Thursday, April 3, 2014

ABCs of HFTs

Of late we have heard much verbosity
Expressing the Street's animosity
Toward traders who trade
With programs they made
To profit by rapid velocity. 

Indignant stock-pickers confront one
With evidence (and it's a blunt one)
That HFTs aim
To rig the whole game
By trading so fast they can front-run. 

HFTs claim, in defense,
Their volume may lower expense 
And help to enrich
The others from which
They're skimming off fractions of cents. 

My view may be non-analytical
But in this matter tends toward the critical,
For it's hard to ascribe
A positive vibe
To a practice at heart parasitical. 

High-frequency trading represents a sort of "rise of the machines" over Wall Street, in which powerful computer algorithms are dedicated to exploiting market information almost literally at the speed of light. The practice has long been controversial among market professionals, where opinions differ as to whether such machines personify R2D2 or the Terminator. 

Michael Lewis, author of Moneyball and Liar's Poker, has written a new book called Flash Boys, which comes down on the side of "hasta la vista, baby."  In an interview on 60 Minutes, Mr. Lewis brought this Wall Street issue on a perp-walk down Main Street. 

"The stock market is rigged," declares Mr. Lewis, by a combination of HFTs, big banks and the exchanges themselves. The HFTs are allowed to see everyone else's trades a split second before the general market does, giving their lightning-fast algorithms time to get out in front of market-moving order flows. This amounts to small-scale theft, repeated so often and so quickly that it becomes large-scale. 

However, some knowledgeable insiders disagree, and say that HFTs have been good for the small investor. Their big volume of small trades has lowered the bid-ask spread, reducing everyone's cost of execution. Much of the complaining, says Cliff Asness of AQR Capital Management, comes from money managers who can no longer place large orders without moving the market. "Well, sorry," counters Mr. Asness, "but prices responding quickly—and traders not being able to buy or sell a ton without the market moving—is what is supposed to happen in a well-functioning market."

A compelling counterpoint to be sure, but the fact remains that some firms trade with high frequency while losing with rarity, or not at all.  "How is it possible that one of the largest high-frequency trading firms executes millions and millions of orders for four years without ever having a down day?" asks Barry Ritholtz.  "The short answer is what they do is not trading -- it is skimming. I call it legalized theft. High-frequency trading is a tax on investors, encouraged by the exchanges, allowed by the SEC."

Are we ready to prosecute the Terminator for algorithmic inside trading?

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