Find out how big banks and hedge funds employ 'bots' to screw 'human' traders by frontrunning. I am reprinting the following article written by Karl Denninger which appeared at http://market-ticker.denninger.net/archives/1259-High-Frequency-Trading-Is-A-Scam.html in July 24 2009.
HIGH FREQUENCY TRADING IS A SCAM
by Karl Denninger
The NY Times has blown the cover off the dark art known as "HFT", or "High-Frequency Trading", perhaps without knowing it
"It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.
"The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.
"In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.
"Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares."
But then the NY Times gets the bottom line wrong:
"The result is that the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders."
No. The disadvantage was not speed. The disadvantage was that the "algos" had engaged in something other than what their claimed purpose is in the marketplace - that is, instead of providing liquidity, they intentionally probed the market with tiny orders that were immediately canceled in a scheme to gain an illegal view into the other side's willingness to pay.
Let me explain.
Let's say that there is a buyer willing to buy 100,000 shares of BRCM with a limit price of $26.40. That is, the buyer will accept any price up to $26.40.
But the market at this particular moment in time is at $26.10, or thirty cents lower.
So the computers, having detected via their "flash orders" (which ought to be illegal) that there is a desire for Broadcom shares, start to issue tiny (typically 100 share lots) "immediate or cancel" orders - IOCs - to sell at $26.20. If that order is "eaten" the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40. When it tries $26.45 it gets no bite and the order is immediately canceled.
Now the flush of supply comes at, big coincidence, $26.39, and the claim is made that the market has become "more efficient."
Nonsense; there was no "real seller" at any of these prices! This pattern of offering was intended to do one and only one thing - manipulate the market by discovering what is supposed to be a hidden piece of information - the other side's limit price!
With normal order queues and flows the person with the limit order would see the offer at $26.20 and might drop his limit. But the computers are so fast that unless you own one of the same speed you have no chance to do this - your order is immediately "raped" at the full limit price! You got screwed, as the fill price is in fact 30 cents a share away from where the market actually is.
A couple of years ago if you entered a limit order for $26.40 with the market at $26.10 odds are excellent that most of your order would have filled down near where the market was when you entered the order - $26.10. Today, odds are excellent that most of your order will fill at $26.39, and the HFT firms will claim this is an "efficient market." The truth is that you got screwed for 29 cents per share which was quite literally stolen by the HFT firms that probed your book before you could detect the activity, determined your maximum price, and then sold to you as close to your maximum price as was possible.
If you're wondering how this ramp job happened in the last week and a half, you just discovered the answer. When there are limit orders beyond the market outstanding against a market that is moving higher the presence of these programs will guarantee huge profits to the banks running them and they also guarantee both that the retail buyers will get screwed as the market will move MUCH faster to the upside than it otherwise would.
Likewise when the market is moving downward with conviction we will see the opposite - the "sell stops" will also be raped, the investor will also get screwed, and again the HFT firms will make an outsize profit.
These programs were put in place and are allowed under the claim that they "improve liquidity." Hogwash. They have turned the market into a rigged game where institutional orders (that's you, Mr. and Mrs. Joe Public, when you buy or sell mutual funds!) are routinely screwed for the benefit of a few major international banks.
If you're wondering how Goldman Sachs and other "big banks and hedge funds" made all their money this last quarter, now you know. And while you may think this latest market move was good for you, the fact of the matter is that you have been severely disadvantaged by these "high-frequency trading" programs and what's worse, the distortion that is presented by these "ultra-fast" moves has a nasty habit of asserting itself in an ugly snapback a few days, weeks or months later - in the opposite direction.
The amount of "slippage" due to these programs sounds small - a few cents per order. It is. But such "skimming" is exactly like paying graft to a politician or "protection money" to the Mafia - while the amount per transaction may be small the fact of the matter is that it is not supposed to happen, it does not promote efficient markets, it does not add to market liquidity, the "power" behind moves is dramatically increased by this sort of behavior and market manipulation is supposed to be both a civil and criminal violation of the law.
While the last two weeks have seen this move the market up, the same sort of "acceleration" in market behavior can and will happen to the downside when a downward movement asserts itself, and I guarantee that you won't like what that does to your portfolio. You saw an example of it last September and October, and then again this spring. As things stand it will happen again.
This sort of gaming of the system must be stopped. Trading success should be a matter of being able to actually determine the prospects of a company and its stock price in the future - that is, actually trade. What we have now is a handful of big banks and funds that have figured out ways around the rules that are supposed to prohibit discovery of the maximum price that someone will pay or the minimum they will sell at by what amounts to a sophisticated bid-rigging scheme.
Since it appears obvious that the exchanges will not police the behavior of their member firms in this regard government must step in and unplug these machines - all of them - irrespective of whether they are moving the market upward or downward. While many people think they "benefited" from this latest market move, I'm quite certain you won't like it if and when the move is to the downside and the mutual fund holdings in your 401k and IRA get shredded (again) by what should be prohibited and in fact result in indictments, not profits.
Senator Schumer apparently believes this is an unfair practice, and I agree.
July 24 (Bloomberg) -- Senator Charles Schumer asked the U.S. Securities and Exchange Commission to ban “flash orders,” saying the transactions give high-speed traders an unfair advantage over other investors.
Nasdaq OMX Group Inc., Bats Exchange Inc. and Direct Edge Holdings Inc. hold these orders for milliseconds, giving their customers the opportunity to gauge demand before traders on other exchanges get the chance to bid, Schumer said in a letter to SEC Chairman Mary Schapiro. Brian Fallon, a spokesman at Schumer’s office, confirmed the authenticity of the letter.
“Flash orders allow certain members of these exchanges to obtain access to order flow information before that information is made available to the public,” Schumer wrote. That allows “those members to use rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity,” he added.
The senator said that if the SEC doesn’t prohibit flash orders, he will introduce legislation that would.
This is my view:
1.Getting a look at orders before someone else does is commonly called "cheating". The National Market System (NMS) was supposed to prevent that; this was the so-called "innovation" of Nasdaq, remember? No specialists, no balancing of orders to open a stock, all done by computer. Equality of access. Up until it became profitable to make some people more equal. The intent of a public stock exchange is to insure equality of access to information so that the markets are orderly, not rigged.
2.Using flash order information (or anything else) to front-run is illegal. In all of its forms, this is an extremely serious matter and it must be stopped.
3.To the extent that these HFT systems are in fact using flash (or other) traffic to get in front of orders and advantage themselves they are dramatically increasing the violence of market moves. A stock trading at $20 that has a bid come in with a limit of $20.10 would normally fill (assuming sufficient depth) at $20; this does not materially move the market. But if a HFT system "sees" that order, steps in front of it and buys up all the shares at $20 and then re-sells them to the customer at $20.04 (one penny better than the next best offer at $20.05) it has caused the current "last" price to move where it otherwise would not. Multiply this by millions of shares an hour and the impact on price moves could be tremendous. While I understand that many people like the move of the last two weeks in the market, the fact remains that what goes up can also come down with equal violence.
4.HFT systems that front-run are able to garner risk-free profits. This is in fact the reason such a practice is banned - their "risk-free" profit is your guaranteed loss. Remember, the markets are in fact a negative-sum game (due to trading costs) - if there is a "risk-free" opportunity out there it can only exist because someone else is guaranteed a screwing.
I call upon The SEC to conduct a full and public investigation of the HFT systems in use today, along with immediately banning the "flash" traffic in accordance with Senator Schumer's request. I specifically want to know:
1.Have any of these HFT systems been using flash traffic (or any other mechanism) to "step in front" of a flashed order?
2.What part did these systems play in the October and March meltdowns, along with the ramp job of the last two weeks? Specifically, were they stepping in front of orders in these cases, thereby dramatically amplifying market moves while skimming off their pennies?
Public and fair markets demand transparency. All users must obtain access to order flow at the same time, without exception, and attempts to "step in front of the line" must be met with both civil and criminal sanction for market manipulation.
I can think of three relatively-minor changes that would leave those who are using HFT legitimately unharmed but would destroy most of the ability to cheat. These are:
1.Eliminate the 'flash order' entirely. All market participants must get order and flow information at the same time - no exceptions.
2.Force all orders (e.g. IOC, etc) to be valid for a reasonable minimum period that allows human response. 1 second would meet this criteria; it would destroy the ability of the "robots" to use abusive order patterns without preventing the legitimate use of "immediate or cancel" orders. The time selected must be greater than the average human reaction time plus round-trip network transit time within the nation; visual recognition time for young adults averages a bit over 200 milliseconds (0.2 seconds) exclusive of the response (e.g. a mouse click) and round-trip transit time on high-speed circuits cross-country (corner-to-corner) is approximately 100ms. Thus the minimum acceptable time is in the neighborhood of 500ms assuming no intervening computer computational delays (e.g. brokerage servers, etc); doubling this to provide for a margin (not all people are 20 years old, there are typically multiple computers between the exchange and end user, charting or display software requires time to post the event on the screen, etc) seems reasonable.
3.Define as "front running" by law any scheme or practice that exposes or discovers orders to any select group of players before the market as a whole, irrespective of how. The unfortunate reality is that there is no mechanism available to prevent computers from exploiting asymmetric information; ergo, you must define the provision or discovery and use of any such asymmetric information in the public markets as a criminal offense. Penalties should include treble forfeiture of all profits gained from such an abuse and a permanent ban on all access to the securities business as well as prison time.
"Arms races" are inherently negative-sum games; the only winning party is the guy who is selling the weapons. In this case the losers are the public and institutions who are attempting to invest or trade in the equities markets.
It is time to put a stop to this part of The Bezzle.
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