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Catching a Falling Financial Knife

High-Frequency Trading Has the Potential to Kill the Markets

Stock-Markets / Financial Markets 2012 Aug 17, 2012 - 10:46 AM GMT

By: money_morning

Stock-Markets

Best Financial Markets Analysis ArticleShah Gilani writes: It's no wonder the public is scared to invest in stocks. They believe the game is rigged.

It is, and I'm going to tell you who's behind it, what's really happening, when it started, where the sinkholes are, why they're there, how you can play in the short run, and how America can get back to investing in a successful long-term future.


The bad news is the problems infecting our capital markets are all systemic. The good news is that they can be eradicated one by one, if not all at once (which won't happen).

Today, we're going to look behind the curtain of high-frequency trading.

It's a nasty bug in the system and has long-term consequences, including the potential to kill the markets.

First of all, high-frequency trading isn't just what you think it is. It is much more than you know, and is in fact part of the fabric of the markets.

High-frequency trading (HFT) is known to be a game that specialized firms and trading desks play. Here's what most people think they know about high-frequency trading.

The HFT crowd uses super-fast computers to execute trades across different exchanges. There are 15 exchanges in the U.S. and more than forty "dark pools" (private trading venues that serve as de-facto exchanges) where shares can be traded.

Part of the problem is that there are so many trading venues trading the same stocks, but that's another story.

Here's what the high-frequency trading game is really about.

The HFT game is about sometimes setting-up and almost always "picking-off" trades that represent tiny discrepancies in prices across all those different trading venues.

Sometimes HFT trades are arbitrage plays where a position is bought somewhere and sold simultaneously somewhere else because price discrepancies across different exchanges make such opportunities possible.

Sometimes HFT plays are manufactured by "pinging" (sending out fake orders to try and move prices), which triggers other orders to be sent, which in turn are picked-off, or to be more politically correct, traded upon.

It's Actually High-Speed Trading
The truth is that almost all trading today is high-speed trading. So to call it all what it really is, we're going to label the problem we're highlighting today "high-speed trading," of which actual high-frequency trading is a huge part.

Who is involved in high-speed trading? Everyone.

The bottom line of trading, or investing for that matter, is that they are both driven by prices. Bids and offers - what people will pay to buy shares and what they are offering to sell them for - are important. People want to get the best price whether they're buying or selling, whether they're trading or investing.

Bids and offers are posted on exchanges (they are not posted in dark pools, hence the name). The object of speedy execution is to reach the place where the shares you want to buy or sell are posted at the prices you want. The first one there gets the shares. That's the simple explanation, without going into how many shares are being bid for or offered at any given price.

So speed is important. That's why everyone is in on the speed train, traders, investors, and exchanges, too.

What the game has wrought, however, is a mountain of unintended consequences. (Although "unintended" can be easily argued, usually by folks like me. But that's another story.)

What's going on is that competition for trades (transactions by themselves are money-makers because people pay to get their trades executed; they pay brokers, trading platform operators, and exchanges) forces intermediaries (brokers and brokerages) and some exchange venues to actually pay for "order flow."

The idea of paying for order flow is that if you have a lot of orders on your exchange to buy and sell any given stock, chances are the spread (the difference between the bid and ask) will be narrower and liquidity (the ability to trade more shares at better prices) will be deeper.

But none of that much matters if you can't get to those opportunities fast enough. So, we're back to speed being a major component.

How fast is fast, by the way? According to Celnet in the past ten years or so, the time it takes to execute a trade on the NYSE has dropped from 3.2 seconds to 48 milliseconds. And that's on a slow day.

Trades can and are routinely executed in fractions of a millisecond, partly depending on how close someone's servers are to the servers that house the exchanges bids and offers.

Feeding the Speed Machine
As I said, the problem (which, don't worry I'll get to, and you will cringe), is systemic. As far as who's involved - which is almost everyone - the exchanges are the biggest purveyors of speed. They feed the speed machine because they get paid to.

For example, in 2010 the NYSE-Euronext opened a $600 million, 400,000 square feet (that's seven football fields) server location in Mahwah, New Jersey, just across the river from the exchange's trading floor.

Why so big? Because they rent space right next to their servers for brokerages and firms and traders that want speedy access to the servers to reduce "latency" (the time it takes to get an order from one spot to another), making super-fast trade executions even faster.

It's systemic because other exchanges do the same for high speed junkies. They get paid to rent space next to their servers; they get paid for each transaction they make. It's about money.

When this all started is quite telling. Starting in 1998, electronic venues were allowed to compete with established exchanges for transaction business, and speed was one of the factors offered as a reason for more competition.

What's interesting is that if you parallel the advent of faster and faster trading, it coincides with the markets essentially being flat over the same time horizon.

Why this is happening is obvious. There's money to be made in pushing speed.

Systemically, the speed game has spawned multiple Wall Street money-making opportunities. Whether it's the exchanges co-hosting trading servers on their premises, or HFT players who now account for between 50% and 70% of trading volume on any given day, or the proliferation of traders and trading desks everywhere, speed equals greed.

So what's the problem with speed and greed? Systems break down when they can't handle it.

Remember the "Flash Crash" in May 2010? How about high-speed exchange BATS blowing up its own IPO on its own exchange because of a technology speed bump?

Or the Facebook Inc. (NasdaqGS: FB) IPO fiasco that imploded because the Nasdaq couldn't handle all the speed orders fast enough? Or that Knight Capital almost said goodnight to its future when its new high-speed software, meant to compete with the NYSE's new kind-of paying for order flow game, blew up in its face?

Oh, and what does Knight do? It buys order flow from the likes of Fidelity, E-Trade, TD-Ameritrade, and a whole lot more outfits.

Speed Kills
What's undermining investor confidence in stocks is that it's all about speed and what Wall Street gets from having the advantage, and what games Wall Street erected to make money from the speed circuit that drives trading.

It's about trading, not investing. It's all about punching out what incremental gains you can in the short term, not about going the distance with safe investments in the long term.

If there are more speed traps, and there will be, markets will collapse one day. When the HFT guys doing more than half the trading on every day the markets are open disappear (as they did during the Flash Crash), and the liquidity they swear they provide dries up like an Iowa cornfield, we'll see how quickly desperate sell orders are executed.

Oh, never mind. Speed won't be a problem if that happens. The SEC, in their infinite wisdom, will shut the markets down with circuit-breakers and cooling-off periods.

Instead of addressing the speed problem, they're going to use a Band-Aid on what will amount to a heart-attack victim.

It happened before and the public knows it will happen again. That's the tragedy. That's why there is no confidence in our markets.

The only way to play these days is to join the short-term trading crowd and not get burned holding onto volatile stocks that, no matter how good-looking, can be turned upside down in a New York minute by the velocity of truth.

And the truth is... speed kills.

If we ever want to fix the markets and make them safe again, we're going to have to slow down the speeding train that's taking us all over the proverbial cliff.

Source :http://moneymorning.com/2012/08/17/the-truth-behind-the-tragedy-of-high-frequency-trading/

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Catching a Falling Financial Knife