The Motley Fool Discussion Boards
Investment Analysis Clubs / Macro Economic Trends and Risks
|Subject: YOU are married to High Frequency Trading||Date: 10/11/2012 4:27 PM|
|Author: yodaorange||Number: 405817 of 489883|
There was a recent METAR thread entitled: Mysterious Algorithm Was 4% of Trading Activity.  LorenCobb commented : For many reasons, we need to reign in the high-frequency traders soon... or all Hell will break loose.
In reading the posts and comments, one thought struck me. METARites and other US investors do NOT realize that they are married to High Frequency Trading. Investors took the marriage vows: for better for worse, for richer for poorer, in sickness and in health. . . till death do us part.
Investors might not recall the wedding ceremony, but it occurred many years ago. It was performed by a legal authority and properly recorded with the county clerk. This marriage is a little different from most US marriages, it can NOT result in a divorce. Annulment is also out of the question. As a practical matter, investors have no choice but to make the best of the marriage. A few points:
1) NYSE specialists are EXTINCT and Jurassic Park is closed. In the “old days” all orders for NYSE stocks ended up at a specialist post on the NYSE trading floor. The specialist was tasked with maintaining an “orderly market” for each stock. The specialist matched up buyers and sellers. The specialist was also the buyer and seller of last resort. So if no buyers had open bids, the specialist would step in and buy the stock for “his book.”
Buyers and sellers paid a price for this service in addition to brokerage commissions. The price was the “bid-ask spread” and was typically in the range of 1/8th (12.5 cents) up to ½ (50 cents). The spread depended on several items, but in the end, the customer would end up paying TWO spreads in order to buy and sell an issue. The specialist business was lucrative. Specialists would tell you that they lost money about 2 to 3 days per year. They made money on the other ~ 237 trading days. Not a bad business model.
There were 35 different specialist firms on the NYSE in 2000. Today there are 3.1. The 0.1 firm is Knight Capital that recently blew themselves up with an errant trading program. Specialists are now called “designated market makers” aka DMM. The largest DMM is a Chicago based company named GETCO. GETCO is also one of the largest if not the largest High Frequency Traders. The other two specialist firms are Goldman Sachs and Barclays.
In the case of GETCO, they now have the official NYSE responsibility of maintaining an orderly market while at the same time trading for their own accounts with their HFT.
IF HFT WAS SOMEHOW BANISHED TODAY, THERE ARE LITERALLY NO HUMAN SPECIALISTS READY, WILLING AND ABLE TO RESUME THEIR OLD ROLE.
Small investors have benefitted from the transition from specialists to DMM. Spreads have shrunk dramatically over time. It is common to find actively traded issues with 1 and 2 cent spreads compared to the 1/8th to 1/2ths that used to exist. Granted, the spread is NOT an issue to the few long term buy and hold investors left.
2) Exchanges EXIST for HFT’s not small retail investors. The NYSE trading floor at Broad and Wall in New York City has become a stage prop. Its main value is for photo ops. The actual NYSE trading floor is in Mahwah, New Jersey. It is a large building, with Fort Knox level security that is home to the NYSE computers PLUS the “co-located” computers used by the DMM’ and HFT’s.
Do you think the NYSE said: “We need to build a new state of the art facility with ~ zero humans present to improve trading for the small investor?” NOT A CHANCE.
The exchanges have added many different “order types “strictly for the benefit of HFT’s. The small investor does NOT use any of these. My broad opinion is that these order types are for the benefit of HFT to the detriment of the small investor. Rimpy will correctly point out that I have NO proof that these are to the detriment of the small investor. Rimpy also has NO proof that these order types are NOT specifically to get an advantage for HFT’s.
IF HFT WAS SOMEHOW BANISHED TODAY, THE NYSE AND OTHER EXCHANGES WOULD SEE AN IMMEDIATE DROP IN SALES VOLUMES AND PROFITS. THEY ARE NOT GOING TO WILLINGLY CUT THEIR VOLUMES AND PROFITS.
3) Congress stands ZERO chance of making meaningful changes to the law that would reign in HFT. On September 20, 2012 the Senate Committee on Banking, Housing and Urban Affairs held a hearing Computerized Trading: What Should the Rules of the Road Be?  They called four industry experts to testify. You can download and read the prepared testimony of all four. I read them all.
I did NOT post anything on METAR at the time, because my main point was simple:
HFT’s are from Venus and Senators are from Mars. There is no way on God’s green earth that these Senators could understand HFT’s and/or implement meaningful reform. I don’t care how smart the Senators are in their own field, but NOBODY can take a 1 hour short course on HFT’s and make meaningful and CORRECT reforms.
Matters of fact, IF Congress were to tackle HFT reform, chances are good, they would make the situation worse instead of better. I WOULD NOT COUNT ON CONGRESS SAVING THE DAY ON HFT REFORM.
I could write a short story on this Congressional hearing but don’t think it is worthwhile
4) SEC. . . is CLUELESS regarding HFT. I posted recently about the importance of “knowing what you don’t know.” Unfortunately, Mary Schapiro and the SEC staff must have missed that post. Many of us have been in situations where we said to ourselves: “I am the dumbest person in the room and I need help understanding this topic.” When you find yourself in that situation, there are several possible responses:
a) Ostrich- Stick your head in the sand and hope the problem solves itself.
b) Volunteers- Ask your internal team who would like to volunteer to become the expert on this topic and lead the effort.
c) White flag- Raise the white flag and hire the absolute, best, most qualified people OUTSIDE your organization to get you up to speed.
The SEC’s original response was the Ostrich plan. It worked OK from 2000 through 2010 until the Flash Crash in May. Then the SEC went out and hired on a contract basis Gregg Berman who has worked in the HFT industry and has a physics PHD from Princeton. Clearly a very bright fellow. The SEC published a report on the Flash Crash.  I posted a critique of it entitled SEC Lays an Egg on Flash Crash.  Short summary is that I thought the SEC was way off base in their analysis.
The SEC also had the brilliant idea of building a multibillion $ computer system from scratch to log every piece of market information from every exchange, dark pool, etc. Luckily they dropped that idea and signed a contract with an existing HFT company, Tradworx, to build the system for them. They announced the contract on July 20, 2012, a few billion $’s short and a decade too late.
On October 1st, 2012 the SEC hired Gregg Berman as a fulltime employee to START a new Office of Analytics and Research. This is progress, once again it is 2 or 5 or 10 years TOO LATE.
The problem with all of this is that the SEC has TOTALLY IGNORED the outside team that could help them TODAY. That firm is the “garage shop” Nanex. It literally is a few guys, a small office and some serious computing hardware and software.
The Nanex analysis of the flash crash was INFINITELY better IMO than the SEC’s analysis. One of the root causes that Nanex identified was two exchanges that got out of time sequence. One exchange thought it was time zero. Another exchange thought it was time zero plus 1 second. You can NOT mix prices from different times otherwise all Hades breaks loose like occurred during the flash crash. (Obviously I have simplified this explanation. See Nanex.net for infinitely more detail.)
At a minimum, the SEC should have contacted Nanex to hear their view of what occurred. Did the SEC contact them: NO. Has the SEC contacted them subsequently: NO. Matter of fact, the internal story is that the SEC strongly dislikes Nanex because it made the SEC look like a bunch of fools. The SEC should have admitted that Nanex was light years ahead and sought their help. Unfortunately, the SEC was too prideful to admit how far behind they were and decided to re-invent the wheel. BIG MISTAKE.
Bottom line on the SEC is that I would not look for them to make any meaningful reforms to HFT. The flash crash occurred on May 6, 2010. Can you name any and all of the reforms the SEC has implemented since then? The main changes were a new rule that allowed trades greater than 30% from the market to be “busted.” 29.99% trades are OK. The other changes are adding “speed bumps” which are somewhat after the fact. ZERO has been done to proactively PREVENT another flash crash type event.
BTW, did I mention that the large HFT firm GETCO has hired several high level SEC staffers in the last few years. They hired Elizabeth King on June 11, 2010 about one month after the flash crash.  I am sure the timing was coincidental. King was associate director of the SEC's trading and markets division, which is responsible for supervising exchanges, brokers and credit rating agencies.
5. “Perfect” changes to HFT are NOT obvious. It would take another short story, but in