Wednesday, July 29, 2009

An Outsider’s Perspective on High Frequency Trading

I think it would be an understatement to say that there is a lot of confusion in the mainstream press and in the blogosphere regarding high frequency trading (HFT). For many of us, it is only in the last few weeks that we have started to add the words “co-location,” “flash trading,” and “predatory algorithms” into our lexicon. Fortunately for HFT novices like myself, blogosphere luminaries such as Karl Denninger of The Market Ticker and Tyler Durden of Zero Hedge have been vigilant in trying to educate us regarding the potential for market manipulation that apparently surrounds HFT. Furthermore, I think that people such as Joe Saluzzi from Themis Trading have done a great job in explaining what HFT is in a way that people who have never worked on a trading desk or never created an advanced trading algorithm can understand. As a result, I am not going to try to explore the nuances and potential pitfalls of HFT. I will let those who have far more experience than I tackle that. My concern only surrounds the illegal uses of certain HFT strategies.

Having said that though, I happen to think this entire developing story is fascinating. Starting with the details of the stolen Goldman algorithm and the US prosecutor’s admission that anyone (including GS) could use it to manipulate the markets, you have a very compelling beginning to a new Russell Crowe movie about corporate espionage and government conspiracies. And now that we find out that some of these HFT programs could be used to front run trades and provide phantom liquidity, I wouldn’t be surprised if Jerry Bruckheimer is currently taking diligent notes. Where is a Law and Order “ripped from the headlines” episode when you need one?

All joking aside, I think the people who espouse the virtues of HFT could use some advice on how to sound more credible. If types of HFT are not actually as nefarious as some people seem to believe they are, then the proponents are doing a terrible a job of defending them. So far, I have seen a couple of arguments that don’t help their cause in the slightest. Both were articulated by Irene Aldridge of Able Alpha Trading who is about to publish a book entitled “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems.” If you haven’t watched her showdown with Joe Saluzzi from last week I highly recommend it. Not that all of it is comprehensible due to the fact that the CNBC moderators always allow people to talk at the same time. But, her reactions to the criticisms are very curious and seem somewhat indicative of a person who doesn’t spend much time out of the office or read the newspaper. Here are a couple quotes from Ms. Aldridge:

Ms. Aldridge: “First of all there is nothing new about high frequency trading…”
Ms. Aldridge: “Everyone knows that front running is illegal, especially in equities, and it is strictly monitored…”

CNBC’s Steve Liesman: “Are some people able to see the data of other people’s orders ahead of time and able to trade in front of it using supercomputers?”
Ms. Aldridge: “It’s illegal.”

Huh? Is there some connection between something being illegal and actually being a deterrent? Let me list a few other things that are illegal: $50B Ponzi schemes, smoking marijuana, jaywalking in New York City and insider trading. All of these things happen (or happened) often despite the fact that they are illegal. Obviously, Madoff’s crime is a little more serious than jaywalking, but that just illustrates the point that the magnitude of illegality does not preclude people from partaking in certain activities. In other words, just because it would be a huge scandal that would likely land people in jail if HFT firms were actually front running does not necessarily mean that it isn’t happening. Our recent corporate history is littered with examples of somewhat brazen attempts to flaunt the law.

Furthermore, the suggestion that we can trust that HFT programs are not front running because trading is “strictly monitored” by the regulators seems very naïve. Here are some examples of recent regulatory failures to protect consumers and investors:

Fed: Mortgage fraud and predatory lending throughout the housing bubble
SEC: Madoff’s Ponzi scheme
SEC: Insider trading- just look back at the spike in the option activity on Schering-Plough (SGP) a few days before the Merck (MRK) deal was announced and tell me people weren’t trading based on knowledge of the deal
FDIC: Continuing to allow regional banks to carry loans on their books at levels that do not reflect the actual magnitude of impairment
SEC & Others: Allowing the rating agencies to deem anything and everything AAA without any scrutiny of their models or assumptions

These are just a few examples off the top of my head. I’m sure there are dozens more. Oh yeah, the regulators have a fantastic track record of spotting and putting a stop to illegal or intentionally misleading practices. Accordingly, for anyone who wants to defend HFT, my suggestion is to not use the fact that the regulators are on the beat and that front running is illegal to bolster your case. Instead, say that your firm does not engage in front running and that any group that does should be prosecuted to the full extent of the law. Or explain how HFT is like a weapon of mass destruction in that it can be abused or misused by less honest individuals. But, in the hands of people who believe they have a responsibility to make markets more efficient and fair, HFT can be a very useful tool.

Additionally, there was another argument that Ms. Aldridge used that I have seen multiple times but does not necessarily help the case of HFT supporters. This is the contention that HFT is not a new thing so we should assume no one is misusing their advantages. In a Bloomberg article on the same subject, Frank Troise of Barclays plc candidly stated:

“This has been going on for quite awhile, and it’s now at a fever pitch…There’s always been an advantage to executing with speed.”

Are we supposed to conclude from this statement that firms aren’t using their enduring speed advantage to swindle institutional and retail investors? As we learned with Madoff, just because something has been going on for a long time does not mean anything about its legitimacy. It is entirely possible that traders using supercomputers have been able to front run for many years now. Does the length of time that HFT has been a force in the market really have anything to do with whether or not specific programs are acting properly? Also, the idea that if front running were going on then it would have already been detected seems a bit foolish, considering the regulatory failures listed above. Therefore, HFT advocates should continue to highlight the benefits in terms of providing actual liquidity to the markets instead of asking us to put our heads in the sand and assume that the regulatory infrastructure is sufficient to protect us from bad actors.

Finally, I would like to conclude with a word of caution. I have no insight into whether or not firms are using predatory algorithms to front run. I hope it is not happening but at this point nothing would surprise me. And that is the problem. We have all become so jaded by the actions of too many of our fellow Americans during this crisis that we don’t even blink anymore when we learn that someone was fleecing or robbing one of his neighbors. We also are now so used to the words billions and trillions that any infraction that falls short of those amounts doesn’t seem so severe. But, in the case of proven front running through HFT, let’s not allow our collective outrage to be shaped by the previous prevalence of scandals or the magnitude of the crime. I don’t care if the entire scheme only netted $1M illegally. The fact that someone was willing to ignore the laws and manipulate our markets so brazenly should be enough to spur on widespread anger, despite the inherent complexity of the crime. If illegality and the presence of regulators are not strong enough deterrents, maybe in the future public shame will be a more effective method of preventing abuses.

(Picture of Joe Saluzzi courtesy of