High frequency traders. They’re the ones causing all the chaos in the markets. That is if you believe all the financial press and television pundits. Their electronic trading algorithms can execute many thousands of trades a second to try to pick off a handful of PIPS (hundredths of a penny) per trade. Volatility is HFT nirvana. The more that prices move, up or down, the more opportunity there is to pick up a PIP or two.
What that means is the HFTs can move markets using clever trading and cross trading schemes. And, according to conjecture, these guys are to blame for all the demises suffered by the markets from the Flash Crash of May 6, 2010 to the botched IPO of BATS and most recently the debacle suffered by Facebook in their May 18, 2012 IPO just past. And that’s bad.
By most estimates, about 60% of all trades are electronic and it’s climbing. Interestingly enough over half of those electronic trades are done by Market Makers. These are the folks who provide liquidity in our markets and create an orderly trading environment for the rest of us. The Market Makers keep the spread between bid and ask in a reasonable range and ensure that there are shares and money to complete our trading. And that’s good.
The HFTs are responsible for many of the trading venues that exist today beyond the major exchanges. From a small number of major exchanges in years past there are now over 50 venues globally, many in place primarily to support HFTs. This competition lowered the cost of trading and improved liquidity across the board. HFTs, it could be argued, make it possible for market participants to engage in fair and orderly price discovery. And that’s good.
May 6, 2010 - $700B Equity Lost in 8 Minutes
Not entirely the fault of HFTs. Based on the official analysis it was an institutional investor that sold 75,000 E-Mini shares using an algorithm that didn’t care about price or time. Shares were sold based on volume of the previous minutes trading. You can see how that could quickly go down a rat hole if HFTs found out and began to trade against those shares, rapidly increasing volume – and it did. The market was not prepared to handle that kind of “erroneous trading” back then and sure enough the prices fell until trading was manually halted. The market regained the losses and we learned some valuable lessons. Programmatic circuit breakers were instituted to halt trading on stocks that change prices unnaturally below or above breakpoints. Regulatory agencies have become more transparent in defining manual break points for “erroneous trades” not monitored by single-stock circuit breakers. And that’s good.
IPOs of Note
On March 23, 2012 BATS (Better Alternate Trading System) made their first public offering. When BATS opened trading at $16 it dropped quickly to $15.25 and a mini flash crash began. In 9 ½ seconds the stock fell to $0.04 and trading was halted, never to restart. The IPO trades were cancelled. Just before the IPO opened, Apple (APPL) also suffered a mini flash crash from a BATS order but the single-stock circuit breaker kicked in and saved the value. And that’s good.
Facebook offered up their stock on May 18 of this year and suffered a different fate. The volume of stock and frequency of trading caused NASDAQ to fumble the opening and the POP never happened. Were HFTs to blame? You can bet they had a hand in the trading but so did everyone else. HFTs will most likely be exonerated in that event. But they were initially blamed, or at least suspected.
So How Do We All Play Nicely in the Same Sandbox?
The truth is that there are two distinct markets at play. The HFTs trade on what we call candlesticks, but to the extreme. The HFTs closest to the trading venue, collocated in the trading venue data center, have the advantage and they play it hard. Market data is transmitted to these algorithms in microseconds and trading decisions are made just as fast. HFTs create liquidity and retail investors can’t play at that speed. And that’s good.
The second market is for the retail trader, you and me. We trade on the “200 day moving average” or so. We put our money in APPL with the hope that they make great products and when we retire our 401K or retirement account will support the lifestyle that we want to become accustomed to. We have to find a way for the HFTs to play with each other and not to screw up our game.
A Couple of Suggestions
First, we give the exchanges the tools to test and certify their algorithms before they enter the marketplace “to identify any unintentional or potentially abusive or manipulative conduct that may cause system delays that inhibit the ability of market participants to engage in a fair and orderly process of price discovery” (words out of the official report from May 6, 2010). We provide a “shadow” market with representative algorithms that would coexist with the target algo to certify this behavior.
Second, we turn our technical attention to near real-time (near-time) surveillance of all of the markets, tick-by-tick. With extremely fast I/Os per second (IOPS) to store the data and extreme data analytics we can identify anomalies and kick in circuit breakers on every instrument from assets to futures, options and derivatives. That way we protect the innocent retail trader and free up the HFTs to fight their own battles.
IBM has already demonstrated extreme data analytics with their Watson computer that made billions of decisions a second, prioritized the results, assigned probabilities, made decisions and pushed the button in sub seconds on the Jeopardy TV game show. With a little research and innovation I’m sure we can do the same for the markets. And iSys is developing a product to do the algo testing and certification and should be able to offer it up by the end of summer.
It’s like the gunfight at the OK Corral. We put the HFTs inside the corral and let them do what they will to each other but we don’t allow them to bring their guns outside the fence. That will allow the “market participants to engage in a fair and orderly process of price discovery” as the regulators wish. And that’s good.
Terry Keene is chief executive of iSys.