of their products, although few of them really say what speed do they have.
Front-running. I would say this is a small part of trading (I don't remember anyone doing this, but maybe they just don't talk about this). It's something with unknown social value (I personally doubt that there is any) and is always around anticipating future order flow and taking advantage of it. Front-running doesn't have to be HFT - it can be done even manually if someone enters, say, huge buy order which is visible to everyone.
However, not all order flow anticipation and not all algos doing "pinging" the market are bad things:
* Market makers do need to anticipate order flow so they can balance their quotes to not take large speculative positions against more informed participants.
* Order execution strategies, run for, say, institutional investors like pension funds may need to "ping" markets in order to discover hidden liquidity in them. The problem with the hidden liquidity is that a lot of parties do want to trade, but they don't want to reveal information to all participants to avoid front-running of their orders, that's why a lot of dark pools appeared and different venues like Turquoise have added "dark" functionality to their systems.
Posted by: kosmik at Jul 30, 2009 3:37:15 AM
I thought the main problem that the "flashes" of information where going to the big players first so their processors could react slightly ahead of anyone else (with a super fast computer.
Posted by: Drew F at Jul 30, 2009 11:51:58 AM
"a student of economics" has it exactly right. Even aside from potential manipulations and distorting effects of HFT, it is a huge expenditure of effort in a pure rent-seeking activity, that is, with negligible social benefit.
Rather than taxing or disallowing HFT, better would be to design market mechanisms where its profit goes away. One way to do this would be to go from the prevalent continuous-time trading rules to a discrete-time call market. For example, a call market that cleared once per second could make the problem completely go away, and offer several other advantages. I've got some more details on my blog.
Posted by: Michael Wellman at Jul 30, 2009 1:53:12 PM
Tyler, in the event that, during shocks to the system, that high frequency liquidity providers stop providing liquidity, there is a profit opportunity for the right trading strategy with risk capital to capitalize.
And for those of you who haven't checked it out yet, read Eric Falkenstein:
http://www.businessinsider.com/the-market-has-never-been-fairer-for-the-retail-investor-2009-7
Posted by: caveat bettor at Jul 30, 2009 4:55:15 PM
Jon and "a student," I agree. I wouldn't even go so far as to call the release of information seconds earlier a "social benefit"--I can't imagine where the social benefit of that would be. I sure do see the private benefit, as you point out.
I've become a fan of Rob Johnson, who blogs at NewDeal2.0, for steadfastly bringing these questions back to big-picture ethical terms. Johnson has a great post this week about how the world of HFT--not HFT itself mind you but the innovation-worshipping culture around it--turned all of its practitioners into wiser-than-thou soothsayers trying to calm the rest of us by promising us that technological innovation on Wall Street was good for all of us. Anyone who questioned that was excommunicated, to draw on Jon's apt religious language (as Johnson did too...tellingly). We were duped, okay. But now we have to move the burden or proof back to Wall Street: Quants for the social good? Prove it.
Making them play ball is, alas, another burden of its own.
(Johnson's post, if you're interested, is here: http://www.newdeal20.org/?p=3476)
Posted by: anne at Jul 30, 2009 5:27:41 PM
Michael Wellman: I read your blog posts on the call market idea. I'm familiar with the mechanism, as I utiltize market-on-open and market-on-close orders all the time in my business. But how did you arrive at 1-second intervals? Why not 100 milliseconds, or 10 minutes?
Posted by: caveat bettor at Jul 31, 2009 5:24:31 PM
most high frequency traders are not attempting to move the market towards a true price. There are definitely some algorithms that do stuff that, but most of them are just attempting to trade against order flow and earn the bid/ask.Thanks Joe for making this point. HFT just doesn't confer an incidental social benefit of liquidity. The profits arise in part from creating liquidity. HFTs are being market makers, and they do so at much lower cost than the specialists.
There are tons of small companies doing this kind of trading. The technology component (having co-located servers and the best datafeeds) costs around 5-50K/month depending on the exchange.Yep. A friend of mine did just this. The barrier to entry is very low.
Posted by: Jon at Aug 1, 2009 2:26:31 AM
