Assessment and Perspective of High Frequency Trading
By Victor Sperandeo with the Curmudgeon ††††
The recent High Frequency Trading (HFT) expose went viral last week, after well-respected author Michael Lewis told 60 Minutes that the stock market was rigged.† Not by accident, Lewis' new book "Flash Boys" was published and shipped this past week. Lewis, whose most recent best seller was "The Big Short," caused uproar with the public when he called Wall Street a "Rigged Game." But readers of these weekly blog posts should not have been surprised.
The Curmudgeon has
reported almost all of this four years ago and has
followed up with several posts since then.†
In the most recent co-authored HFT article--High Frequency Trading Firms
Push Speed Limits in Risky New Arms Race --I summed up with a
hypothetical casino scenario that's applicable to today's stock market:
"Suppose you walked into
a gambling establishment with a big sign on the wall saying "This is a
rigged game. We cheat.† Caveat emptor."†
Would you play?† At least it would
be an honest disclosure, something that's foreign to Wall Street."
To update and
clarify the HFT issue, let's put the real facts on the table.† "Rigged"
means granting an "unfair advantage." This is a very
polite way of saying the HFT traders have been given a license to steal.† HFT is simply "front running"
orders (typically to buy stock), using lighting like communications access
speeds and high performance computers located near or within the stock
This incorrigible trading tactic has been granted by stock exchanges for a fee. The SEC has blessed this privilege, and therefore it is part of the problem (or is it a conspiracy?).†† Please see Editor's Notes below for other opinions.
Why has the SEC permitted HFT to continue if it grants those traders an unfair advantage? Ask them!† Actually, it is more than an advantage as front running a market order is a guaranteed profit and illegal virtually everywhere else in the U.S.† This model best compares to "rigged" arbitrage (or "pimping for prostitutes").
As an example, suppose an institutional investor puts in a market order to buy 10,000 shares of IBM, last sale $191.77.† The trade is most likely to be executed at ~ $191.80.† But wait...here come the HFT flash boys!† The order is seen in advance and executed in microseconds by HFT traders at $191.80 and sold back to the original IBM market order buyer at an estimated $191.83. Well that's only skimming pennies, but multiply those pennies by the volumes of thousands of similar orders which are similarly skimmed each day!
Now some people
don't care.† Some benefit and some- like
the IBM buyer- lose.† But that
institutional buyer is probably not aware (till maybe now) that his order was
front run. Over time, this adds up to significant money to give HFT firms for
doing nothing more than setting up an ultra-high speed fiber optic or microwave
network and paying an "exchange fee" for special access.† Do you think that's fair?
The concept that makes this practice 100% illegal, and is not properly understood is "full disclosure."† Ironically, full disclosure is required by any broker -dealer, in any public or private offering of securities to be sold to the public.
You can run a card game and say the house has a right to cheat sometimes, and people would still play. They do this in a different way in Las Vegas, but it is not "cheating" because it is a business.† Even though the "games of chance" are built statistically in the casino's favor (the odds dictate the players will lose over time), that's well understood by the public.† The odds of all of the casino games can be seen in this light.† That's why itís called gambling - everyone knows the odds are with the house and against the player.
However, if the HFT game was fully disclosed to the "players" on Wall Street, orders would be handled differently.† But the HFT trading structure has not been properly disclosed. If front running is allowed, but disclosed, then investors can act accordingly and use more limit orders. But when it is hidden (from buyers and sellers of stock) it is no different than the NSA spying on you via your cell phone calls, texts, emails etc.
In any other individual trading set-up that "front runs" brokerage orders, SEC Chairwoman Mary Jo White would invite the "front running" trader to her office via a subpoena.†† But she has done nothing to stop HFT.† Evidently, Ms. White believes in "killing you softly" with jail time for insider traders, but not for HFT players!† Please refer to Editor's Note 3 for a corroborating opinion on the SEC and Ms. White.
Editor's Note 1: Mark Cuban thinks otherwise about what the SEC should do about HFT and insider trading in general--nothing.† This week he wrote, "Leave insider trading to the Justice Department," in a blog post that claims the SEC's approach to insider trading is completely wrong.
Note 2: In an HFT article
published last week titled, "Blame the Refs," colleague Tim
Quast of ModernIR wrote:†
"The SEC's Regulation National Market System (or Reg NMS) linked markets around a national best price, forcing competitors to share orders and to undercut each other, while perversely rewarding data revenues to exchanges setting the price most often. What did we get? Pandemonium in pursuit of price-setting that coalesced into a game controlled by big banks, HFT firms, and exchanges. But we should single out the refs -- (namely) the SEC.† Penalizing people for adroit rule-following is Ė well, as dubious as HFT."
Note 3:† From an April 6th blog post, How
Today's Traders Hurt ETF Investors
previous era of low-tech cheating has simply been replaced by high-tech
cheating with software algorithms.† In
this case, stock exchanges allow high-speed traders the privileged access of
buying faster data streams and putting their computers close to stock exchange
data centers. This gives HFTs a significant edge by trading stocks milliseconds
ahead of the public.† Why donít major
stock exchanges crack down on HFTs? Because HFTs are clients of these very
exchanges and pay millions of dollars for their privileged front seat!"
"How pervasive is high-speed trading? HFTs account for around half the share volume in the U.S., according to some estimates."
"The HFT scandal is another example of the colossal failure by financial regulators, who after the Madoff scandal, continue failing to protect investors. Why hasnít the lead commissioner (Mary Jo White) at the Securities and Exchange Commission lost her job over the HFT scandal? How much further financial damage must the investing public face before the illicit relationship between stock exchanges and HFTs is finally crushed? Until then, the money stolen from many will continue to be divided among an elite few."
Note 4:† The March 31st New York Times Magazine cover
story is titled "The
Wolf Hunters of Wall Street."† The
article by Michael Lewis is a condensed version of the major theme in Flash
Michael Lewis wrote: "... to function properly, a financial market didn't need to be rigged in someone's favor. It didn't need payment for order flow and co-location and all sorts of unfair advantages possessed by a small handful of traders. All it needed was for investors to take responsibility for understanding it, and then seize its controls."
Scenario Planning Needed Now- NOT Later:
The offset of some paying more "after execution costs," and some less to lower commission charges (or tighten bid/ask spreads) is not the proper way to view HFT.
In addition to the missing disclosure rules for HFT, the regulators (SEC, FINRA, Treasury Dept. and the Fed; perhaps others?) should be thinking about what might occur when we have a real, sustained and† (Fed) uncontrollable stock market decline.† Something more than a one hour Flash Crash, but rather a decline with serious fundamental devastation behind it!
In my opinion, the HFT traders will be selling in front of market orders causing a greater velocity of decline (note that the uptick rule on short sales was eliminated in 2007).†† Such an exacerbated stock market decline could be greater than anything in modern history, but we certainly hope not!
In that case, neither the Fedís dealer banks nor the government's Plunge Protection Team would be able to stop such a fast moving, waterfall decline.† The Fed, being the nation's central bank and bank of last resort, might announce the buying of stocks for its own account (much like the BoJ does in Japan), in order to stabilize the markets.† Is that the future of U.S. regulator's benign neglect of HFT?
How about some pro-active thinking to deal with various bear market scenarios?† Or do the regulators believe that stock market cycles and bear markets are "things of the past?'
A common and consistent flaw in human nature is to see the future as we see the present and recent past. For the last five years, financial markets have been historically calm with a large upward bias.† As we've repeatedly said in many Curmudgeon posts, that is primarily due to zero short term rates and QE (which places a floor under stock and bond prices, while causing newly created money to flow into financial assets, rather than the real economy).
But what if
a 1929 -- like stock market decline gets under way due to some unknown external
trigger?† We will then have to depend on the
"Plunge Protection Team" and "circuit breakers" to slow the
decline, which will likely have been worsened by HFT.† To think differently is to see the world on a
perceptional level of awareness, i.e. like the Neanderthal man (or politician)
What is being suggested here is an urgent need for transparency and full disclosure for all HFT firms.† Also, for the regulators to consider (and attempt to circumvent or at least mitigate) the damage HFT might do during a fast moving market decline. That is, thinking on the conceptual level of what might happen when we have all sellers and no buyers - without a "specialist system" in place to make a market in the securities being sold (either via market orders or sell stops).
The U.S. government system is not set up with equal rules for all.† Rather, it's a "pay to play" type of extortion and exchange of favors (i.e. campaign contributions) for privileges that are then granted. This is the problem and why Lewis (and many others) has called the stock market a "rigged game."
Till next time........................
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1979) to profit in the ever changing and arcane world of markets, economies and government policies. As President and CEO of Alpha Financial Technologies LLC, Sperandeo overseas the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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