You know what’s eating at me? I’ll tell you. High Frequency Trading, around in one form or another for over a decade easily, has really taken the US Equity markets by storm since the implementation of Regulation NMS, but I really fear what effect it will have as it now fires through the derivative markets.

In cash equities we have seen HFT surpass 70% of trading volume. We have seen the number of HFT-practicing firms multiply like rabbits (wait make that bacteria). They are brazen and in your face, unlike the real players, who were content to be in the background and secretive for years. Today we hear how much we need their liquidity, and their penny spreads, and their $8 trades at the retail level. You know what? I never wanted a $0.39 hamburger, and I never wanted an $8 trade. But that’s just me. And with hindsight, knowing the cost we all are paying for the privilege of $8 trades, I’d forego them in a microsecond.

I actually am pretty comfortable thinking that HFT has peaked in cash equities trading in the US. More and more entrants have meant declining marginal profitability. The increase in regulatory and media attention, along with the events of May 6^th, have also aided in slowing the growth of this bubble. While the SEC has its plate full with FrankenDodd, I am still hopeful that some thoughtful regulatory actions will be implemented that perhaps can keep in check what we all fear: systemic risks. By the way, that firm Nanex has an update to their quote stuffing proofs yesterday: Bookmark this page!!!

http://www.nanex.net/FlashCrash/CCircleDay.html

Forget the awesome graphs; ask yourselves this: what economic non-nefarious reasoning could there be for the quote patterns in this link? If we were to believe TABB and the Legion of HFT Defenders, slowing down the quoting, or limiting “market makers” in any way from doing the above would “take away their ability to manage risk, and quotes would widen.” I tire of this.

Anyway, while HFT may have peaked in US cash equities, as we have said all along, it will move on through to other markets like termites. HFT in global equity markets has still not peaked. And it has only just begun to really make a move in the derivatives markets. Let’s recap the background:

–                 Record cheap money. So cheap that IBM is borrowing at 1%.

–                 Re-leveraging of many global trades.

–                 A literal explosion of ETF’s, and their second derivatives (inverse, double, and triple inverse) which are based on swaps and baskets of underlying stocks.

–                 Certified financial planners recommending “diverse” baskets of these ETF’s to every mom and pop, without regard to how their actual correlations are behaving.

–                 Options on these ETF’s and inverse ETF’s picking up volume.

–                 Less managers fundamentally picking stocks and more utilizing these ETF’s.

–                 Exchanges focusing intently on servicing these markets (The NYDE (New York Derivatives Exchange, also known as NYSE Euronext) yesterday reported 2^nd quarter earnings, where it was revealed that derivatives were responsible for nearly half of its profit, and growing).

–                 Firms tripping over themselves to get approval for option dark pools (Instinet recently started using its dark pool for options), where liquidity in options has never been great. We are sure that will change now that maker/taker, “liquidity provision” and IOI’s further entrench themselves into the fabric of option trading.

Heck, May 6^th was initially blamed on a trader’s fat finger in the Midwest executing a large number of E-mini’s algorithmically. When will the next May 6^th happen? What will trigger it? Will it be a bug in the routing logic of some exchange, tweaked the night before to maximize internalization rather than best price? Will it be a large number of options executed in a double inverse grain ETF, in the exchange that had just erroneously tweaked its router? Will that cause ADM to trade down 9.9%, causing a trading pause in ADM, which will then result in a flood of sell orders going in to other commodity and food stocks, and ETF’s, and other food stocks, which will cause them in turn to go to 9.9% down, which will cause trading in those instruments to slow down, which will cause a quant firm to start shorting technology stocks, because over the past 8 months their correlation was high with food stocks. Then the spillover will happen to the currency markets. Screens will freak out. Everyone will look for news of some disaster, and folks will panic.

But hey, spreads are narrower and trading costs $8 bucks at the retail level. And again, I never wanted an $8 trade, and I never would wanted a $.39 hamburger.