High Frequency Trading Firms Push Speed Limits in Risky New Arms Race

by the Curmudgeon and Victor Sperandeo

Introduction:

High Frequency Trading (HFT) is back in the news again- big time. Several enlightening articles last week illustrate the steps HFT firms are taking to gain a competitive edge on their rivals. Meanwhile, the SEC, CFTC and other regulators have not taken any action to stop the HFT "arms race."

The Curmudgeon has been very skeptical of HFT in the past, as expressed in our last post on that topic--HFT 2.0: Wall Street Gyrations Negatively Impacts Main Street.

New Tactics for HFT Firms:

High-Speed Stock Traders Turn to Laser Beams (on line subscription required) was a front page story in Wednesday's (Feb. 12, 2014) Wall Street Journal. The article states that this March, Anova Technologies (a small Chicago telecommunications transmission company), plans to activate an array of laser devices to link the New York Stock Exchange's data center in Mahwah, N.J., with the Nasdaq Stock Market's data center in Carteret, NJ. The lasers are being installed atop high-rise apartment buildings, towers and office complexes along the 35-mile stretch between the two New Jersey communities as the first phase of a grid intended to link nearly all U.S. stock exchanges. What's the primary purpose of such an ultra-fast link? Rapid-fire stock trades with round trip execution times in microseconds.

The Journal reports that in recent years, HFT firms (which currently account for about half of U.S. stock trading), have adopted first custom-built fiber-optic cables, then microwave and later millimeter-wave transmissions. Networks built on all three technologies operate today; tying together exchanges around the U.S. Internationally, fiber-optic cables laid across the oceans link America's markets with Europe's and Asia's.

"This is a never-ending race," said Michael Persico, founder and chief executive of Anova Technologies LLC, the company designing the laser communications link between the NYSE and NASDAQ data centers in New Jersey. This race is all about speed of order execution. It's a race between HFT firms that are trying to "front run" one another.

High-speed, computerized trading firms today trade everything from stocks to oil futures to government bonds, including securities whose prices move instantly when the government releases economic data such as jobs reports. To obtain those reports faster than anyone else, HFT firms use communications links that have networking equipment residing within a data center on 1275 K Street in Washington, physically close to U.S. government agencies.

HFT firms get a further speed advantage by placing their compute servers—the machines that generate their buy and sell orders based on algorithms—at the exchanges' data centers.

And now, some of them are paying for direct access to news releases. A February 7th WSJ article Speed Traders Get an Edge (on line subscription required) reported that high speed traders are paying for news releases from Business Wire (which distributes corporate-earnings releases and economic reports such as the Philadelphia Federal Reserve's monthly manufacturing survey), and from Marketwired (a Toronto company that distributes earnings releases and the ADP monthly employment report). Those not willing to pay up continue to receive news releases from media companies -such as Bloomberg LP and Dow Jones & Co. - and/or from websites such as Yahoo Finance or Google Finance.

Those paying for direct news access are attempting to eliminate the tiny time lags between the instant the distributors release the news and when media outlets send them out to the public, including other investors. That enables HFT firms to input the news into algorithms being executed on the computer servers that spit out the buy and sell orders that are transmitted over ultra-fast communications links.

What's the Impact on the Race for Zero Time to Execute Orders?

Federal regulators are wary of HFT algorithmic traders' relentless push for speed. They say they are worried about the potential for future market shocks such as the "flash crash" of May 6, 2010—when heavy selling and waves of high-speed traders fleeing the market triggered wild stock swings—and the loss of more than $460 million in 45 minutes by electronic-trading firm Knight Capital Group Inc. in August 2012. Last August, the CFTC stated they planned to increase oversight of HFT. Earlier this week, the NY Times reported that the SEC will re-examine the rules on market structure.

But the regulators really haven't done anything to control the risk if something goes terribly wrong- as it did during the 2010 Flash Crash.

HFT firms say they add liquidity to the markets, which results in tighter bid/ask spreads for all investors. Not everyone agrees.

Mark Gongloff, writing in the Huffington Post says, "High-speed traders often make money by adding confusion to markets, sending and canceling thousands of false orders in fractions of a second. Studies have shown this can be bad, not only for financial markets and normal humanoids, but it's also bad in the long run for the high-speed traders. High-speed trading has been blamed in a series of scary market glitches in the past few years, including the 2010 Flash Crash and the collapse of Knight Capital."

Our colleague Tim Quast, founder and president of market structure analysis firm ModernIR, wrote in an email: "HFT is bad. It distorts prices with over-intermediation and impairs the purpose of the equity market, which is capital-formation. We have overwhelming statistical evidence in the data that HFT harms price-discovery, a jargoned term that simply means knowing the supply and demand so that one can identify a proper price at the nexus of the two. The central problem is that prices are set by intermediaries, and the intermediaries vastly outnumber the actual buyers and sellers."

"What if you were selling your house and 55 brokers showed up to bid on it, and one buyer? If the buyer pays the price that finally emerges after all the intermediaries syphon off their little fee, the market works fine. You’re a happy seller, and everybody thinks the market is thriving. The problem develops when the one buyer decides not to buy. Now you have 55 incorrect prices between the seller and the buyer. This is called a Flash Crash."

"That specter presents itself all the time (with HFT in the stock market). What’s remarkable is that it works as well as it does! But intelligent people would assess the risk presented by wildly over-intermediated markets where prices are set primarily by shill bidders who want to own nothing and risk nothing, and decide that rather than waiting for the day the one buyer doesn’t show up, maybe we should fix the structure by a) disconnecting all the interconnected markets so one cannot take down the entire system; and b) reverting to a structure where intermediaries have a vested interest called a book of business."

Matthew Obrien wrote an article in The Atlantic this week that condemns HFT: High-Speed Trading Isn't About Efficiency—It's About Cheating. He writes: "There's a big difference between buying early access to public data and early access to private data. The University of Michigan, for example, sells the rights to its Survey of Consumers to Reuters for $1 million a year. Reuters then sells early access to it either five minutes before the public gets it or five minutes and two second before—for the HFT crowd that wants to frontrun the frontrunners. It's a horribly unlevel playing field (and we should tax some of it away), but, as Matt Levine points out, the University of Michigan might stop doing the survey if they couldn't make money off it."

"If a company sold hedge funds an early look at their earnings, it'd be insider trading. But when a third-party like Business Wire sells hedge funds an early, albeit split-second, look at corporate earnings, it's perfectly legal. Its nuts. As Paul Krugman argues, we need a financial transactions tax—something like 0.1 percent on all trades—to make this kind of socially useless speculation personally useless too. Long-term investors wouldn't notice this small a tax, but ultra-short-term investors would: their warp speed trading would become less profitable and less prevalent."

Tim Quast takes issue with the proposed HFT targeted transaction tax. Instead, he writes: "Why not just remove the rules that gave an advantage to the first bid?"

Curmudgeon Comments:

A frightful concern I've had for a long time is that if there is another steep stock market selloff, the HFT players will withdraw their bids and go flat on all positions. Since the Specialist system is gone, there will be no one else left to make a market in stocks that are crashing. I expect any stock market decline to be exacerbated by margin calls on over leveraged players. If you divide the record high margin debt by the decreased volume of today (40% of what it was in 2007), this has the making of a lot of forced liquidation of stock with few or no institutions willing to take the buy side. (Victor adds that computerized re-allocation of institutional assets from stocks to government bonds may also play a role in steepening any stock market decline).

Tim Quast's reply: "Heartily concur, Curmudgeon! I think you’ve nailed the risk. Add in the distorting effects of monetary policy, where money is plowed into contractions and allowed to run during recovery, and nobody really knows how to value any risk asset or fixed-income asset, reflected in about $1.2 quadrillion of notional value in swaps (figures vary depending on who’s compiling them but LIBOR interest-rate swaps alone were over $800 trillion). Everyone has attempted to swap away the risk of the unknown to someone else. We don’t know the proper discount rate, and we don’t know if assets are inflated, undervalued, or a mirage. It’s a truly spectral picture should anything go wrong."

Note: Watch for Tim's op-ed piece in the March 2014 issue of Traders Magazine. The February issue notes that four high-frequency trading firms have formed the Modern Markets Initiative to defend HFT's role in the trading landscape.

Victor's Closing Comments:

The backdrop for HFT is the Federal Reserve's strong influence on the markets through their aggressive central planning (ZIRP & QE), which has been prevalent for almost six years now. Many markets [stocks, bonds, gold, the U.S. dollar, etc.] have been manipulated by the Fed to cover up a lack of effective fiscal policy. That hasn't helped the real economy, which continues to stagnate (as per the bad economic reports identified in last week's Curmudgeon post ).

Don’t believe the Fed is "Independent." To quote William McChesney Martin - the longest running Fed Chairman in U.S. history - after he was ordered by President Johnson in 1966 to NOT raise interest rates. "We are Independent within government, not Independent from government." And Arthur Burns -Fed Chair in the 1970's - "We dare not exercise our independence for fear of losing it."

We find it ironic that on one hand the SEC is cracking down and prosecuting stock analysts for obtaining information from companies they cover (which someone else calls "insider trading"). But on the other hand, the SEC permits HFT firms to buy information BEFORE the public gets the same news. Even though the public isn't generally aware they get news releases later then the "professionals" that are paying for faster access! Yet that's NOT considered to be insider trading and seems to be perfectly OK with the SEC? Who's kidding whom?

What will be the bottom line to this corruption game? Players will stop playing! It's already happening. There is a slow but steady corrupting of the investment landscape to the extent that the individual investor is not playing the game. The low volume figures illustrate this point. Volume is only 40% of what it was in 2007.

Next, we have "program trading" that moves the market in one direction for hours when a large institutional investor or group of investors sell stocks and buy bonds (or the reverse) in lockstep to the close of trading. The trades are done by the biggest investment banks with the blessing of the SEC for almost three decades now (since at least 1986).

Lastly, there's the Plunge Protection Team (PPT) waiting in the wings to buy stock index futures- directly or through investment bank surrogates- to stop a stock market decline from turning into a rout (anecdotal evidence indicates this occurred in Oct 4, 2011 when the market rallied strongly in the last 40 minutes of trading without any news--see chart and Bear Market Bounce story).

The PPT together with Fed directed buying by investment bank pawns (to stop stock market declines) results in eliminating short sellers from the investment process. Short sellers actually add more liquidity then HFT firms, particularly through short covering. The end result is no legitimate buyers when you need them most.

All this adds up to a Wall Street I don't recognize from 45 or 47 years ago. The market manipulation and corruption has gotten even worse in the last five years.

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.

The end game is less players, more volatility, and government corruption run amok!

Till next time........................

The Curmudgeon
ajwdct@sbumail.com

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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