[Infowarrior] - How HFT Changed The Way Markets Trade

[Richard Forno]

How HFT Changed The Way Markets Trade

	• Posted by Jeff Carter
	• on August 2nd, 2012

http://pointsandfigures.com/2012/08/02/how-hft-changed-the-way-markets-trade/

In all the hub bub about high frequency trading, we are missing several points. I don’t want to belittle electronic trading because managed correctly it’s great for the marketplace. However, ever since electronic trading began to take over futures markets, I have seen a noticeable difference in the way the market trades in volatile situations.

In the prehistoric days when people stood in a pit side by side and fought for trades, we had crazy up and down days. But the volatility today is unlike anything long time traders have seen. It’s not just the stock market ($ES_F, $SPY), but it’s in the ag markets($ZC_F,$ZS_F), currency markets, and Treasury markets.

Years ago, Peter Steidlmayer wrote a book with a new type of data analysis called Market Profile. Today, when he looks at data from the same exact markets, it’s lumpy. Markets no longer trade through a range, but go point to point.

For traders this heightens risk.

Financial numbers are generally a volatile time in the market. In pit traded markets, even one second before the number, you could get some small sized trades off. In the Eurodollars ($GE_F) for example, if you needed to move 500 lots and had one minute before the number to do it you could. Today, bids and offers in the book are non existent. The number comes out and the market jumps to the next price level.

Because of speed advantages or co-location, or both, only certain entities get a chance to participate in the market. This also increases the amount of risk.

On the flip side, usually when risk profiles increase, returns increase. Not so in today’s marketplace. Because it’s not as easy to enter into and exit the market, traders are forced to give up the edge. This trims their return on each side of the trade.

The way speed is used has killed moment by moment liquidity. It also killed the depth in the book. No longer are entities willing to put orders at risk. Back in 1998, I was looking at the Bund options traded at the Eurex. A friend of mine who traded options there showed me the bid/ask for the at the money straddle. He said, “It’s only showing 2000 up, but I guarantee you it’s at least 20,000 up if you want to move a number.”. Looking at any electronic book today, you don’t see near the amount of depth that you would have in the pit days. One reason is order fillers didn’t disclose their orders. The other is there is huge risk of some rogue algo picking you off, running stops and then selling/buying to the market on the other side.

Part of the problem is the HFT industry won’t police themselves. They are too competitive. If one sees the code or order types of another, it’s giving away proprietary information that could leave the firm vulnerable. There is also too much money at stake. Exchanges can’t keep up. Neither can regulators.

A lot of people point to speed as the only problem. I don’t see speed by itself as a problem. But speed combined with other factors is a problem. If we change market structure and keep the speed, better markets will result.

Market structure is the only sure fire way to keep things in line. Our current structure stinks. Dark pools, payment for order flow, trading against customers through internalization, front running, decimalization, co-location are all standard operating procedure today. Each undermines competitive marketplaces in one way or another, undermining confidence.  

However, if market structure is changed to a flatter, more competitive, horizontal marketplace, the current economics of the marketplace will be severely altered. The big banks won’t be as profitable. Exchanges might do less volume. Online brokers will be affected. Most certainly, the private firms and hedge funds that have HFT operations will be affected.

Oh, and this is how a mistake in HFT killed a perfectly good company($KCG):   < snip >

http://pointsandfigures.com/2012/08/02/how-hft-changed-the-way-markets-trade/

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