High-frequency Trading – HFT, for short – is the trading technology most traders love to hate. It is sneaky, opaque, kind of scary, and obscenely profitable. But now there is evidence it may become a victim of its own success. Hooray!
Count us among the many who would cheer the demise of high-frequency trading. We think it distorts the markets, hinders true price discovery, gives a small group of well-heeled market manipulators an unfair advantage, and drives human traders – like us – out of the market.
Our cheers may be premature; but there are encouraging signs the BORG – the acronym chosen for one of the first successful HFT programs – is now eating its young. And not a moment too soon.
BUT FIRST SOME BACKGROUND
High frequency trading is a trading methodology that uses computers programmed to execute trades on electronic trading networks in huge volumes and at incredible speeds. It is a commonplace for some of the “bots” or “algos” to place and cancel several hundred orders a second, hoping to scalp a small fraction of a penny on each one.
It is sort of like day-trading on steroids, except that the trade durations are measured in milliseconds, not days.
There is nothing inherently wrong or immoral with this. (Full disclosure: we are frequent day-traders). Fast in and fast out is often a winning strategy, and there is no moral high ground in holding positions for a month instead of a day, or an hour instead of 0.011 seconds.
Besides, we can’t respond to ‘investors’ who complain that we eat their lunch by complaining that the algos are eating ours.
Our quarrel isn’t with the technology; it is with the way is used, and the effect this is having on the markets.
WHY THE BORG SUCCEEDED
The BORG succeeded because it worked. By the time that first program – a tongue-in-cheek acronym for Brokered Order Routing Gateway – was fully operating it was responsible for almost 10% of all stock trading in the United States, scalping the “spread” (the difference between the bid and the offer) on hundreds of millions of shares a day.
By some estimates HFT now accounts for more than 60% of all trading on U.S. equity markets; as recently as 2006, it scarcely existed. You can’t have growth like that unless the technology really works.
And it does work. To give just one example, in the final quarter of 2012, Bank of America proprietary trading, which is believed to make extensive use of HFT methods, showed trading losses on only two trading days out of 61.
Shameful! Because in the next quarterly report, for the first quarter of 2013, it had zero days with trading losses (out of 60) and had seven trading days when it generated more than $100 million a day in trading profits.
Or as the bank explained:
During the three months ended March 31, 2013, positive trading-related revenue was recorded for 100 percent, or 60 trading days, of which 97 percent (58 days) were daily trading gains of over $25 million.
Bank of America isn’t alone in achieving results like this. Goldman Sachs, for example, while it no longer attributes its results to “trading” (they now talk about “client services” or “client execution”) once regularly reported quarters with 100% trading success.
And that’s just the ones we know about; both GS and BAC are publicly-traded companies and so must file quarterly statements of their financial results. Most HFT trading houses are private companies, and secretive about their results.
SO WHAT’S NOT TO LIKE?
For the companies using HFT it looks like roses and pixie dust all the way; big paydays, no losers. But for the rest of the market participants there are problems.
To cite the most obvious, trades are a zero-sum transaction; every winner is offset by a loser somewhere else. So when a HFT prop trader makes $10 million a day, somebody else – really everybody else – loses that amount, not individually but collectively.
Does that matter to you? Not unless you own an equity mutual fund, or a 401k, or contribute to a pension plan, because it is these institutional investors, for the most part, whose returns are diminished.
One study, by Pragma Securities, estimates that the HFT creaming profits from the most widely-traded stocks costs investors billions of dollars a year.
MARKET INTEGRITY
The second problem is market integrity. HFT, with its millisecond trades too fast for the eye to follow or the mind to comprehend, makes it all too easy to game the markets.
The methods used are not much different from the techniques used by flesh-and-blood market manipulators: wash trading, quote stuffing, front-running, painting the tape, pump-and-dump.
HFT didn’t invent any of these market-gaming techniques; but it does make it easier to conceal them, in part because to some extent HFT firms have changed the ways markets operate, to their own advantage.
HFT firms are far and away the best customers for the now-privately-owned-and-profit-seeking exchanges … and the exchanges are eager to keep their best customers happy.
That includes allowing special order types that aren’t available to ordinary (or even institutional) investors, helping HFT firms get to the front of the order queue, where they can act ahead of other buyers or sellers, and in some cases allowing them to act first when important news is released.
The exchanges also pay HFT firms for order flow, the “maker-taker” rebates that allow them to collect a small fee for taking either or both sides of a trade. So they can make money if their trades are a wash.
GOING SOMEWHERE ELSE
For more and more investors and traders, the markets are increasingly seen as fundamentally unfair, a rigged casino where the odds are stacked against you.
So they pick up their marbles and go somewhere else. For institutional traders, that often means “dark pools” where buyers and sellers are connected directly without going through an exchange, and where the transactions are not publicly reported.
There are now 50 “dark pools” operating in U.S. markets, compared with 13 public exchanges, and the exchanges are losing trading volume as a result.
The total value of shares trading on exchanges has been steadily declining since HFT became a common practice. In the case of the New York Stock Exchange, the value of shares traded is down more than 60% from 2006 to 2012.
For retail traders, it also means that the price discovery available from the markets does not reflect all – and perhaps not even most – of the transactions occurring. Market transparency is impaired, so to some extent retail accounts are trading blind..
MARKET STABILITY
And then there is the flash crash, a term that has been added to the trader’s lexicon since the advent of HFT. While HFT firms deny responsibility, most market participants believe – in our view correctly – that the sudden crash (or spike) in prices is often the result of an algo trading program running out of control.
One notorious example was the Knight Capital algo that ran amok for 45 minutes on August 8, 2012, simultaneously buying the offer and selling the bid on dozens of stocks, which is pretty much the opposite of what you want to do.
By the time the exchange halted trading, Knight had lost about $440 million, or about $10 million a minute. The company had to offer itself to competitors to avoid bankruptcy.
DUCKING THE LOSSES
Similar, smaller “flash” events occur almost every day, and mainly go unreported. Knight was only unusual in one respect: they had to eat the loss.
The new normal is for the exchanges to “DK the trades” for large accounts – trader slang for canceling the transactions – as they did when a Goldman Sacks HFT program went crazy in the options market on August 20 this year.
Canceling the trades allowed Goldman to avoid about $100 million in losses – and cost the people on the other side of those trades the same amount in profits. Zero sum, remember.
Those actions also affect small retail traders. Here’s a not untypical comment from the blog Zero Hedge about a different flash crash that was subsequently DK’d:
I bought RMBS the most recent time it plummeted intraday (yes its happened more than once). I stepped in and caught a falling knife in a stock that was tanking hard and then it recovered miraculously within a few minutes. I sold my shares and then they busted the buy so now I’m illegally short and losing a buck on my illegal short cause the stock rallied more from where I sold it. I was risking my own capital to stop an out of control algo and I get punished.
For a lot of investors, it looks the exchanges are taking good care of their best customers – even at the expense of almost everyone else.
BUT THE TIMES, THEY ARE A CHANGIN’
Nothing that good can last forever, and the heyday of HFT trading is probably already winding down.
For one thing the various regulators for equity and futures markets, asleep these many years, are beginning to stir. There is talk of regulations that will make it more difficult and/or less profitable to use HFT techniques. Or at last make the users of those techniques pay for their mistakes.
But the real change is likely to come from the changing economics of the HFT business itself. Carbon-based life forms – that’s us – have been squeezed out of some markets to such an extent that there is nobody left for the bots to trade with, except each other.
It is one thing to jump in front of a slow-fingered human trader; it is a lot tougher when your competitor is another algo, just like you. As a consequence, the profit margins are going way down, and costs are going way up.
As BloombergBusinessweek’s Technology Report points out:
“According to estimates from Rosenblatt Securities, as much as two-thirds of all stock trades in the U.S. from 2008 to 2011 were executed by high-frequency firms; today it’s about half. In 2009, high-frequency traders moved about 3.25 billion shares a day. In 2012, it was 1.6 billion a day. … Average profits have fallen from about a tenth of a penny per share to a twentieth of a penny… In 2009 the entire HFT industry made around $5 billion trading stocks. Last year it made closer to $1 billion. “
In an ironic twist, some HFT firms are trying to resuscitate the goose that laid the golden eggs by offering their “expertise in executing trades” to the same institutional investors they once used to scalp profits from. In other words, if you can’t beat them, join them.
And here is the final irony: as the HFT business is winding down, the SEC recently announced a major investment in software that will finally – after seven years – enable it to monitor … High Frequency Trading.
One consequence of the SEC program will likely be increased demand for a tax on stock market transactions. By then, of course, the only traders left to pay it won’t be the machines. Most of the bots will be gone, leaving only … humans.
= = =
Naturus is the web-name of Polly Dampier, the brains behind Naturus.com, a live-voice, real-time subscription service for carbon-based life forms actively trading futures markets. Visit www.naturus.com for more info, or contact admin@naturus.com
