Friday, July 24, 2009

High frequency bovine scatology

Charles Duhigg is a good journalist, whom I've quoted a couple times in the past year.

His latest article made quite a splash on trading desks and the journalists who follow us today. He reports:

Yet high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. The Securities and Exchange Commission says it is examining certain aspects of the strategy.

“This is where all the money is getting made,” said William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.”

For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea.

But as new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds.

High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.

High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.
I agree with everything that Duhigg has reported, but the reporting is one-sided. In order for a high frequency trader (HFT) to make money, someone has to take the other side of the trade, and the liquidity Taker pays a higher fee than the exchange pays the liquidity Provider. The exchange keeps the spread. (You may be familiar with this concept if you have a savings account with a bank, and a credit card or mortgage--the bank keeps the spread between the interest rate they pay you and the interest rate you pay them. If you hate that, maybe you should consider a career in banking.)

Ever play Texas Hold 'Em? If you are the Big Blind, you pay most of the ante, and in return you get to see if anyone wants to play with you--they need to give you information first. So it is with the liquidity provider: putting your limit order out there means you are showing a card first (the shares you are willing to buy or sell at a given price level), and you've taken the risk of getting picked off. You get paid for taking risk and providing liquidity, or at least, you should. Otherwise, there is probably a more productive career somewhere else for you.

Certainly, the grocer who takes the risk to provide food for you in your neighborhood should get paid for that service? Or are "experts" suggesting we go back to subsistence farming so we don't get ripped off by Big Food and Big Supply Chains? I thought reducing poverty was a good thing.

While there is an advantage for the players with the best technology, the playing field is more level than ever. Thirty years ago, a retail investor would have to pay a few hundred dollars to Merrill or other broker to execute a few hundred shares. Now we pay less than $20.

Ten years ago, your mutual fund manager would have to use Goldman or a competitor's block desk to move 100,000 shares of Proctor and Gamble. And they would have to trade an eighth wide, i.e. 12.5 cents per share. The financial intermediaries would take that spread, or more, if another customer was willing to trade through your manager's limit to take the other side of the trade.

No one pays those types of commissions any more. Tick sizes have shrunk over 90%, and as have costs to the retail investor.

The fact that Duhigg had to quote a dinosaur, Bill Donaldson, tells you something. I've spoken to the founder of DLJ and SEC chair on one of his lecture circuit gigs, and the guy is from a different age. His research driven business model was fantastic back in the 70s and 80s, but its a woolly mammoth now. His appointments since cashing out have been largely political; those who can't do teach, and those who can't teach must regulate ...

There are a lot of grizzled Wall Street veterans who pine for the days of tick sizes an eighth wide, and funneling trades to a single market maker on a trading floor. That's because a monopoly is great if you are on the right side of it.

Price discovery is improved with liquidity. There is more liquidity because of high frequency trading.

Right now, GE is quoting $11.97 x $11.98, half a million shares a side. I guess Donaldson and Duhigg are pining for the days when it would be quoting $11.875 x $12.000, and we retail investors would be paying Merrill $300 to sell 1,000 shares, in addition to giving up $95 extra in the day of eighths, in that we would be selling at $11.875 rather than $11.97.

As usual, the good ol' days aren't as good as they seem, once you realize you are giving up your clean running water for the outhouse.

NOTE: The flash orders that Duhigg refers to are a new feature. I'll have more to report on in the coming weeks as I find out more about them.

UPDATE: Eric Falkenstein weighs in a week later than this post, but, oh my, is it worth the wait!

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