Some of you have met Haim Bodek and listened to his order types presentation in the past six months. Many others of you have read his book, The Problem of HFT, which we sent to you months back. Even more of you are just recently hearing his message. To recap, Haim Bodek is an electronic trading veteran who has spent most of his career engaging in proprietary quantitative trading at UBS, and at his own firm Trading Machines LLC. He is an HFT insider, and has brought a whistleblower lawsuit at the SEC pertaining to improprieties he has found over time at the US stock exchanges.
He has recently given a presentation at a Trade Tech conference titled HFT Is An Artificial Industry. It is a 43 minute video, and the link we just referenced includes that video and the written transcript. We want to pick out some key points for you in this morning’s note.
- The type of high frequency trading that dominates the markets is what you would call HFT Market Making. The game is dominated by about six large players. Their strategy is to trade as much as possible, as they view the public markets as toxic – you institutions subject them to too much adverse selection.
- Their trade goal is a single tick (penny), and less. More recently their goal is to even buy and sell at the same price, but collect rebates and be “makers” and not “takers.”
- They need speed to get to the top of the queue – being at the top does two things: it maximizes their rebate collection probability, and it minimizes “run over risk” – which means that if they choose to exit the trade they can quickly before it becomes a “1 tick loser.”
- Starting 2004-2005, their game was amplified with special exchange-provided order types that allow them to “post only” and “hide and light” – essentially queue jump. Every exchange provided them with these innovations. While some exchange executives have mentioned that there are 2,000 order types, there really are about 15 of them that are distortive. And the exchanges have created them because the HFT market makers have asked them to.
- These six large players have perfected the art of reading the proprietary data feeds, especially with an eye to when they should cancel their bids/offers. They watch each other too – so when they see the fastest guys among them cancelling to avoid sweep risk, then they all do the same. Mini Flash Crashes seem to make a tad more sense?
- The HFT market making game is all about trading as much as possible, and stacking the deck so that they can be at the top of the queue the most often, collect rebates, and exit trades pre “adverse sweeps” . In that frame of mind, they do not just wait for the NBBO to change, which Reg NMS says they need to do as locked markets are prohibited. The HFTs are not waiting for that 2-tick wide market across every exchange. They are not waiting for those 13 exchanges to fade before they place their bets. All of the special order types in a class related to rule 610 are all designed to allow HFTs to place their bets before the NBBO changes.
This game is not passive. It is highly aggressive and has not been arbed away because of the maker taker pricing scheme, which allows for the buying and selling at the same price for a guaranteed profit. The game maximizes rebates as revenue, while avoiding “1-tick losers” (sweep risk). Those successful at this game have perfected the use of speed, special order types, and reading exchange data feeds and your dark pool orders to give them a hint as to which way the NBBO is likely to change over a sub second period.
This game has not brought tighter spreads. Those tight spreads have existed pre -2005, as did $8 retail commissions. Do not allow these HFT firms’ lobbyists and big money to manipulate the markets into thinking that they are beneficial and passive. They distort prices, and destabilize markets – especially in times of stress.
Want to end the game? Insist that the regulators eliminate maker-taker and those order types. The next time stock exchanges and HFT executives tell you to embrace free markets, tell them that their game is the antithesis of free markets – it is one of collusion and regulatory capture. And the next time HFT and stock exchange executives tell you that they are innovating, and that change is good, while drawing analogies to 1987, tell them to stop pi$$ing on your shoes while telling you that it is raining.