Our Opinion on HFT in Turbulent Markets

First off, the above picture is a 2010 submarine cable map. It details where the guts lie in connecting exchanges and data centers globally. It does not include the new billion dollar tunnels being built by some developers to capitalize on HFT’s desire to shave microseconds off their getting to the quote, or canceling their quotes. HFT is a huge business, much bigger than anyone realizes. That explains the money paid to so many lobbyists, and PACS in finance by HFT firms.

We received a plethora of questions regarding the role of high frequency trading in the recent market sell-off. The questions all pretty much start the same way: “Do you think that HFT…?” We always answer as completely and factually as we can; we can only go by what we see and what our experiences are. We do not have Goldman’s code. We do not have Getco’s code. We do not have Tradebot’s code. We do not have the code being used by the 20 SLP’s of one of the major exchanges, who get flashed every dark marketable order in that exchange.

We do have our experiences watching and interacting with 1) “market making”, 2) internalizers, and 3) predatory HFT prop trading at work. I just listed these three activities, not as all-inclusive HFT styles, but just to give you an idea of what HFT looks like from different vantage points on a yardstick.

– Perhaps the most benign form of HFT is market making. The market-making computers and DMM’s have supplanted humans serving these same functions in the past, only more efficiently. Bob Pisani states in his blog yesterday that HFT is only making 6 mils (6 cents per hundred shares) on each share traded, and they go home flat, so they cannot be the culprits. TABB group estimates a higher mil rate: 15-20 mils. I will add this: How much do these market makers make running the opening and closing auctions? They see all that flow, know where all the bodies lie, and you will never convince me they make 6/100ths or 15/100ths of a penny on average on the closing auctions, even if I believed those intraday market-making margins. But only they will ever know the truth for sure, as well as perhaps the SEC, if they look at the secretive code.

– Internalizing is a dicier subject. Their role in May 6th was so distasteful, as is the idea of their getting a free look at such a substantial amount of all order flow. What amount do they make on the trades they choose not to price improve by 1/100th of a penny? How many cents do they make when they instead front run the order flow’s owners? Who sees that code? Oh, and how much do they make by financially modeling the “private order flow” passing through them and developing prop trading programs to capitalize? Finally I will just refer everyone to the SEC-CFTC Joint Advisory Committee who examined the Flash Crash, who can detail the hot potato insanity that ensued from frantic order routing, or “exhausting”. Do these guys make 6 cents per hundred? Is that why they pay for the order flow?

– Predatory HFT is the most damaging. We don’t know how much it is combined with the other two activities we just highlighted above, by the same firms, or if separate firms engage. We do feel it is the most damaging. This style of HFT exacerbates price movements up and down, and is fed by exchanges and dark pools who court their volume. When you place a bid to buy a stock at 40 cents, with discretion to pay up to 43 cents, and that discretionary amount is flashed to SLP’s and ELP’s, who in turn take the stock ahead of you and run it 15 cents higher, they are not making 6 cents per hundred.

At the end of the day, none of us really know how much money HFT firms are making. Quite frankly, we are not in the business of deciding how much money firms can earn in America. The market can decide that, provided the system everyone operates in is fair. This is where we speak out harshly. The for-profit exchange model arms the players mentioned above, and the referees in the game are not neutral. Simple. Some things, like highways (physical or capital) should be overseen. There are too many historical crisis that demonstrate what happens when Wall Street is left to an “invisible hand.”

One last thought. There are no shortage of folks who defend the for-profit exchange model as making the market more efficient, and a welcome change from past structures that served for tens of decades. Ask yourselves this. When trading slows down, for whatever reason, and becomes unprofitable (exchanges are already making only a sliver of their revenue from trading anymore), can they decide to just close down the unprofitable business, like a crappy factory? Is that the foundation our capital-raising foundation is built on?

I apologize for the heavy read, which matches my heavy mood, as well as the heavy tape. The price moves and swings yesterday were intense, in equities as well as other assets. It’s all connected now more than ever.