Should High Frequency Trading (HFT) be banned ?
Inky, this is an interview with Manoj Narang founder and CEO of Tradeworx. I simply post it to present the opposing argument.
HFTR: What do you see as some of the biggest myths circulating about HFT? Can you help us debunk some of those myths (Latency Arbitrage for example?)
MN: So many myths and so little time. Here’s a sampling of six, for starters:
(1) HFT causes volatility when it trades: This is easily disproved as a simple consequence of the definition of high-frequency trading, as I discussed previously. The reason this myth is so pervasive is people conflate it with the fact that HFT benefits from high volatility. If you believe the latter, which is a true statement, then you can not believe the claim that HFT causes volatility. If HFTs were able to manufacture volatility in order to create the conditions for their own prosperity, you’d never see another period of low volatility again! The fact is, liquidity is a commodity that has suppliers and consumers. As is the case with other commodities, supply and demand are sometimes in equilibrium, and sometimes not. When the demand for liquidity far outstrips the supply (as was the case during the credit crisis of 2008, or during the flash crash), volatility ensues. In such situations, becoming a supplier of liquidity becomes quite profitable, but the act of supplying liquidity brings supply and demand back into equilibrium, thereby reducing volatility. By way of comparison, when there is a shortage of oil, oil producers benefit from high oil prices, but if they increase their production in response, the result is a DECREASE in oil prices, not an increase.
(2) HFT causes volatility when it DOESN’T trade: Ever since the “flash crash,” this has become the prevailing narrative, primarily used by detractors to support the idea of “liquidity obligations.” Liquidity obligations are misguided because as is the case with all commodities, virtually all the elasticity of liquidity exists on the demand side. If demand for liquidity suddenly goes up by 100% or 200%, liquidity providers can’t all of a sudden double or triple their capacity to produce. The point is that demand for liquidity fluctuates far more than the supply, and THAT is what causes volatility. The natural consequence of this fact is that if you want to eliminate volatility, you had better eliminate the market itself (this is why circuit-breakers, in fact, are the most effective means to prevent “flash crashes” in the future). Furthermore, liquidity obligations are not designed to prevent these sorts of events. Even the strictest obligations force market makers to post two-sided markets less than 100% of the time. Guess which 2% or 3% of the time the market-maker will decide NOT to be obligated? You guessed it — when they expect to lose lots of money. That is why you had flash crashes in 1962, 1987, 2000, and lots of other points in time when market-makers were subject to “obligations.” As long as there are markets, there will be periods of extreme volatility, liquidity obligations or not. You simply can’t regulate volatility out of the market, particularly by focusing on the side of the market where there is minimal elasticity!
(3) HFT generates massive amounts of profit for financial institutions: In reality, HFT generates at most $2-$3Bn of trading revenue per year in US Equities. If you multiply the profit margin (0.1 cents per share) of a typical HFT trade by the amount of HFT volume (around 10Bn shares per day), you arrive at around $2Bn per year of profit. Some firms, like TABB, have grossly overstated the amount of HFT revenues by expanding the definition to include algorithmic trading in general, regardless of the actual holding period of the trader. Large stat-arb firms which hold positions for multiple days are NOT engaging in HFT. By definition, if you are able to hold positions for that long, you are not part of the HFT arms race, and don’t need superfast technology to access opportunities before they disappear!
(4) Technology gives HFTs an unfair advantage over individual investors: This charge is preposterous, because the two sides are not in competition. In fact, retail investors are completely insulated from the details of market structure, because their orders never make it to the exchanges where they compete with other orders. Virtually 100% of all retail orders are routed directly by the originating brokerage firm to a highly exclusive group of HFTs (known as OTC market-makers) to be executed. To the extent that such HFTs adopt advanced technology to provide this service, it accrues to the BENEFIT of retail investors. Would you want your surgeon to be using anything less than the most advanced technology? If not, then why would you want the firm that is being hired by your broker to fill your orders to use anything less than the most advanced technology? For the record, I’ve had an account at TD Ameritrade since 1998, when it was known as Datek Online. Since that time, I’ve executed 100% of my discretionary trading activity (which is substantial) in that brokerage account. Though I am the CEO of a firm that has uses advanced technology to engage in HFT, I see no benefits whatsoever to using such infrastructure to execute my discretionary trades, which is why I’m perfectly happy to continue using a run-of-the-mill online brokerage account for this purpose.
(5) Technology gives HFTs an unfair advantage over institutional investors: This assertion is misguided on a multitude of levels. First of all, technology confers a competitive advantage, not an unfair one. Imagine policy-makers complaining that Google has an unfair advantage because its search engine uses better technology than its competitors. In no other industry would such a claim make sense. Second of all, HFTs use technology to compete with each other, not with investors. Investors are not (and ought not be) concerned about fleeting correlation-based opportunities that come and go in fractions of a second. Nor do they have the cost structure to benefit from such opportunities. Furthermore, the technology and tools used by HFTs are widely available. Buy-side investors who wish to benefit from colocation and direct feeds have a multitude of cost-effective choices, such as automated trading algorithms (“algos”) which are often offered for virtually no cost by sell-side brokers. Those investors who choose not to adopt advanced technology only do so because it is irrelevant to their investment objectives.
(6) HFTs who use direct feeds can “predict the future” a few milliseconds in advance, or “anticipate” investor orders: This claim serves as the basis for a number of blatantly false claims of malfeasance against HFT leveled by firms such as Themis. It is a completely invalid assertion which is based on a mental sleight-of-hand. Using a direct feed DOES, in fact allow you to predict what the SIPs (standard consolidated feeds) will say a few milliseconds later. But that is not predicting the future, it is predicting the past. If a quote arrives on a direct feed, that means that the order has already been accepted by the exchange providing the feed. Knowing that the order has not yet shown up on the SIP, but inevitably soon will, does NOT entitle you to any benefit — the order is already posted on the exchange and can not be “front-run,” “anticipated,” or otherwise jumped ahead of. In short, direct feeds tell you where prices really are, and where trades can actually get done. There is no way to make easy money just because you know where prices are. That is simply observing the present, not seeing the future. Reading the morning paper will allow you to predict what will be on the evening news, but that is not predicting the future, either!
WASHINGTON — The Financial Industry Regulatory Authority (FINRA) today announced that it has censured and fined New York-based Trillium Brokerage Services, LLC, $1 million for using an illicit high frequency trading strategy and related supervisory failures. Trillium, through nine proprietary traders, entered numerous layered, non-bona fide market moving orders to generate selling or buying interest in specific stocks. By entering the non-bona fide orders, often in substantial size relative to a stock's overall legitimate pending order volume, Trillium traders created a false appearance of buy- or sell-side pressure.
And that's only a few seconds worth of trading, literally.
buynhold said: Well, the illegal trading was only on 46,000 occasions (that we know of). At least it's not rampant. :)
The title of this thread is "Should High Frequency Trading (HFT) be banned"
I have said that it should not be banned, but that certain aspects of it need to be modified to ensure a more fair playing field amongs all participants and that is exactly what the above article suggests. This is an excerpt from the article.
"There are aspects of the market structure which give [fast traders] an unfair advantage," says Manoj Narang, chief executive of Tradeworx, a high-frequency firm in Red Bank, N.J., that trades about 200,000 times a day, turning over roughly 50 million shares. "And those should be changed."
One such practice: 1,000 shares are offered for sale at $20, and someone wants to buy 2,000 shares at $20. The buyer should be able to purchase the 1,000 shares immediately, while the other 1,000 shares should instantly show as the new "best bid" at $20.
Instead, says Mr. Narang, while the 1,000-share purchase goes through right away, the open order to buy another 1,000 is displayed to the entire market at a slight delay. Traders that can place orders faster can jump ahead, putting them in the best position to buy more shares at $20, in hopes of reselling them at a higher price. Mr. Narang says this occurs "at least tens of thousands of times per day."
HFT should not be banned, but current market structure gives HFT an unfair advantage and should be modified.
IT, the problem that Narang outlines is not a problem of HFT, it is just plain wrong. In theory the person who placed the order (for 2000 @ $20) is in front of the line when the 1000 shares are executed (this also shows his order was not AON, which puts you out of the line.) No one in theory should be able to jump ahead of him, unless they are willing to buy at $20.01, otherwise this is bucking the line. And that would be true of anyone HFT or not.
The point is, when this occurs the offender is not hung by his belt from the school yard fence. The point isn’t to make an example of the Madoffs of the world; they will always be crucified (and rightly so) when caught. The point is the hang the school yard bully on the fence, so he doesn’t dream of growing up in such a manner.The real issue with HFT, to me, is do we want to countenance an advantage to those who have access to super computers. There is no question that in certain ways, those with the computers can do things those without can’t do. Most people will accept that those with a lot of money can drive around in fancier cars than those with much less. But most people believe that those with a lot of money shouldn’t receive special consideration before the bar. The only question is on which side does HFT fall?
Mindful that even traditional institutional strategies have historically incorporated a form of pumping the market to lure retail investors and then bailing, it also occurs to me that HFT's might also be incorporating a similar strategy with traditional investment firms as well as the retail investor.
Anyway, Like I have been saying, there are unfair advantages to those employing High Frequency Trading because of current market structure. Even the HFT traders themselves for the most part, agree that there are situations where they have an unfair advantage because of their computing speed.
Now the question is, do you try and hold back technological advances by setting a governor if you will, to cap market "speed" or do you change the current structure to accomodate HFT while also ensuring that those with access to mega computers are not the only ones who can make money trading!
We all agree that HFT creates some much needed liquidity. Inky argues that the cost to that liquidity is too high and not worth the consequences. I believe that the cost of evaporating liquidity would be disastrous to the current market structure and that instead of eliminating (banning) HFT, the SEC needs to establish rules and regulations to deal with this segment as it does with any other segment of the market. I believe that banning HFT would be somewhat like swatting a bug on a glass table top with a baseball bat, you may eventually kill the bug but you will also destroy the table in the process.
There are many things that could be done to ensure that traders employing these strategies are held to some standards that will eliminate some of these unfair advantages and I am sure that, as was said above, there are political and fiscal reasons why it has been difficult to get these loopholes fixed. But then again, isn't that par for the course these days?
What I hope to make clear in this thread is that there are consequences to both extremes of this debate. Either keeping HFT as is or banning it outright, are not the answers.
Joe Saluzzi from Themes Trading who was on the 60 minutes program last Sunday was on CNBC today and basically said exactly what I have been saying. His points were:
He is not against HFT trading, but against the market structure that allows for these arbitrage opportunities. He mentioned the problem of fragmentation and having so many exchanges and dark pool providers. Finally he cleared the air and admitted that HFT trading is not an illegal activity and that traders are just taking advantage of market structure loop holes.