High-Frequency Trading Round-up

Reuters has three interesting articles on high-frequency trading:

High-frequency trading surges across the globe

Geeks trump alpha males as algos dominate Wall St

Who’s afraid of high-frequency trading?

Staying Calm in a World of Dark Pools, Dark Doings

Via Jason Zweig in WSJ:

Last week, the Securities and Exchange Commission accused the Galleon Group of hedge funds of trading on inside information. Tens of millions of shares move each day through “dark pools,” where quotes aren’t displayed until after the trade is done. “Flash orders,” appearing for a split second, give some customers a sneak peak at potential trades. More than two-thirds of stock-market volume comes from high-frequency traders, who can buy or sell in less than 400 microseconds, or nearly a thousand times faster than you can blink your eye.

When markets move so maniacally fast, and firms like Galleon seem to have such an informational edge, how can small investors possibly stand a chance? The game seems rigged to favor the hyperactive giants of Wall Street.

In one sense, that is true. If you try to play Wall Street’s new game on Wall Street’s terms, you will probably come off the field on a gurney. But you are under no obligation to churn your own portfolio just because other people juggle stocks for only minutes or seconds at a time. Paradoxically, their frenzy renders you a service as a buy-and-hold investor: On the very rare occasions when you do need to trade, you will be able to do so more efficiently than ever before.

Read the full article here

The Impact of High-frequency Trading

Via Knowledge@Wharton:

According to some estimates, high-frequency trading by investment banks, hedge funds and other players accounts for 60% to 70% of all trades in U.S. stocks, explaining the enormous increase in trading volume over the past few years. Profits were estimated at between $8 billion and $21 billion in 2008.

Some market observers, members of Congress and regulators are worried. Are those profits coming out of ordinary investors’ pockets? Is Wall Street’s latest qet-rich-quick scheme going to harm innocent bystanders? “I don’t think it would hurt people to become educated as to the intent of these strategies,” says Wharton finance professor Robert F. Stambaugh. “What is their effect on the markets? There is a little sense of 2001: A Space Odyssey [in that it] does kind of create an air of mistrust.”

Its defenders say high-frequency trading improves market liquidity, helping to insure there is always a buyer or seller available when one wants to trade. And so far, high-frequency trading doesn’t look threatening, according to several Wharton faculty members. Indeed, it may well provide benefits to mutual fund investors and other market participants by reducing trading costs. But at the same time, several note that not enough is known about how trading at light-speed works, whether it can be used to manipulate markets or whether benign-looking moves by different players could interact to produce a new financial crisis.

“High-frequency trading involves investors with good computers taking advantage of small discrepancies in prices,” says Wharton finance professor Marshall E. Blume. “Generally, economists think that drives prices back to where they should be…. If they bring liquidity to the market and make prices more accurate, then that’s good. Now a concern, which is hard to document, is that somehow these traders manipulate the market, which would be bad.”

Turning decision-making over to machines has not always benefited humans, notes Wharton finance professor Itay Goldstein. “People believe the crash of ’87 was caused by this kind of computer-based trading.” In that case, a vicious cycle swirled out of control as computerized trading programs dumped stocks in response to falling prices, causing other programs to do the same.

Traveling at Light Speed

High-frequency trading refers to computerized trades seeking to profit from conditions too ephemeral for a human to exploit, like a miniscule increase in the spread between bid and ask prices for a given security, or a slight price difference for a stock traded on various exchanges. Trading is so fast that some firms locate their server farms near the exchange’s computers, to shorten the distance orders must travel through cables at light speed.

Aside from being made possible by the proliferation of high-speed computers, high-frequency trading has evolved out of several regulatory changes. In 1998, the Securities and Exchange Commission’s Regulation Alternative Trading Systems opened the door to electronic trading platforms to compete with the major exchanges. A couple of years later, the exchanges started quoting prices to the nearest penny rather than 16^th of a dollar, causing spreads between bid and ask prices to narrow and forcing traders who made money on those price differences to look for alternatives. Finally, the SEC’s Regulation National Market System of 2005 required that trade orders be posted nationally instead of only at individual exchanges. This allowed quick-moving traders to profit when a stock traded at a slightly different price at one exchange versus another.

With the effects of the subprime crisis still being felt, regulators and lawmakers are especially alert to any dangers that might lurk in unfamiliar Wall Street products and strategies. Alarm bells started going off with news accounts this summer about “flash orders,” a subset of high-frequency trading that exploits regulatory loopholes to give favored traders notice of orders a fraction of a second before they are transmitted to everyone else. Flash trading has been widely condemned as giving a favored few an unfair advantage.

“Some people are getting advantages that others aren’t, and that may lead to abuse,” says Wharton finance professor Franklin Allen. “It is a form of front running.” Front running, which is generally illegal, means improperly profiting by using advance information to jump ahead of someone else’s trade. In the textbook example, a broker receives a customer’s order to buy a stock for up to $10 a share. The broker buys the shares at the market price of $9.75 and sells them to his customer at $10, cheating the customer out of 25 cents a share. Flash orders can do the same thing, much faster and more often.

Flash trading now appears to be on the way out. In mid-September, the SEC proposed a ban, and the Nasdaq market quickly moved to prohibit the practice. A number of firms that had offered flash trading to clients have exited the business. The SEC ban requires a second vote by commissioners to become final.

Because many people have been unclear about the distinction, the flash-trading controversy has triggered worries about high-frequency trading, which involves strategies that appear to be perfectly legal. In some cases, high-frequency traders test prices by issuing buy or sell orders that are withdrawn in milliseconds, giving those traders insight into investors’ willingness to trade at specific prices. High-frequency traders can also earn tiny profits, millions of times over, from “rebates” provided by exchanges to players willing to buy and sell when there is a shortage of other traders.

Read the full article here

So Much for High Frequency Trading

It was only a matter of time. Via The Big Picture:

The Securities and Exchange Commission has proposed halting high frequency and flash trading.

In response, Nasdaq (and others) are now prohibiting flash orders. Supposedly, the NYSE is also considering banning the practice.

This was a given. The real question that remains unanswered and demands a thorough investigation is this: WHAT EXCHANGE OFFICIALS APPROVED THIS? WHO BELIEVED THAT ALLOWING FAVORED FIRMS TO FRONT RUN OTHER INVESTORS WAS OK?

Quite bluntly, the clueless dolts who allowed this to occur need to be publicly excoriated, fired from their job as exchange officials, and driven out of town on a rail. Oh, and, all the gains from this organized theft should be clawed back from all the front-running firms that stole this money — THAT’S RIGHT, ITS THEFT — one quarter cent at a time. Put the recovered ill-gotten gains into the SIPIC fund that compensates investors who have been defrauded by their stock brokers.

Read the full post here

Bloomberg: Flash Trade Halt Backed for Nasdaq, Bats as SEC Vote