The controversy over high frequency trading has been brewing for several years and only recently has been thrust on to the wider media stage. It has been frustrating to follow because so much of what high frequency traders do is a mystery. Not the concept of speed, which is as old as the markets, but the actual strategies and the alleged ways that high frequency traders gain an edge.
They have often been bucketed with algorithmic traders in general, which is a much wider category. People outside the trading business even viewed the term algorithmic trading with suspicion, and the baggage and negative implication with the term ”black box trader” has always been a pet peeve of mine. Put simply, algorithms are the step-by-step procedures of a systematic trading strategy. High frequency traders use algorithms that can usually only be successful if they are faster to market than the competition.
Speedy access to the market has always been a goal of traders going back to the open outcry days. A firm I worked for would often send out maps of the trading floor indicating how its floor location was in a highly desirable spot, suggesting orders would reach the market quicker than with a firm in a less desirable location. The firm would pay for direct access to clerks on headsets in the options pit and pay for direct phone lines to institutional trading desks. Customers just picked up the phone and entered orders. They didn’t have to dial or even wait for a quote because we had a clerk doing nothing but broadcasting quotes in the U.S. Treasuries directly in a squawk box going to the traders’ office, so they knew the size on the bid and ask before you picked up the phone.
All this expense was taken on so our customers’ orders would reach the floor before someone else’s.
HFT in the age of electronic trading is a little different because those engaged in it, to a certain extent, are trying to play the role of the market maker in the pit scalping each trade. But not all of them.
(A note to Mr. Lewis—there is nothing illegal, unethical or wrong with scalping. It is just the market making process of attempting to buy on the bid side and sell on the ask side on a semi-consistent basis).
But it is not just market making. There are thousands of orders placed, and often, just as quickly canceled. This can be illegal—spoofing the market—and some traders have been sanctioned for it. The standard is that every order must be exposed to risk. If it is not, if the trader has figured out a way to get an order on the screen that may affect other orders but can pull it away without a chance of it getting hit, that trader should be sanctioned.
But even this is not unique to the electronic world. In the floor days you would often see a group putting in huge size on the bid or offer: 1,000 bid, 2,000 bid, 3,000 bid. Often nothing happened and the bid would be pulled and some folks on the floor suspected that the mysterious bidder actually had 200 or 300 lots to sell on the offer side. Every once in a while a large local would hit the bid just to keep someone honest.
To what extent the advantages offered by co-location are public and reasonable is key. It seems reasonable for a firm to pay to have its server co-located next to the exchange match engine just like having a more desirable floor location. As long as individuals or entities aren’t offered some exclusive right.
But at the very least, we must say the exchanges and proprietary trading shops who profit from offering and using speedy access to the markets have not done a good job in allaying people’s fear that something not quite kosher is going on.
In our virtual roundtable (see “High frequency traders: Fall guys or felons,”) we hope to answer some of your questions and at least elevate the debate. There have been a lot of foolish things said regarding what HFT is and isn’t in the last few weeks, which is inevitable when a focus is put on the trading world. Too many people jump to conclusions.
Secrecy is not a crime, particularly in trading where traders are always fearful of the competition discovering their edge and exploiting it.
But secrecy is not always the norm. This month’s trader profile (see “Tim Fligg: Cooking up profits,”) is a great example of how many in the industry prefer to share their knowledge and help the next generation of traders rather than hoard their knowledge in fear they give up an edge.
There would be no Futures magazine if it wasn’t for traders wanting to share what they have learned. And experience of these type of strategies employed by high frequency traders tells us that this is usually a short-term edge.
Arbitrage-type strategies exploit an inefficiency for a time until there is nothing left to exploit and those traders must go look for their next edge. The current raft of HFT strategies will soon enough go away, replaced by something better. That is not to say they do not provide a service to the markets.
But there should be no secrecy regarding access to the market. Exchanges should take a close look at their market structure because these strategies, like many before them, will go away. So it is important to make sure they are not harming the longer-term customers who need these markets to hedge their risks.
One thing is for certain; proponents of HFT will need to make their case because they have a target on their chests.
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