A Fervent Defense of Front-running HFTs

http://www.chrisstucchio.com/blog/2014/fervent_defense_of_frontrunning_hfts.html

by spindritf • 12 years ago

107 152 12 years ago

elecengin2• 12 years ago

This is great - it hits major topics that should be part of this debate. It's long, and it's a bit complicated... but so is the issue.

Some things you should be thinking about after reading this:

* What exactly constitutes front running? Does trading based on public data (albeit in expensive feeds) constitute front running?

* Large trades are almost all traded through algos. Are those algos better than proprietary "market making" algos? Why?

* What is adverse selection? How do dark pools contribute? Who benefits and who suffers?

Read more articles like this. Be suspicious of "simplified" discussions.

exelius4• 12 years ago

I have some questions based on yours:

* What constitutes public data?

* How likely are the types of front-running HFT algos that are discussed in this article to be the old, traditional players?

* What are the ethical (lol) rules against front-running your own customers if you're a market-maker? How could your customers even find out? What happens when the proprietary information is that a customer has just placed a large trade, and you drive up the price before it even hits the market? How is this fundamentally different than the commission these firms already charge?

reverend_gonzo4• 12 years ago

What are the ethical (lol) rules against front-running your own customers if you're a market-maker? How could your customers even find out? What happens when the proprietary information is that a customer has just placed a large trade, and you drive up the price before it even hits the market? How is this fundamentally different than the commission these firms already charge?

Market makers are generally proprietary firms that trade their own money, and don't have customers.

Brokerages (ie: Scottrade) have customers and it illegal for them to front run their customers.

elecengin2• 12 years ago

Good questions.

* Along with order routing, market data is heavily legislated under RegNMS as well. Both the creation of the SIP feeds (the slower consolidated data) and the rules around exchange proprietary feeds are legislated there.

As part of the Fair Access Rule, exchanges cannot favor a certain participant with preferential pricing. Therefore, even if proprietary exchange data products are expensive, they are equally expensive to all participants. I consider that fair.

An argument could be made that the price of the feeds is exclusionary. I do not buy this - there are many types of data available in the market that come at a high price. The next question (if you assume that the price makes it effectively non-public) is if there are effective substitutes. I think for non-professional traders (moving less than, say, $10mm notional per month) the SIP and similar feeds is acceptable (just as many retail traders accept 15min delayed market data as acceptable). For more serious traders, there may not be an acceptable substitute, but given their usage the higher costs are more justified.

* Ethical rules around front running of orders is covered in the Manning Rule. In short, it prevents placing a firm's trading interests in front of a client. The details can be found at FINRA: http://finra.complinet.com/en/display/display.html?rbid=2403...

davidw• 12 years ago

I've been following (sort of) the back and forth on this and find it quite interesting. Here's a question though: what happens when the "whale" is really something like an index fund that, ultimately, is composed mostly of retail investors? Aren't they getting ripped off in that case? This isn't a rhetorical question, I'm curious to know how it plays out.

exelius4• 12 years ago

Yes. But you get ripped off less in an index fund since in general, they are also run by algos within other algos that just rebalance to match whatever they're tracking. The idea if you're an investment firm is that index funds can hide risky investments: they're often large and they're often not highly leveraged.

In reality, index funds are the safest way for individuals to make money in the market because you're placing a bet on the economy as a whole.

harryh24• 12 years ago

Here's the CIO of Vanguard (who run some of the biggest index funds in the world) saying that HFTs cut costs:

http://www.cnbc.com/id/49434073

daveed2• 12 years ago

I think it really depends on what you mean by ripped off. I think that institutional investors looking to place multi-million dollar moves shouldn't be able to just place an order and cry foul when it's not completely filled on all the exchanges either. From another point of view, that's the slippage you get from an improper order placement strategy.

crdoconnor9• 12 years ago

Here's a question though: what happens when the "whale" is really something like an index fund that, ultimately, is composed mostly of retail investors? Aren't they getting ripped off in that case?

Damn right they're getting ripped off.

The defense in the OP is essentially "yes, that can happen but it's very rare". Which is about as believable as it sounds.

wavesounds6• 12 years ago

I'm not buying it. Healthy markets are markets where everyone has access to the same information. HFT by definition means some traders have more access to information than others. This is fundamentally unfair and bad for markets and the economy. I don't see how HFT is any different then insider trading and everyone agrees that should be illegal.

giergirey• 12 years ago

Where do you draw the line? Some retail investors still rely on reading stock quotes in the financial section of their daily newspaper - should we force everyone to only change prices once a day?

reverend_gonzo4• 12 years ago

HFT does not have more information. They have access to the same public information as everybody else, but they have invested in better technology and are therefore able to parse and utilize that information more efficiently.

Insider trading, by its definition, is insiders trading on non-public information, that outsiders simply do not have access to for any amount of money.

Pxtl• 12 years ago

If I tell you that I know privately a piece of news about company XYZ that's about to become public tomorrow, and then you use that knowledge to trade based on how you know its shares will change, that's insider trading.

If I tell you that I know privately a piece of news about company XYZ that's about to be come public in 0.25 seconds and your machine is fast-enough to parse and react to this information before that deadline, that seems pretty close to insider-trading, it's just the "insider" is the exchange itself.

hft_throwaway2• 12 years ago

People have to have different information or views on a market, otherwise no trade would take place except between gamblers.

HFTs have no unfair advantage. Everything that they use is available publicly for a cost. It's like saying running a retail store in New York is unfair because rents are high.

Is it wrong that some hedge funds or mutual funds are able to build a superior valuation of a stock through hiring more researchers? What about guys counting cars going into walmart parking lots? Everyone can do those things, but most opt not to and are at a disadvantage.

001sky• 12 years ago

People have to have different information or views on a market, otherwise no trade would take place except between gamblers.

This is wrong. The house is not a gambler.

wavesounds6• 12 years ago

You could pay Bill Gates a lot of money to wear a wire for you and perhaps if the number was high enough he would do it and you could then argue that anyone could have paid Bill Gates to wear a wire and therefore everything the wire records could be public knowledge you can use to trade MSFT on. But that's illegal and we've all agreed it's illegal and its basically no different then front running in HFT.

djoldman3• 12 years ago

Everyone in this story has the same information or rather the same access to information. Anyone with know-how and the money to colocate servers at matching engine data centers has access to the same information. Aka every pension fund, insurance fund, mutual fund, wall st. bank (including Royal Bank of Canada, RBC), and prop-shop.

If your definition of HFT is "people/firms who have access to more information on stocks than others" then HFT doesn't exist; notwithstanding illegal insider trading on private information, which isn't what this blog post describes.

harryh24• 12 years ago

Healthy markets are markets where everyone has access to the same information.

This is not true at all! People are working really hard all the time to gain information that they are the only ones they have! If I figure something out about a stock that makes me realize it's mispriced that's only valuable to me as long as that information remains non-public.

wavesounds6• 12 years ago

I think you are confusing "analyzing public information in a new way" with "getting access to non-public information". The former is what all smart traders do, the latter is illegal.

runeks3• 12 years ago

Healthy markets are markets where everyone has access to the same information.

I don't want to sound condescending, but did you read the article? One of the points is that this is exactly what HFT accomplishes:

Bob wants to buy a lot of Apple shares. At this point he has more information than all other market participants. He knows that in a few moments, the price of Apple shares will rise. Is the market for Apple shares -- at this point -- an unhealthy market, because Bob has access to more information about it?

If Bob's large order is larger than the current number of open orders, then an HFT algorithm might see Bob's trade -- where he buys some of the stock he wants to buy -- and assume he wants to buy more, so it adjusts its orders accordingly. This very act disseminates information into the market about Bob's large order (if the HFT algo is right, if it isn't it loses money). Information about Bob's future order is now more evenly spread between market participants, though a higher ask price, reflecting Bob's large future order. The information that each participant has is now more equal than it was if no orders were adjusted, because the buying price has risen as a result.

wavesounds6• 12 years ago

My point is these traders get to know things before other traders, thats not fair, everyone should see Bob's purchase order at the same time and arguing that Bob has an unfair advantage because he knows what he's going to do before the HFT's know what Bob's going to do is just silly.

patio113• 12 years ago

Healthy markets are markets where everyone has access to the same information.

If I want to sell 100,000 shares of Yelp (which is a multi-million dollar transaction), the fact that several million dollars of Yelp is about to hit the market is a really, really important bit of information. I have a reason to hide that from the rest of the market at least until I can complete my sale. HFTs profit by ascertaining my intentions faster than I can complete my intended action and then broadcasting my intentions to other market participants via the ticker tape, whereas previously my intentions were proprietary information locked in my head.

An argument against HFT is, necessarily, an argument that I should be allowed to benefit from material non-public information about the near-term state of trading in Yelp.

wavesounds6• 12 years ago

Your saying you should be able to front run the market because otherwise its unfair that I know what decision I'm going to make before you know what decision I'm going to make?

klochner2• 12 years ago

That's private information. It is an important distinction. You're saying the market should have a right to know whether I plan on selling my shares next year.

pedrocr• 12 years ago

If I want to sell 100,000 shares of Yelp (which is a multi-million dollar transaction), the fact that several million dollars of Yelp is about to hit the market is a really, really important bit of information. I have a reason to hide that from the rest of the market at least until I can complete my sale. HFTs profit by ascertaining my intentions faster than I can complete my intended action and then broadcasting my intentions to other market participants via the ticker tape, whereas previously my intentions were proprietary information locked in my head.

Let me see if I understand your example. I want to dump 100k@100$ and yet the current book doesn't have that many buy orders (otherwise the order would just complete). The book has buy 1k@100 and sell 1k@105 So I try to be sneaky and just clean out the book with 1k@100, selling 100 shares each to 10 retail investors and wait for more 100$ retail investors to show up by placing another 1k@100 sell order. The HFT sees this quickly and puts in orders for buy at 90$ and sell at 95$. Now the next retail investor sees this and just buys at 95 instead of 100, saving 5. I need to then sell at 90 instead of 100, losing 10. The HFT firm makes 5.

So the HFT firm is taking money from informed investors and taking some for itself and giving some to people who have no special information about the market like retail investors. If that is the case the only problem with HFTs are second order. That (much like bitcoin) they spend a bunch of resources with busywork that could be at least partially eliminated by more decimal points in pricing trades. And that they may discourage some informed investors from adding information to the market because they can't profit from it, reversing their benefit.

sseveran2• 12 years ago

The trading pit that electronic trading replaced had far more potential information leakage. You can see which broker is demanding what. Also in order to get the "direct feed" you had to be an exchange member, or rent a seat from someone who was. What we have now is a far lower barrier to entry at the cost of all the existing players. And many of those players are mad.

dllthomas5• 12 years ago

"Healthy markets are markets where everyone has access to the same information."

If it's not a matter of degrees, then the speed of light means there's no such thing as a healthy market.

jellicle2• 12 years ago

TL;DR: Stucchio thinks that front-running people is fine in circumstances where it's not prohibited by law. It's legal, therefore morally right, is his argument.

Other people (including very many securities regulators) think that the problem here is that the law is missing a prohibition.

exelius4• 12 years ago

You'll find this attitude (it's legal, therefore it's morally right) is very prevalent in the investment finance industry. It's as if these guys lack a moral compass of their own...

kasey_junk4• 12 years ago

That sort of smear may or may not be true, but it isn't what is happening in this case. What is happening in this case is that 2 groups (large liquidity purchasers and liquidity providers) have a natural antagonistic relationship with each other. Purchaser always want to lower the price and providers want to raise it. This is good for the markets operation.

But there is a PR/Power imbalance currently in the market. The large purchasers have tons of money had influence. They are using it to smear the sellers of the product they want. The sellers happen to be an easy group to smear (they are highly technical, secretive, and operate in a world that no one seems to understand).

If anything is immoral in all this is that they are actively trying to obfiscate what is happening in the markets and thereby spreading fear.

eudox• 12 years ago

You will find the attitude almost everywhere you look. "If it is legal it is moral". Saying it's exclusively in the finance industry is absolutely delusional.

chollida12• 12 years ago

Replace investment finance industry with silicon valley and you would be just as correct.

spindritf• 12 years ago

Stucchio thinks that front-running people is fine in circumstances where it's not prohibited by law. It's legal, therefore morally right, is his argument.

This is completely not the argument presented in the OP. "Front-running" is fine because it leads to quicker inclusion of market information in price and makes large players pay for their own large trades.

sseveran2• 12 years ago

Also because it is not front running. Front running has a technical and legal definition that someone looking at a public feed does not meet.

nodata• 12 years ago

Using the same logic, if we were to make a law that forbade it, then he would agree that it was wrong? Perfect!

harryh24• 12 years ago

And you think it's morally wrong even if it leads to better functioning markets with lower costs and better prices for everyone else.

Also, what specific prohibition would you change in the law? And who do you think that would help?

mike_herrera• 12 years ago

And you think it's morally wrong even if it leads to better functioning markets with lower costs and better prices for everyone else.

Citation?

jellicle2• 12 years ago

And you think it's morally wrong even if it leads to better functioning markets with lower costs and better prices for everyone else.

But it doesn't lead to any of these things. It leads to worse-functioning markets with worse prices for everyone else.

Where do you think the profits made by HFT come from? The air? Ghosts? Fairies?

kasey_junk4• 12 years ago

One of the single biggest problems with discussions on HFT is a lack of rigour in the use of terms that mean specific things.

Front-running is a specific thing, someone who has a duty to you to execute on your behalf instead executing on their own behalf. Large market participants have started co-opting this term to mean, "not allowing us to hide our huge information advantage and thereby screw the rest of the market".

They do this because they know the idea of a market run by computers scares people and most people have heard the term front-running and know that it is wrong. They are trying to bypass market dynamics for their own gain, to the detriment of everyone else through public relations/regulation.

crdoconnor9• 12 years ago

The only difference between front running and what HFTs do is that they've found a loophole whereby they don't have to be your broker to figure out what your trades are in advance.

daveed2• 12 years ago

One of the problems with this whole issue is that people are prone to looking at tl;dr's. Your comment assumes that front-running is occurring, which is not what's happening. Would you rather the debate go to: whether everyone should trade based on the SIP? But then:

- What happens when the SIP goes down? Should the US markets shut down? - What is the motivation for innovation if everyone uses the SIP? One advantage of multiple markets is that they are also competing with each other to improve in terms of technology, and rates. - Why is it better to trade in a world with less information?

rayiner2• 12 years ago

In what other context is using indications of a big buy or sell to bid up the price ahead of the big buyer or seller considered wrong? If my observation of Disney suggests they're going to buy up some land in a neighborhood to build a theme park, is it morally wrong for me to buy up the land and sell it at a higher price?

hackinthebochs12• 12 years ago

Why would it not be? You're taking money from the original owner [edit: and costing the buyer more] through asymmetry of information. You are providing no service to either of the parties.

hft_throwaway2• 12 years ago

How is it any different from arbitrage? If I see the price of ES move in Chicago before others and trade SPY in NY based on that, is it front-running?

Somebody will make that trade, so we're really just arguing over who gets the money.

chollida12• 12 years ago

I think this article does a good job of illustrating why its so hard to have an open dialog on this subject.

Start with asking "What is front running."? The market's definition would not include what HFT do. But bring this up to someone without knowledge of the public markets and their first reaction is to say, hey this is front running, it must be wrong. "Front Running" has a specific definition and it only relates to a broker and their own clients. You trading before me because you are faster is not front running. You understanding my flow is not front running.

You can then ask "What is public information". The fact that everyone can see any tape they pay money to see so there doesn't seem to be any one acting on "insider knowledge."

Now tell people that HFT's will use their fast machines to change their orders due to a change on one exchanges tape before the main NBBO tape is updated and some people will claim that this is obviously wrong.

The other argument I've seen made here is that trading on "insider knowledge is obviously wrong." Well it isn't obviously wrong and the entire commodities market assumes that anyone can trade legally on insider knowledge. Imagine you are the biggest producer of oranges. You know that you are going to have a bad crop so you but some orange futures so you can meet your demands. This is insider information you've traded on and its the way the market is intended to work.

jalopy3• 12 years ago

TL;DR: Defending HFT’s argues for rewarding market participants who simply jump in front of the line b/c they see other people doing it, at the expense of participants who have worked hard to decided which line to get into.

Here's a more fundamental question to ask:

What kind of behavior do you want to reward in the stock market?

If you view the stock market as a bunch of numbers that wiggle around, where "information" is conveyed by the actions of other people participating in the market (ie, what they’re buying and selling), then the HFT's play a legitimate role in spreading that information around.

If you view the market as a place to buy and sell businesses (equivalently - shares of businesses), where capital is allocated to businesses commensurate with the value they provide to society, HFT's are parasites on the effort of others.

There are participants in the market that spent an enormous amount of time, diligence and thought into deciding allocating capital to businesses according to the value they ascribe to the businesses. For these participants, the signal they send by putting out their orders is currently taken advantage of by other participants who spend enormous time, effort and money into trying to “tap into” the result of the efforts put forward by the first group and rush to another exchange to buy up that company before anyone else gets there.

So: Do we really want to reward all of the effort spent building faster machines, communication links, and algorithms to jump right in front of someone in line? Or do we want to reward those people who are actually determining which businesses have intrinsic value and which do not?

It's easy to hate Einhorn or Ackman b/c they're rich. What's important to keep in mind is that they are custodians of and act on behalf of thousands, probably even millions of other people to improve their financial situation. Pensions, endowments, sovereign wealth funds, etc make up the bulk of the funds that Einhorn, Ackman and others invest. The fact that they're rich an indication of their legitimate hard work at researching and allocating capital and enhancing the financial well-being of their clients. (Note: yes, there are always bad apples that get rich by illicit (read: insider) means, but that is an exceedingly small amount of participants and over time they usually get caught).

Warren Buffett has often said that a perfectly good stock market would be one which is open only one day a year, where participants put up orders based on the value they actually ascribe to a business. If those orders cross, then trades occur - all in one day.

Makes you wonder what would happen to society in that market. Would people would be able to find a way to channel all the frenetic activity currently employed in chasing prices and watching others’ actions into a more productive endeavor?

tptacek2• 12 years ago

David Einhorn is a hedge fund manager, not a mutual fund manager. Vanguard, one of the world's most reputable mutual fund managers, is on record as saying that HFT has improved their cost to trade.

That was an easy point in your comment to respond to. The rest of it doesn't appear to have been based on Chris Stucchio's post at all; you could just as easily have posted it in every thread on HN about HFT. I must be missing something; what is it?

klochner2• 12 years ago

If we're all going to cite Vanguard, we should at least get the quote right:

There are literally hundreds of strategies that are high-frequency trading, ranging all the way from those that really perform much of a market-making and liquidity-providing function to perhaps some on the opposite end of the spectrum, where they are abusive and trying to manipulate the market, " he said.

Obviously, we need to get rid of those types of high-frequency traders, but I think the bulk of them are creating liquidity and reducing spreads for us, which has dramatically reduced costs.

yummyfajitas4• 12 years ago

My attempt at a charitable interpretation of Jalopy's post is that he is saying it's actually a bad thing to transfer wealth from informed traders. This is because David Einhorn has demonstrated great competence at trading, and if HFTs predate him it reduces his incentive to continue transmitting useful information to the markets.

I find this to be an argument I can't dismiss easily.

I've added a link to your comment to the original post. It's important to spread this idea as well.

jalopy3• 12 years ago

Yes, but Greenlight Partners (Einhorn's fund) is a Limited Partnership that can include Pensions, school endowments, etc, in addition to "other rich people".

Vanguard's CIO (Gus Sauter) has mentioned in a CNBC interview (see http://www.cnbc.com/id/49434073) that the liquidity providing aspects of HFT tech are valuable - ie, the tools that help the real market makers fill orders on the other side. In the same breath he says the abusive practices (predatory trading) need to be reigned in.

Chris Stucchio's post seems to be defending the "predatory" side of HFT's as "spreading around" the information advantage conferred by hard work and due diligence into the workings of a company.

I'm refuting that by describing the actual effort that goes into attaining the information advantage obtained by Einhorn, Ackman, etc he describes and contrasting it with the effort involved in HFT predatory trading.

Which effort is more important and should be rewarded?

Shinkei• 12 years ago

I really like your TL;DR summary. It's spot on.

One of the debates that seems to underlie a lot of these discussions is probably more reflective of the values of the individual than the actual issues at play. It seems like some people value justice above all else and others think that--at least in some arenas--justice is not necessary, and may be detrimental. So that the final question could be:

How do we balance fairness in the market with the need to provide liquidity?

candybar• 12 years ago

The line of reasoning you've taken seems reasonable, but I don't think it works. So let's step back a little and take on an even more fundamental moralistic argument. The workers of the companies whose shares hedge fund managers trade may say, wait a minute, we're doing all the work and there's somebody out there creating models of our work in some dinky little spreadsheet and making more money than all of us by trading units of our work! From some moral standpoint, they are not really wrong - hedge fund managers are disproportionately well-compensated and they don't directly add value.

But what happens when you stop hedge fund managers (or really any informed traders) from arbitraging based on whatever research and analysis they do? Prices get out of line. And if prices get out of line or disappear, transactions either go away or are made on uneconomic terms. That's the problem with getting rid of hedge fund managers. This is why financial speculation is tolerated.

Now how does HFT affect this equation? Well, it's quite simple - they accelerate the social benefits of the actions of hedge fund managers while reducing their profits. When you're looking purely at the interaction between HFT and hedge funds, it seems like hedge funds are doing all the hard work and HFT is taking a cut for no reason. But when you realize that the product sold by these hedge fund managers to the rest of the society is better prices, HFT is bargaining with the hedge fund managers on behalf of the broader society and delivering the product quicker and cheaper.

The key to understanding this is that while the social value of hedge fund managers comes from efficient markets they help create, they themselves don't want efficient markets because they can't get paid as well in efficient markets. What HFT does is it brings about efficient prices a little quicker than they would otherwise.

Edit: The above does not preclude the possibility that HFT is harmful, but it limits the possibility largely to a world where hedge fund managers as a group are too poorly paid to be properly incentivized to do their work well. I don't think anyone's gonna go there.

Edit2: Another way to think about this is that hedge fund managers expressing outrage are trying to have it both ways - they want to get paid for their work but don't want to move prices in the process, even though price movements are their only contribution to society. And don't forget their access to liquidity comes from noise-traders who are willing to accept prices as they exist and HFT helps even the playing field between noise-traders and informed-traders, allowing the former to trade in sufficient volume to keep the spreads low.

But for the most part, it's not the buy-side complaining about HFT, because there have always been gate keepers and paying them has always been part of the game. Almost all actual complaints about HFT seem to come from people whose work is being replaced by HFT - the old school line-jumpers whose art no longer seems to translate to the brave new world.

vlad_didenko• 12 years ago

Interesting exercise, yet I feel a little detail is missing. In the two presented "views" of stock market functioning the first "informational" function is an integral part of price discovery, and so of the second "capital allocation" function. With that in mind the question turns into - who is an "authorized" entity to decide, how to proceed with price discovery?

bakhy5• 12 years ago

reading about the stock market is always kinda disgusting to me. "If a speculator believes AAPL is undervalued, he buys a bunch of shares of AAPL. This drives up the price until AAPL is no longer undervalued - then the speculator can sell his AAPL and reap the profits." -- the part after the dash shocked me :) seems like the entire purpose of the market is speculation? does anyone actually invest in companies any more? :D

i did like reading this, informative. gave me a nice other perspective on HFT.

however: (a) Goldman Sachs does not have it's own HFT outfit? they are the "helpless victims" here? sounds a little unbelievable. (b) why is it exactly socially beneficial that some HFT company performs this "robin hood" act (lol)? particularly if it exposes us all to the risk of market volatility due to mindless algorithms performing enormous, senseless trade volumes with each other?

all in all, i'd vote for that very small tax on trades, just to get rid of this as-yet-unseen level of speculation.

bakhy5• 12 years ago

p.s. how does moderation on this site work? i have been downvoted, and i wonder - is this an act of some admin moderating, or do users with sufficient karma get a downvote button and one of them simply dislikes my comment?..

Codhisattva• 12 years ago

Sometimes downvote means "I disagree". Since you proposed a transaction tax, most likely a libertarian apologist pounced on you.

probably_wrong• 12 years ago

..., or do users with sufficient karma get a downvote button (...)?

Yes, they do. I always forget the threshold, but there is one. Check the 4th point in the FAQ: http://ycombinator.com/newsfaq.html

Jtsummers• 12 years ago

The threshold when I crossed it was 500 karma to downvote. Not sure what it is now, but I got the impression it doesn't change that often.

KMag• 12 years ago

Speculators are people or institutions who purchase an instrument (stock, commodity, etc.) in anticipation of price movements in order to later sell the instrument, without having an underlying business need for the instrument. [1] In the case of common stocks, unless someone's intent in buying the stock is to take over the company, use the voting rites to influence the makeup of the board, or otherwise use the voting rights, you are a speculator. You may be a long-horizon speculator, but you're still a speculator.

Now, if you're a long-term speculator and the reason you dislike people who typically speculate over shorter term horizons than you do is that you believe they adversely affect your prices, consider that short-term speculators are often the people with the highest bids and lowest offers are shorter-term speculators.

[1] http://www.nasdaq.com/investing/glossary/s/speculator

politician• 12 years ago

If HFTs liberate access to price information, then does that make them the "open-source software" equivalent of our current economic operating system? That is, in the same sense that OSS delivers bundles of information about how to do various computational tasks efficiently via source code, HFTs deliver bundles of information about how to value companies efficiently via the ticker tape.

In the same way that the source code reveals the genius of the programmer's understanding, the excellance of an HFT is revealed by the report of the ticker tape.

JumpCrisscross2• 12 years ago

Why isn't HFT front-running? Let me attempt an explanation without relying on legalistic constructs.

Customers pay brokers a commission to execute their orders. This involves a customer trusting a broker with their confidential order information. Until an order goes to the exchanges, only the customer and broker know about it. The order is material non-public information.

Brokers have a fiduciary obligation to look out for their customers' interests. This applies even when the customer's interests conflict with the broker's. For example, suppose a broker holds Tesla stock. A knowledgeable customer calls the broker, seeking to sell 2 million shares. This would depress Tesla's stock price. Front-running would involve the broker selling his shares first, and then the customer's. This violates the broker's fiduciary obligation. That is why it is fraudulent and thus illegal–an explicit trust relationship would be ruptured.

Across the trading floor from the brokers are us market makers. We trade our own capital. We also have no customers and thus no fiduciary obligations. Our income comes from the bid-ask spread (and liquidity-provider rebates from exchanges). For example, here is how a phone call might go:

COUNTERPARTY: "2 million Tesla?"

MARKET MAKER: "209 at 210."

COUNTERPARTY: "Buy 2 million Tesla for 209."

The counterparty is looking to buy or sell 2 million shares of Tesla stock. They do not specify which in advance. The market maker says they will buy at $209 or sell at $210. The customer then confirms that they want to buy, and will buy at $210.

An order, when properly executed, does not betray its owner's intentions. This applies as much in the meat space as in HFT. For example, here is how one would not place an order:

COUNTERPARTY: "I am looking to sell 2 million shares of Tesla stock at whatever price you'll give me. My wife just left me for a Brazillian stripper and I'm halfway through my handle of morning vodka."

This guy won't get 209 at 210. He might not even get 200. This isn't the market maker front-running a customer. It's a liquidity provider protecting his book and bottom line. This adversarial relationship is efficient - it keeps markets from getting too clubby.

There are valid critiques against HFT. (My pet is that HFT has no obligation to continue providing liquidity in adverse market conditions. This means they can pull out when the seas get rough, i.e. precisely when liquidity is needed. Traditional market makers cannot do that.) "Front-running" is not one of them.

nissimk• 12 years ago

Yeah, and isn't it true that the traders managing those large orders never enter them through traditional means anyhow? They either submit them to "dark pools" where the huge blocks can trade with other large participants without impacting the market as much, or they enter them as algo orders with their broker and they are split up into many smaller orders throughout the day with the goal of transacting at the average daily price.

crdoconnor9• 12 years ago

Why isn't HFT front-running? Let me attempt an explanation without relying on legalistic constructs.

That's quite funny since your defence of 'HFT front running' relies upon a fine legalistic distinction --- that the person who fucked you has no fiduciary responsibility towards you (HFT) vs. the person who fucked you having a legal responsibility towards you (broker).

Bottom line, though - they'll both fuck you.

harryh24• 12 years ago

That's not a fine legalistic distinction! That's a HUGE distinction!

One of the people is someone that you've hired to work for you. The other is someone you have no previous relationship with.

300bps• 12 years ago

Until an order goes to the exchanges, only the customer and broker know about it. The order is material non-public information.

The problem with your argument is that it doesn't address that certain companies have paid money to co-locate their servers in the same datacenter as the exchanges. This is unethical because:

T + 0.000 seconds order is sent to an exchange

T + 0.001 seconds order is received by colocated companies

T + 0.090 seconds order is received by non-colocated companies

For the first 90 milliseconds, the exchange has engaged in "selective disclosure" which means the order is still material non-public information after it has arrived at an Exchange. For colocated firms to then act on that material non-public information is unethical at best.

Citation on "selective disclosure":

http://www.investopedia.com/exam-guide/cfa-level-1/ethics-st...

Selective disclosure? When information is disclosed selectively, i.e. just to a handful of investment analysts, or perhaps on a conference call, or in an email, the information may still be regarded as nonpublic. Companies are bound by specific procedures designed to make the information truly public and to ensure a system of fairness in which all market participants are given a chance to act on the information.

harryh24• 12 years ago

If people couldn't pay to co-locate with the exchanges they would still compete for latency reductions. They would try to get in the building across the street. Or the one two blocks away. Or the one with a direct fiber connection.

Being able to pay to co-locate with the exchange actually serves to democratize things because it puts everyone on a level playing field where they pay the exact same cost for the exact same access.

msandford5• 12 years ago

The big problem is that the human definition of "front running" is bigger and more complex than the strict one that the computers (probably) obey.

To the computers the milliseconds of lag between the orders arriving at one exchange and the other is an eternity, it's plenty of time for the information to propagate and make price changes happen. As far as the computers are concerned the whole counterparty/market maker exchange above happened in totality at one exchange before it got anywhere close to the next exchange.

But to the human beings which by definition operate at human time scales it's seems as though the counterparty says "buy 2 million" and at that exact instant someone else cuts in line, yells "buy 2 million" and gets his execution price and causes the market maker to up the price that he has to pay.

I realize that TECHNICALLY that's not what happens. But to a human being it can easily seem that way. That's why the HFT folks argue so vociferously -- they're technically right -- but it makes them look like giant assholes to everyone else. It doesn't matter if they're technically correct, it's indistinguishable from "we're all smarter than you and you just need to trust us on this one" which people don't have a strong affinity for.

Here's that idea fleshed out:

COUNTERPARTY: "2 million Tesla?"

MARKET MAKER: "209 at 210."

COUNTERPARTY: "Buy.."

HFT: "BUY 2 MILLION TESLA!!!"

COUNTERPARTY: "...2 million Tesla for 209."

MARKET MAKER: "Sorry bud, now it's 210 at 211"

COUNTERPARTY: "WTF?!"

I realize that's not ACTUALLY what's happening. But when the time-scales of human beings and computers are so incredibly different it's not hard to understand why people FEEL like it is.

JumpCrisscross2• 12 years ago

I realize that's not ACTUALLY what's happening. But when the time-scales of human beings and computers are so incredibly different it's not hard to understand why people FEEL like it is.

The guy getting screwed by HFT isn't the chap looking to sell 2 million Tesla at 209. It's the guy on the other side who was hoping to pick up 2 million Tesla for 209 (to flip it at 211). Now the HFT buys it for 209 and sells it at 210, compressing the margin the flipper would have earned from $2 to $1. That's not front-running - that's competition. There is no privileged relationship between the HFT market maker and the other market makers or brokers looking to buy stock. In fact, there is an adversarial relationship. That adversarial relationship is what allowed the original chap to offload his 2 million Tesla at 209 in an instant. It is also what allowed the next guy to buy it for 210, versus the 211 the other market maker wanted to flip it to him for.

bertil• 12 years ago

As I understand it, the main issue with HFT are two fold:

* some cases of insider trading at under-a-microsecond rhythm, that sound like faster-than-light favoritism but are actually covered by existing legislation (you just need to update judges and the SEC on basic technological feasibility);

* dangerous unmanned behaviour -- flash-crashes.

Front-running has always been presented as controversial at best, i.e. taking cents from people who could spare dollars; more often illustrative of finance’s excess (spending the GDP of a large country to establish even faster lines between cities already well connected, not that makes any more sense than blaming Formula 1 racing for going above the legal limit).

I understand his passion, and the “I’m a geek and I work for a small company facing Goldman” inferiority complex must be crushing -- he writes himself ‘A fervent defense’. However, that seems to be missing the key issues most people have with such technology left unmonitored.

foobarqux• 12 years ago

I think there is a lot of nuance being left out in these types of defences which are misleading. For example,

Note that the market maker at no point had the ability to change any order in response to Big Joe.

But they sort of can, specifically the canonical example in Lewis' book is that HFT market makers change their standing order on other markets faster than it takes the orders of buy/sellers taking liquidity to hit that venue. That behavior isn't what a reasonable person would expect by default.

There is no mention of things like flash orders (which no longer exist in US equities?), hide-not-slide, payment for order flow, maker/taker, etc, all of which are potentially problematic and deserve discussion.

In short these defences are nearly as simplistic as the attacks they attempt to counter.

kasey_junk4• 12 years ago

Agreed. But the difference is that the people defending them are not trying through public perception, or regulation to change the current system. If they are not asking for change, why should they be held to a higher standard than the attackers.

For all of the potentially problematic items mentioned, there is an equally problematic issue on the liquidity taker side. Invisible order books, iceberg orders, preferred router agreements, and large block rebates are all "features" that the markets provide to give advantages to the large institutional investor that harm the rest of the market but they aren't mentioned in the Lewis book, and are never referenced by folks trying to defend "the little guy".

yummyfajitas4• 12 years ago

Big Joe is a retail trader trying to move 1-2 lots. His order can be entirely filled at a single exchange. Changing standing orders on other markets is only an issue for big players trying to move many lots.

You are correct that the financial markets are complex and I can't possible cover every topic. Even if I had the stamina I don't have the knowledge.

salmonellaeater• 12 years ago

If we had no price discrimination, perhaps because of a regulation requiring market makers to leave their quotes out in the market for 60 seconds, then ... [t]he net result is that Big Joe would pay more to trade and Little Billie would pay less.

The debate about HFT is largely about who gets to benefit from new information. Suppose someone does a lot of research and discovers that a firm is undervalued. Should they get to profit from the information, at the expense of current stockholders? Or is it better for stockholders to quickly figure out that their holdings are worth more? HFT helps the stockholders in this case, because it moves the price faster to its eventual higher equilibrium before the researcher can buy up many shares at the (low) current price. The researcher may have expended a lot of time and effort to get this information, and with the existence of HFT their work may not be sustainable.

Contrast this with someone who accidentally discovers public information that could be profitable, or someone who engages in insider trading. In both these cases it's hard to argue that we as a society should create rules that let them profit at others' expense.

In other spheres of life (software patents, copyrights), the law over-protects dubious discoveries and creations. Is information related to stock pricing different? Are we under-protecting it, such that we should let someone with new information collect more profit than they can today?

thatthatis2• 12 years ago

Predatory traders detect information and split the profits with the counterparties (taking a cut in the process)

No. No they do not. They detect the information, and extract part of the value without improving the situation of the seller.

The seller was going to get filled at $21 in either case, the only difference is that the front-runner bought and resold those shares to the "whale" buyer.

This intellectual backflip is premised upon two mutually exclusive things happening:

1) the predator trades on information that there is demand coming and 2) in the counterfactual for the seller, that demand may never have come.

But because the front-runner is cutting the line, they only place trades once the demand is in the order book.

As a work of acrobatics, this is impressive. As an intellectual work, it is saddening.

yummyfajitas4• 12 years ago

But because the front-runner is cutting the line, they only place trades once the demand is in the order book.

There is no "cutting the line". If the demand were already in the order book the trade would have occurred.

Please go read the tutorial before commenting further - you demonstrably do not understand how a matching engine works.

thatthatis2• 12 years ago

I re read your article, and it appears I took information from your headline and assumed it into your examples. I think you're talking about plain vanilla market making and speculation. Nothing in there is what I would consider predatory or HFT or front running.

These things exist, per my best reading of the wsj, and you said you were defending HFT but as best I can tell merely defended computerized market making and speculation.

MaggieL• 12 years ago

I'd be more impressed by a "fervent defense of HFT" from somebody who isn't in the business.

yummyfajitas4• 12 years ago

Do you disagree with my arguments or are you appealing to the genetic fallacy?

Not that it matters - I left HFT a long time ago.

crdoconnor9• 12 years ago

Predatory traders break this information advantage. Instead of Goldman, David Einhorn or other informed traders gaining the full benefit of their information, predatory traders detect that information and split the profits with the counterparties (taking a cut in the process). Predatory traders improve market efficiency by turning information about market demand into price movements. They are simply criticized because the price movement happens before the whale actually wanted it to.

This is the exact same defense used against insider trading and front running in general.

There is nothing special about HFT in this respect, other than the fact that it is currently still legal.

Edit: downvoting without responding. classy.

A Fervent Defense of Front-running HFTs

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