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The Technology Investor: "Indispensable" HFT Mitigates Risk

In a piece for Casey Research’s The Technology Investor, senior editor Doug Hornig zeroes in on some of Flash Boys author Michael Lewis’ most questionable claims about HFT. He also settles the score about HFT’s role in the flash crash of 2010, seeks to settle misplaced fears about HFT, the role it plays and whether or not the markets are “rigged.”

In discussing what actually causes major market disasters – and HFT’s true role – he writes:

Well, consider this: Market disasters generally result from risk that exceeds supportable levels. The collapse of ‘08 was triggered by the trading and re-trading of mortgage-backed securities that couldn’t be accurately valued. With each trade, the risk was magnified some more, until it finally overwhelmed the system. Or take the dot-com crash, which came about because the price of revenue-free startup companies was bid so high that the risk of continuing to hold them blew way past the probability of selling to the next sucker in line.

HFT, on the other hand, is about the exact opposite—mitigating risk.

And on the flash crash:

As a market stabilizer, proponents say, HFT has become indispensable. They point to the infamous Flash Crash of ‘10, which took the Dow down nearly 1,000 points in 20 minutes.

 The trigger for that was a simple human error. HFT quickly re-priced securities and stair-stepped them back up to their proper levels, it is argued, thereby reversing the crash before it could spin entirely out of control.

Hornig’s piece is a frank look at recent HFT criticisms combined with an easy-to-understand translation of what actually occurs in the markets. Through his piece he shows how HFT benefits investors, today’s modern markets and establishes that it is not something to fear.

Check out more of the best lines from his piece, “How I Learned to Stop Worrying and Love High-Frequency Trading” here.

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Pete Kyle: Obvious That High Frequency Traders Didn't Cause the 2010 Flash Crash

In a 2012 panel held by the American Enterprise Institute that explored high frequency trading (HFT) and its impact on financial markets, Albert (Pete) Kyle of the University of Maryland explained that high frequency traders did not cause, nor could they have prevented, the “flash crash” that occurred on May 6, 2010.

Professor Kyle is co-author of “The Flash Crash: The Impact of High Frequency Trading on an Electronic Market”, a study that used proprietary CFTC data to examine the 2010 market disruption.

In this excerpt of the panel discussion, Professor Kyle uses public data to summarize his key finding that high frequency traders were not the cause of the flash crash. The key quote:

“It’s pretty obvious that high frequency traders didn’t cause the flash crash. It’s also pretty obvious that following a strategy like this they couldn’t have prevented it either. They’re just part of the machinery of the market functioning by buying and selling and turning over inventories very rapidly.” 

As part of the full discussion, Kyle also points out that high frequency trading firms did not sell but rather held onto their positions during this trading period and lost millions before the market eventually rebounded. As Kyle explains:

“As this large order hit the market and started pushing prices down, the high frequency traders kind of hit what seems to be their maximum position of about $150 million and then the market kind of just continued going down, and the high frequency traders didn’t in aggregate sell but they kind of held on and as a result of holding on they lost several million dollars because the market fell several percentage points and then they continued to hold on and the market rose several percentage points back to its old level and they made  the money all back.” 

Watch the below video to view the entire AEI panel discussion on HFT and its impact on financial markets.



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Electronic Markets and a "Better World" of Price Transparency and Liquidity

In a recent blog post, Mark Spanbroek explains how electronic trading has vastly improved markets since the 1980s:

“Thanks to electronic trading, the dark days, described above, are over. It seems people often forget how fortunate we are today. The information we are dealing with on exchanges and platforms is publicly available, not just to members of the exchange in a millisecond. The information is stored and kept for potential market abuse analyses and other surveillance analyses. It is not possible to trade lower than a shown bid or higher than a shown offer. The best price always wins and is filled first. What you see is what you get because you can trade it. No fake liquidity is shown. Be glad we live in 2014!”

In the piece, Spanbroek also stresses the responsibility of the entire industry – including exchanges and platforms – to strive for continuous improvement to avoid technology related glitches in the future:

“And I DO believe we can still improve things: the systems malfunctions, glitches, and so on. The industry as a whole has a job to do, including exchanges and platforms. The fact remains that current markets are a huge improvement over the past and it is the responsibility of all participants to strive towards continuous improvements. Before, the physical strength of a trader, his voice, his spot in the pit and his brain alone were the key ingredients. You decide yourself which world is better for price transparency and liquidity.”

Spanbroek’s entire commentary is available here.



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Remember: New Rules Affect All Market Participants, Not Just HFT

Trader’s Magazine recently published some commentary on the general future of U.S. market structure regulation in a piece titled: “Attention HFTs: New Rules are Coming.

In fact, when it comes to any new rules, all market participants should be paying attention. Any changes to the rules will impact the full range of market participants, and positive change occurs only if we are all paying attention and working together to make the markets better.

The authors of the piece explore recent high-profile market issues and the search for their root causes:

While these disruptions are often popularly blamed on high-speed traders, U.S. regulators have recognized that the causes are far too complex to be attributed to any single group.

This is an important recognition. The markets are fragmented, yet highly interconnected, just as they are complex – arguably overly complex. As we’ve witnessed in recent years, the failure of complex systems is not a pretty thing. Ideally, the authors are correct that U.S. regulators recognize that mere finger pointing isn’t a solution and the best way to solve for issues in a complex system is to examine the system as a whole and make appropriate changes to the entirety of the system.

According to the article, regulators are taking this holistic approach:

The U.S. has embarked on a principle based approach, with regulations focusing on the structural integrity of the markets as a whole.

Working to improve the structural integrity of the market is in everyone’s best interest. But the details matter, since any changes to a complex system introduce new risks. The goal is to reduce the risks and for new risks to be less impactful than the old ones. This is best accomplished if we minimize unintended consequences and are not blind to the issues and needs of all investors.

All market participants need to work together and take into account all points of view on the issues. This is something the article recognizes as well:

Industry participants now have a unique opportunity to help shape the form of regulations which will govern trading for the foreseeable future. Market participants must become familiar with the proposed regulations and proactively respond to regulators’ requests for comments on these proposed new regulations.

 This is a sentiment that all market participants can probably agree on: Become familiar with proposed changes. Have a voice. It is the only way that cooperation, conversation, and compromise will lead to better markets for all involved.

Automated trading of all types is linked with the changes in market structure over the last few years. Market structure will continue to evolve, as will automated trading. But no matter the future changes, let us all recognize that electronic markets and automated interaction in the marketplace are here to stay. Improved structural integrity of these electronic markets allows for safer trading, sustainable businesses, and a better overall profit and risk environment for all investors.



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“Making Sense” of Electronic Markets

Since the Modern Markets Initiative (MMI) strives to provide observers with relevant and accurate information on how today’s electronic markets work, The Latest takes notice of a Yahoo Finance column that does an admirable job of helping to make sense of HFT, albeit with a limited amount of space.

The speed of consuming and acting on information has always been part of the financial sector and, as the Yahoo Finance piece points out, “since the earliest days of trading, investors who got information – and acted upon it – the fastest, have been able to capitalize upon it.” It is correct that in electronic markets software developers are more important to trading than they have ever been before.

Also, the article contains this accurate and easy to understand description of algorithms:

At a time when virtually every transaction is already entered, executed, confirmed, settled and warehoused digitally, faster computers combined with better connectivity have made a super fast process, just that much faster. 

To do so, programs (or “algorithms”) are created that automate the normal buy and sell process in ways that aren’t humanly possible.

Yes, algorithms are prevalent in today’s marketplace, and used by most market participants, whether HFT or not.  Algorithms are used because of the efficiency and accuracy that they bring to getting investors the best possible price.

One important graf towards the end of the piece, though, requires further explanation:

“…high frequency traders are routinely able to cut the line, so to speak, and move in front of larger orders, affecting the price and costing the next guy in line money.”  

 This is often referred to “front running” and is one of the most often cited concerns people have about HFT.  But this concern is misplaced. As Jonathan Brogaard explored this issue at length in his recent academic study, High Frequency Trading and its Impact on Market Quality:

“front running by HFT before large orders is not systematically occurring. In fact, it appears that larger trades, relative to each stock, tend to be preceded by fewer HFT initiated trades.”  

Brogaard’s study goes on to explain that the activity as explained in the Yahoo Finance article is more often than not the activity of non-HFT market.

The bottom line: Any trader, fast or slow, is able to place an order at a better price; however, no trader, no matter how advanced their technology, has the ability to circumvent the exchange’s priority queue.




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Apple's Ups and Downs? Ask Your Broker and the Outdated National Tape, Not HFT

Fortune/CNN Money has an item out this morning exploring the issue of “odd lots” and their effect on a closely watched stock like Apple.

Here’s a sample:

A 2011 study out of Cornell University found that computer algorithms were using odd lot trades for what the researchers called “price discovery” — pinging the market with thousands of tiny orders designed to both disguise their intentions and to smoke out the big institutional orders than can push a stock up or down. For the past six years, high-frequency trading computers — wired directly to the stock exchanges — could see this information. The public — until last week — could not.

The piece implies, wrongly, that information isn’t making its way to the average investor while algorithmic traders happily enjoy an unfair advantage. That’s simply not the case. There is no “invisible hand” at work as the story’s headline wrongly implies.

Anyone who consumes data feeds directly from the exchange sees odd lot trades. The exchanges do not limit consumption of these feeds and they are not cost prohibitive. Anyone can subscribe to the data and most do. Many brokers, if not most, get direct feeds that contain odd lots. Whether they pass this information on to their customers or use it in their pricing algorithms is up to them.

Despite the erroneous insinuation offered in the Fortune/CNN Money report, the exclusion of odd lot information is an artifact of an old regulatory structure that has not been modernized.  In reality, the HFT community supports the inclusion of odd lot trades in the Consolidated Tape.  In fact, the electronic venues like Island (now Nasdaq) that spawned the growth of automated trading way back in 1999, were the first to allow odd lot executions and include odd lot trade information in their data feeds.

The institutional community, however, continued to oppose their inclusion because they believed, at the time, that odd lots were irrelevant and a nuisance.

It needs to be noted that high frequency trading firms actually add value to the market.  Trading costs for retail investors have never been lower both from the perspective of commissions or market impact.  And its no coincidence that investor trading costs fell with the rise of efficient automated traders that are known as HFT.

Unfortunately, the Fortune/CNN Money fails to put this odd lot issue into proper perspective.

Update: 1:30 p.m. EST 12/18/13

A reader points out that individual investor websites like Yahoo!Finance, CNBC, WSJ, etc. use direct exchange feeds.

This is from the Yahoo!Finance data disclaimer:

“Quotes are real-time for NASDAQ, NYSE, and NYSEAmex when available.”

So what feeds are they using?  It turns out that Nasdaq and NYSE have direct data feeds specifically geared toward individual investors.  If you look at the spec, you will see that they include odd lots in these feeds.  BATS makes their order book available on their website.

Also, real-time NLS data is available at no charge to the end user on the following public websites:


“Extra! Extra!”
Since we’re on the topic of price discovery… a recent University of Washington research paper studied how high frequency trading contributes to price discovery and actually facilitates price efficiency for investors. See it here:
High Frequency Trading and Price Discovery



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Why High-Frequency Trading is Boosting Investor Confidence

While many still perpetuate the myth that automated trading or high-frequency trading techniques hurt market inflow from “mom and pop” type investors, the truth is that today’s modern marketplace offers more options and equality of access than ever before to today’s investor – particularly the retail investor.

In a commentary for the Financial Times, Justin Schack, managing director and partner at New York-based Rosenblatt Securities, highlights how investor decision-making has not been negatively impacted by HFT:

“News stories, blogs and social media posts refer ominously to such incidents [2010 ‘flash crash’] and, generally, to high- frequency trading, as seriously damaging investor confidence. The average reader could be forgiven for thinking that worries over HFT and modern market structure are driving mom-and-pop investors from the stock market in droves, like so many terrified villagers in a Godzilla film.

“Don’t believe it. Facts don’t support such a conclusion.

“. . . Again, according to Birinyi, during the same post-flash-crash period US equity ETPs have seen a “$314bn inflow. On a net basis, then, investors have added almost $53bn to their holdings of US-listed companies in the past three years. . . .

“In 2012 alone – the same year in which the BATS and Facebook IPOs, followed swiftly by the Knight incident, supposedly put the fear of death into investors – securities listed and trading in the US equity market saw a net inflow of $57bn. If investors were truly terrified of market structure, surely they wouldn’t have added such a huge sum to the capital they have at risk.”

>> Read Schack’s entire May 10th commentary.

In addition to not deterring investors, automated trading is actually a driving factor in growing investor confidence. The open competition, transparency, and reduced trading costs enabled by high frequency trading have increased market resiliency and liquidity, creating a healthier market by historical measures.

>> Want to know more? See our Myth vs. Truth infographic.