Tuesday, July 21, 2009

T2's Whitney Tilson On Toxic Trading

Excerpts from Whitney Tilson's client email:


1) STOP THE PRESSES! This "toxic equity trading" appears to be MUCH bigger than I thought (see the paper I sent around as part of my last email: www.themistrading.com/article_files/0000/0348/Toxic_Equity_Trading_on_Wall_Street_12-17-08.pdf).

Here's a REALLY interesting comment I received:

I’m writing to communicate that there is significantly more than a bit of truth to this paper. I can tell you from first-hand experience that predatory algorithmic trading, as outlined in your “Toxic Equity Trading” attachment, is an ongoing and rapidly evolving practice. The bleeding edge in this field is currently well beyond the scope and level of sophistication discussed in this article.

More than a decade ago, I attended a presentation by someone who was attempting to perfect the latest iteration of an “automated algorithmic trading system” he had concocted. After a short discussion, I was disgusted to realize that his “investing system” was merely a mechanism to automate the front running of institutional orders. The program ‘sensed’ institutional orders via stochastics rather than ‘pinging’ for algos. He had already implemented his first crude version of the program, so you can extrapolate forward and imagine the current state of these techniques. In fact, you don't have to imagine. I know that co-located servers, predatory algos and funds set-up specifically to execute rebate strategies are all very real. I think you would be really shocked by the way some of the funds operating in the upper mathematical/technological strata conduct business.

The moral issues here are multi-fold; these “high frequency” shops operate with a near constant information advantage (due in part to their co-location contracts) and their operations literally make the markets less efficient, all while systematically reallocating wealth away from normal market participants.

2) Another person's comment:

I just wanted to assure you that everything in the Themis paper is occurring in today's markets. It first started about 10 yrs. ago with the "rebate traders" and has evolved as the paper suggests. High frequency trading and automated market making has been a major growth industry on Wall St. the last few years. The exchanges have been courting them like mad, offering co-location of servers etc. The new push is into the options markets where the rebates are much richer, this is one of the toxic byproducts of "payment for order flow" in both equities and options. Some of the firms out there trading hundreds of millions of shares a day in these strategies are outfits very few have ever heard of, and they would like to keep it that way. The reverse engineering of institutionally used trading algos has been a booming industry. You might enjoy the following story regarding NYSE program trading transparency (or lack thereof) via the blog zero hedge.


Interestingly, both of these people VERY much wanted to remain anonymous. A lot of people who are making an awful lot of money don't want anyone to know what they're doing...

3) Here's a post from the Zerohedge blog (http://zerohedge.blogspot.com/2009/07/guest-posts-even-simpler-and-high.html) that explains what's going on in plain English:

Even simpler…

My partners frequently poke fun at me (ok there is a long line offolks doing this…), specifically for thinking too deeply about a topic,and expressing an idea with too much detail.

I would like to get real simple here. High Frequency Trading is proprietary computer trading with the goal of collecting rebates, and/or detecting real order flow (ie. instititional flow) and frontrunning it and making pennies. What bothers me? Two things:

First, whether the market is trading at a 16 P/E, or a 22 P/E, or a 30P/E… this is decided by 30% of the volume in the market. 70% of the volume is noise. In the “olden days” there were many different types of market participants (Value players, MOMOGOGO momentum players, Chartists, GARP players, and so on). None of them were 70% of the volume. This made for an efficient market. This made for a market where we felt strongly that the pricing in the market reflected actual asset values. This new HFT 70% market share makes me very nervous. I hope it does you, as well.

Second, the HFT players are courted by the Exchanges, ATS’s, ECN’sand Dark Pools. They are given whatever they want, as these for-profitdestinations all want their volume. Would they (HFT) have grown to thislevel if the exchanges and trading destinations were not for profit?

Is there a national interest in insuring that (1) our exchanges are the fairest, with equal access for all to the best prices, and not just those with their servers located inside the actual exchange, (2) our exchanges are transparent, and (3) that the system is working as it should, where asset values are reflected in prices? Was it the beginning of the end when all our exchanges went to a for-profit model?

These comments further underscore the need for urgent regulatory action to put a stop to this blatent market manipulation.

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