The Dangers Of High Frequency Trading... As Predicted By Lawrence H. Summers

When discussing high-frequency trading, Zero Hedge recently asked "As Goldman is becoming the primary conduit of trading (whether principal or agency) in virtually all markets, the risk of a
massive liquidity drain becomes exponentially larger, and the risk of an exogenous event approaches LTCM and Lehman levels. It is this key risk driver that regulators should be focusing on, instead of chasing and attempting to punish the perpetrators of the most recent market crash (we are not saying they should not, but they should prioritize and now should focus on what is most critical to maintaining a functioning market topology). " It seems we were wrong about authoritarian figures never predicting the implicit risk of this subset of program trading - ironically, it was well over 20 years ago and none other than the future Chairman of the Federal Reserve Larry Summers who had some prophetic words of caution. In a paper titled "Commentary on 'Policies to Curb Stock Market Volatility" in which Larry was discussing the cause and effect of Black Monday (about which he is quite wrong that nobody had seen coming), he lays out some oddly forward looking observations about program trading, or positive-feedback trading as high frequency trading was yet to become a staple market diet.

"In any event, positive-feedback trading is likely to increase volatility substantially. If one wants to design regulatory interventions that will decrease volatility, one must think about measures that will discourage positive-feedback trading rather than negative-feedback trading. Positive-feedback trading is substantially discouraged when traders using that strategy suffer massive losses, which is what one observed after the crash. Everyone who had been pursuing positive-feedback strategies bought more and more as the market went higher and higher, thinking that their portfolio insurance would enable them to get out. They were wrong. It's clear that the crash reduced volatility by reducing the attractiveness of positive-feedback trading."

And some very peculiar observations on margin requirements by Larry, which may have much to do with why it has become so difficult to borrow any heretofore presumed liquid stock:

"More generally, the case for margin requirements raises a question. Instead of asking why the market fell 500 points in one day, it might be more important to know why the market reached 2700 in the first place. Low margin requirements, by encouraging positive feedback trading, may well have encouraged the market increase, setting the stage for the crash."

Could it be that Larry is attempting to negate the positive feedback implications of program trading and other + feedback trading patterns by enacting higher margin requirements? That would be quite a departure, as it would mean that Goldman Sachs is in fact taking advantage of Larry's policies as they impact traditional market mechanisms (the stock loan houses State Street and BoNY in particular), by taking the other side of the positive feedback trade. Consider this in the context of the elimination of market diversity that Zero Hedge discussed in the above referenced article.

A highly insightful paper, definitely worth your read, written by a much younger and much less conflicted Larry Summers (notable phrase: "I conclude that it may be noise rather than news that is driving the market." Zero Hedge agrees wholeheartedly that the N in CNBC stands for noise).

And to conclude, a phenomenal Yale/London School of Economics paper discussing the explicit risk of High Frequency Trading. The authors argue that you can get a liquidity hole due to leveraged short-term traders (e.g., HFTs) driving prices far above what risk-averse long-term investors will buy them at. If the market falls due to an exogenous event, herding behavior, and loss limits, then prices may need to fall a long way until they hit the residual demand curve at which risk-averse long-term value investors will buy. Perhaps Larry should have read this paper when he was considering Black Monday - both the one in 1987 and the upcoming one, compliments of HFT and its #1 purveyor.

Hat Tip Richard

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Goldman's $4 Billion High Frequency Trading Wildcard

A recent story in Advanced Trading goes after some of the minutae of High Frequency Trading and provides a glimpse of the total value that HFT may provide to behemoth PT powerhouses such as Goldman Sachs. The article presents a very valuable perspective on just why HFT is so critical these days, especially when cash traders go for 6 hour Starbucks breaks between 10 am and 3:30 pm: "high frequency trading firms, which represent approximately 2% of the 20,000 or so trading firms operating in the US markets today, account for 73% of all US equity trading volume. These companies include proprietary trading desks for a small number of major investment banks, less than 100 of the most sophisticated hedge funds and hundreds of the most secretive prop shops, all of which operate with one thing in mind—capture profit opportunities by being smarter and faster than the closest competition." And as the market keeps going up day in and day out, regardless of the deteriorating economic conditions, it is just these HFT's that determine the overall market direction, usually without fundamental or technical reason. And based on a few lines of code, retail investors get suckered into a rising market that has nothing to do with green shoots or some Chinese firms buying a few hundred extra Intel servers: HFTs are merely perpetuating the same ponzi market mythology last seen in the Madoff case, but on a massively larger scale. When it all blows up, the question is whether the SEC will go after the perpetrators of this pyramid with the same zeal that it pursued Madoff himself. We think not.

The reason for this, as the AT article points out, is that HFT has become the biggest cash cow for Wall Street: "The incredible capabilities offered by technology have given meteoric rise to a relatively few high frequency proprietary trading firms that now wield far greater influence on the markets today than most people recognize." How big of a cash cow:

"Proprietary trading takes in a number of unique strategies, including market making, arbitrage (ETFs, futures, options), pairs trading and others based on the linked trading of more than one asset class, e.g., futures index and cash equities. In fact, TABB Group estimates that annual aggregate profits of low latency arbitrage strategies exceed $21 billion, spread out among the few hundred firms that deploy them."

The $21 billion estimate is smack in the middle of the FIXProtocol estimated $15-$25 billion in revenue that HFT generates. So let's do a back of the envelope calculation: Goldman controls roughly 50-60% of principal program trading on the NYSE, which in turn accounts for 30% of all global program trading. Throw in Goldman's domination of dark pool trading through Sigma X, and one can come up to quite a sizable number - It would not be a stretch to conclude that, through various conduits, Goldman is directly responsible for over 20% of global HFT trading. 20% of $21 billion is over $4 billion a year. As margins on HFT are sky high (it doesn't cost all that much to tweak a few hundred lines of code - and if Sergey Aleynikov is any indication, $400,000/year for VPs in the program is peanuts for a firm like Goldman), this $4 billion likely drops to the bottom line almost dollar for dollar. Let's recall that Goldman's Q2 earnings were $3.44 billion. Does this mean that HFT/PT accounts for roughly 25% of earnings for the firm that is a hedge fund in all but FDIC backing? Zero Hedge would in fact take the over, especially in this environment where M&A fees are a distant memory. We leave this question open, but even if we are off, it would not be by order of magnitude, and would explain why Goldman has thrown the kitchen sink into dominating such NYSE programs as the SLP, and is expending so much energy to dominate dark pools as well.

Going back to the AT article, which provides some additional critical observations, especially with regard to the Aleynikov arrest and his ludicrous $750,000 bail which surpasses that of indicted Ponzier Sir Allen Stanford:

First, strategies that optimize the value of high frequency algorithmic trading are highly dependent on ultra-low latency. The right decisions are based on flowing information into your algorithm microseconds sooner than your competitors. To realize any real benefit from implementing these strategies, a trading firm must have a real-time, colocated, high-frequency trading platform—one where data is collected, and orders are created and routed to execution venues in sub-millisecond times.

Next, since many of these strategies require transacting in more than one asset class and across multiple exchanges often located hundreds of miles apart, i.e., NY to Chicago, that infrastructure will often require roundtrip long haul connectivity between the data centers. [TD:Any real estate professionals out there who can determine just how easy it is to set up a colocated station within millisecond distance of the NYSE, and whether or not Goldman has any rights of first refusal on this real estate optionality? Nothing like a little derivative monopoly to keep potential SLP vendors at bay]

Lastly and most importantly, this code has a limited shelf life, whose competitive advantage is diluted with each second it is outstanding. While a prop desk's high level trading strategy may be consistent over time, the micro-level strategies are constantly altered—growing stale after a few days if not sooner—for two important reasons. Firstly, because high frequency trading depends on ridiculously precise interaction of markets and mathematical correlations between securities, traders need to regularly adjust code—sometimes slightly, sometimes more—to reflect the subtle changes in the dynamic market. The speed and volatility of today's markets is such that the relationships forming the core of our algorithm strategies often change within seconds of our ability to implement the very strategies that exploit them. Secondly, competitive intelligence is so good across all rival trading firms that each is exposed to the increasing susceptibility of their strategies being reverse engineered, turning their most profitable ideas into their most risky. As a result, any firm acquiring the "stolen" code would gain benefit from it for no more than a few days before that firm would need to adjust the code to the dynamic conditions. Since these changes build on themselves, in a matter of weeks that code would look quite different from that which was originally "stolen."

And the conclusion:

There's no doubt that Goldman Sachs, or any other proprietary trading firm, could indeed lose tens of millions of dollars from its proprietary trading if their strategies are stolen—and that is very serious. The competitors that obtain access to these trading secrets could (and would) use it to front run or trade against it, ruining even the most well-planned tactics. This news story contains many very important sub-plots: trading espionage, the necessity for a trading firm to have sophisticated security systems built around its technology, the requirements for risk management, and even the potential for proprietary trading software to be targeted on a wider scale for terrorist activity; but more than anything else it highlights the critical role played by high frequency prop trading in this new market.

This is indeed, a conclusion that Zero Hedge has been pounding the table on for months. It is imperative that Wall Street firms shed much more light into this astronomically profitable yet highly misunderstood and under the radar concept. In the absence of more information, the likelihood that Wall Street firms who dominate order flow and have material unfair advantages over virtually everyone else, should be isolated from trading up to the point where they provide sufficient information to make the market a fair and equal playing field for all investors. Until that moment, investing, trading and speculating is doomed to have the same outcome for the majority of market participants as playing roulette with 35 instances of 00, a much lower fun coefficient and no ability to be comped for your room in light of significant trading losses.

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Market Preparing For Some Crazy Action

SPY Out Of The Money Vol spiking relative to At The Money.

Two days ahead of OPEX, market is gearing for some fireworks. The chart demonstrates the vol skew on SPY over the last three days. Today we have seen net Call covering and net Put buying - this is what one would expect given the current SPY price is way above the equilibrium option price.

So Vol is dropping as it always tends to drop more quickly into OPEX, the skew is likely forcing near the money Vols down as dealers hedge OTM buying, also the net impact of the option action would mean net buying of underlying to delta hedge. With HFT taking away most of the market liquidity, could delta hedging be the primary culprit for the inexplicably stupid market move over the past week.

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Introduction To High Frequency Finance

In the absence of anything else being even remotely relevant in today's market, here is some good bedside reading on this increasingly more pertinent topic.

An Introduction to High-Frequency Finance -

h/t Economics of Contempt.

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