High Frequency Trading Is A Scam | Hacker News Reader

High Frequency Trading Is A Scam

market-ticker.denninger.net

24 pointsFlemlord41 comments

Just so you guys know, there's actually nothing economically inefficient with what these high frequency algorithmic traders are doing.

With the example they gave, the buyer was WILLING to pay up to 26.40. This means, in the buyer's opinion, the stock is worth $26.40 per share. The sellers were willing to sell for anything above 26.10, which was the ask price. As basic economics teaches us, them trading for ANY amount between these two prices is 100% efficient. And, in this case, it doesn't matter who gets the extra money, whether that be the seller, the buyer, or the high frequency trader.

The trader is doing nothing to hurt the liquidity of the market - they are not 'gaming' the system in any way, nothing and nobody is being 'manipulated'. The seller sold for a price that they thought was a fair value, and the buyer bought for a price that they thought was a fair value. The traders are simply looking to make that 30 cent difference. Although it seems like they are contributing nothing, it is still economically efficient.

Except that they're paying money (both to the exchange, for privileged access to the low-latency data, and to their own employees/vendors for their software and hardware) to be the ones who pocket that $0.30/share surplus. That's rent-seeking, and from the point of view of the economy as a whole it is a deadweight loss. The resources used on HFT could have gone toward creating wealth, rather than generating a zero-sum transfer from one market participant to another.

Thank you. I had been a little "hmm...that seems fishy but I can't put my finger on it", but your analysis gives the missing piece.

Aren't the HF traders exposing themselves to price risk, creating more opportunities for sellers to sell and buyers to buy, and narrowing the bid-ask spread?

Yes, that's a good point - and both my criticism and your rebuttal could be applied to any number of professional traders, not just HFT systems.

I was mainly focused on this claim from the New York Times article: "A loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee."

If true, this means that the HFT operators are not necessarily taking on the normal level of price risk, and their incentives aren't necessarily aligned with efficiency as they would be in a neutral market.

And the point I should have made is that most of our market regulations are not about efficiency, but about more specific ideas of fairness or transparency. For example, insider trading does not introduce inefficiency into a market, but it's regulated nevertheless.

There's a whole slew of strategies used by these people. There are a lot of strategies used just to find out what other strategies are being used. People are paid big bucks to develop new strategies that hide what the trader's intentions are. This is a very difficult thing to do, and that is why the salaries are so large.

I'm not sure how that's zero-sum. There's value in a) liquidity and b) the exchange existing at all. If the exchange didn't get "rent" how could it function?

If you plop a big limit buy order at $26.40 and the market's at $26.20, you will wind up paying close to $26.40 because you'll eat through all the sell offers and transact inefficiently. It's called slippage.

However, what's preventing you from getting f*ed is that this is a market, so basically you have 10+ HF shops fighting who can be on the other side of that slippage. The fact that it's a competitive market ensures you don't get raped like the guy claims.

Can I just point out --- knowing full well that this is not a meaningful or valid argument or constructive comment on the article --- that Karl Denninger is a huge, notorious Internet crank? He's burned a whole through operating system teams, ISP markets, the security community, at least two major world religions, the SCUBA industry, and now this. He has a bias here, and it's towards controversy he can be self-righteous about.

He may actually be right about this --- he is occasionally right --- but man I wish there was a credible source that backed him up.

He doesn't seem to extend very far past the facts as presented in the NYTimes article.

I do too. I almost feel bad saying I agree with the Yamhead, but the more I read about HST and the wave of financial types claiming this is all perfectly legal just makes me angrier and angrier.

Without donning the tinfoil hat for too long, you gotta wonder if that source code Aleynikov tried to take away from Goldman was a smoking gun. I've never seen the FBI move so fast. When the hat comes off it's probably just one mechanic trying to take the toolbox to another garage.

I think this characterization of HFT is a bit overblown. The activity he's calling unethical--offering a security at price, getting hit at that price and continuing to raise your price until you stop getting hit--is exactly what market makers have always done. This is basic free market dynamics. You offer at $100, you get hit, you raise your price a little bit, say $100.05, and see if you get hit again. Don't get hit? Ok, drop your price back down a little. The same thing happens in open pit trading, it's just a lot slower.

Here's a good thread over at New Mogul on the subject. This type of trading is not illegal, and it's actually commonplace among the big players on Wall Street.

http://newmogul.com/item?id=14134

Call me jaded, but 'commonplace' and 'not technically illegal' don't strike me as a very compelling defense.

Please don't try to interpret what I meant. What I wrote is exactly what I meant to write. This trading is not illegal. This trading is perfectly acceptable. The only people who seem to have a problem with this are a subset of the people who don't have the resources to do it. Frankly, the arguments I have read against it are mostly penned by ignorant folks who simply come across as jealous.

> The only people who seem to have a problem with this are a subset of the people who don't have the resources to do it.

That's likely true, since only a couple of firms can do it, and there are millions of people's interest in the markets. The NYTimes article this article pulls from specifically points out that these few firms are taking money out of the pockets of "slower" firms, like hedge funds. Given that a large number of people in the country have their retirement funds tied up in hedge funds, until someone shows otherwise, this is clearly the rich stealing from the poor.

I understand that those in the industry have a different worldview, but try to see the bigger picture. The only difference between grossly immoral and illegal is a few years and a new law. If this isn't illegal, its because the population hasn't been sufficiently outraged. Yet.

I do see the bigger picture. I've worked in the industry, but I've moved myself outside the industry to go back to school. I do not feel in any manner that I am being stolen from. When I enter a trade as a retail investor, I accept that I don't have nearly as much information about my trade as I would like to have. I wouldn't walk onto an NFL field expecting them to change their ways simply because I can't bench 400 pounds.

With due respect, this isn't about you, or me. It isn't your money (or mine, as I don't invest in the market) at stake here. Yes, financials are a competitive place to be, and you may have a great deal of humility as well as respect for those in the market. Like it or not, there will be a day of reckoning, when the average person will realize they are being had and take their money (aka "the leverage" that makes those commissions larger). That day will be much farther off if average people feel that they are being taken for less of a ride.

What I'm about to say is not pleasant. It comes from working in several different parts of the industry.

The greatest thing Wall Street sells is dreams. This will never go away. Every buy carries with it the thought that this one will go higher. Otherwise people wouldn't buy. As long as Wall Street continues to allow retail investors to play in the markets, there will be people who will come along for the ride.

EDIT: Don't get mad at me for saying it. I think I'm doing people a favor by pointing this out. You won't hear this from many other people.

Funny thing. I can swap "Wall Street" for "Las Vegas" in what you just said, and it reads exactly the same.

It boils down to this, in my opinion:

1) The market is simply random. Every stock you buy is a bet placed on a roulette table.

2) Mutual funds, derivatives, etc are just ways of hiding the randomness. (Hey, why play at one roulette table when you can play at 1,000 at the same time! Less risk!)

3) Even if you do decide to take the plunge and buy in, the system is rigged against you. Much smarter people have figured out how to get theirs and get out before you know what's happened. The house always wins.

Certainly not mad at your for saying that... I personally have this opinion of the markets, and thats why I don't "invest". When I go to Vegas, I have a great time, and treat money on the table as an entertainment expense. That said, society has convinced the average person that their retirement money needs to be in the market (via 401k's). As long as it is the case that uninformed people are coerced into trusting the market, I will be vocally angry when they are cheated out of their money.

I personally have no problem with people investing their retirement in the market...if the market was directly tied to the economy and the growth of companies.

But I don't see that market as being ABOUT that anymore. It's become a world of side bets and arbitrage plays. When an outsider analyst has more influence over the price of a stock than the company itself, then the market is a game, not an investment.

For example: a company can show growth, real POSITIVE growth...but ohmygodholyjebus if it's not EXACTLY what the analysts predicted then the stock is toast for the quarter. What the hell is that all about? Why do we play quarter to quarter instead of decade to decade? Because Wall Street is now about churn. And churn makes commissions.

What you are talking about is market efficiency at work. You can't accept some things about the market and not accept others. The market can be viewed as a machine that takes information and turns it into a stock price. Previous information, such as an analyst's predictions, do influence the price of a stock. If the company releases their earnings, a new piece of information, it is only natural that the price would adjust to reflect that. What many people fail to understand, is that an earnings announcement carries with it much more information than just how the recent quarter was.

Now, with that said, I will say that I don't believe the markets are 100% efficient. No matter how many papers Sharpe, Fama, French, and others publish, I will never change my mind. Globally, the markets are extremely efficient, but there are local inefficiencies. Identifying and exploiting the local inefficiencies are what makes one really good at making money off of the markets.

I'm not putting words in your mouth; my bias goes under my username, which is as clearly visible as your original post.

I don't 'have a problem' with automated trading. I'm just opining that frequency and legality, in and of themselves, are not compelling defenses.

Imagine Party A says 'marijuana's awful' and party B says 'everyone's doing it, and it's technically legal because we all have glaucoma'.

I'm pointing out --separate from whether I (dis)agree with A-- that party B isn't going to sway anyone with that approach.

I was not offering a defense. I was offering commentary. I thought that what I wrote would be more acceptable than simply saying that the author clearly doesn't understand finance or how Wall Street operates. Perhaps I should just go back to my usual sledge-hammer comments. At least my intentions are understood when I do that.

The 'price limit' phrase reminded me of the traditional fish selling method called 'lota' in my corner of Europe.

It goes like this: the fishing boats come in, crates of fresh fish are brought to a market area where buyers await. For each crate, the announcer starts with a high price (say 100) and counts rapidly down ("99, 98, 97 ...") until one of the buyers shouts out "Soo" to buy the crate at that price.

Not as amusing as bidding up an auction, but this seems a time-efficient method for finding the buyer's price limit - after all, the fish is not getting any fresher sitting there ...

From the article:

"If you're wondering how Goldman Sachs and other "big banks and hedge funds" made all their money this last quarter, now you know."

But from this article at Bronte Capital (via New Mogul):

"Anyway if 10 percent of global stock volume provides 220 million dollars revenue per quarter then there is no way that a substantial proportion of Goldman’s trading profit can come from high frequency trading. The numbers do not work."

(http://brontecapital.blogspot.com/2009/07/high-frequency-tra...)

John Hempton thinks it's impossible for this to amount to $22billion/yr - http://brontecapital.blogspot.com/2009/07/high-frequency-tra...

He's not a crank.

This sounds like the kind of story Technologists love.

Machines at better are stock market trading, so the humans are being replaced in this industry.

When the average investors leave the market because of this, front running (http://en.wikipedia.org/wiki/Front_running), , and the fact that small number of firms (~400) is involved in 70% of the US trading volume (http://www.ft.com/cms/s/0/a5f03366-6d69-11de-8b19-00144feabd...), will they ever come back?

The average investor accesses the equity market through mutual funds, which are large institutional investors that can compete with high frequency traders. If stuff like this keeps my uncle-in-law out of daytrading, I see that as a feature, not a bug.

There are markets where the entire order book is transparent, and the bulk of investment dollars don't even go to equities. Hard to see this as the end of the world.

True, but stories like this makes them pull out of equity funds and into bond funds.

Every single asset class experiences some firm using some software to effect some strategy. Moving into bond funds wouldn't eliminate exposure to Wall Street's technology.

You can't even invest in frozen concentrate orange juice without dealing with scalpers.

The average investor is not going to leave the market. I spent time as a retail broker, and the truth is most have no idea what they were doing to begin with. I don't think this is going to persuade them to stop.

They're not going to leave because they can't.

Their 401ks, IRAs and the like only work as tax shelters if they invest and (for the most part) they don't even have a choice of which firm they work with.

So long as the firms don't skim more than the tax benefit is worth to the average investor, it's still in the investor's best interest to keep contributing.

Those investors (no idea what they were doing to begin with) already got spooked by the 60% drop and pulled out of 401k/into bonds. I mean the average investors who have some knowledge of the market, and have decent capital (20k-200k) but is just trading normally using online trading services.

Trust me, they don't leave. There's something about the markets that make people think that they can compete against a firm with a multi-billion dollar IT department, a slew of economists, and direct access to the exchanges. I'm not denying that the game is in favor of Wall Street firms. I'm simply saying that this will not cause retail investors to exit the market.

Front running is illegal and is regulated (Rule 92 - also called the "Manning" rule I believe). This should not be keeping average investors away from the markets today.

To refute your second point, there are probably more firms trading today then there ever were before. It's really an economy of scales issues. The large firms have the capital and the resources to: lease fiber lines, buy servers, and hire analysts/developers to build the systems required to be an efficient player in the market players. Many smaller firms simply employ the services offered by these institutions.

To reply to a previous point, the article is very biased and tells a small part of the story. Most of the noise in the media and in blogs today about HFT is very one-sided. The fact is that these HF proprietary trading systems which trade on behalf of the big wall st firms are competing against similar systems offered as "algorithms" to the Institutional investors. To use an example, a mutual fund manager will try to buy 100,000 shares of IBM. That fund manager will go to an investment bank and route his order through a VWAP Algorithm. That Algorithm may be competing in the market against the same investment bank's HFT Black Box trading app. These two "Algos" don't know about each other due to "Chinese Wall" restrictions. I digress.

Bottom line is that these systems which are "gaming" the market are competing against similar systems which aim to prevent such practices. The playing field is much more level than the author leads his audience to believe.

Hope that offers some insightful perspective.

Rule 92 is NYSE, Manning is FINRA, and both --- if I understand them correctly --- apply mostly to traders trading for themselves against their customers interests. (NB: this is just Google research).

Keep in mind that 70% of trading volume is not at all the same thing as 70% of all the money in the system.

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