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The Problem With HFT

24

January, 2013

 

By now you have read Broken Markets (except for one of you, located on the West Coast – you know who you are!). By now you have read Scott Patterson’s Dark Pools. Perhaps you have also read Jim McTague’s Crapshoot Investing, and have even ventured into the most excellent book by Senator Ted Kaufman’s former aide Jeff Connaughton – The Payoff – Why Wall Street Always Wins. If you have, you have ventured into the land of stock market plumbing, in exchanges and in dark pools. If you have, you kind-of understand what we have been saying for years about uneven playing fields, unfair advantages, strange and curious order types, and the for-profit exchange model.

If you have read the above works you have the foundation to take it to the next step. You have the foundation to engage in the surprisingly easy-to-understand “deep dive” into how modern high frequency trading works. It is time to indulge in the quick-reading The Problem Of HFT, by Haim Bodek.

Bodek clearly and concisely takes you into a world where some stock exchanges have created little-known order types and advantages for only certain types of market players:

“Modern HFT wasn’t a paradigm shift because its innovations brought new efficiencies to the marketplace. HFT was a paradigm shift because its innovations proved that anti-competitive barriers to entry could be erected in the market structure itself to preference one class of market participants above all others.”

Bodek is no defender of old-school markets, mind you. His book instead explains why a type of scalping activity, which should have arbitraged itself away quickly long ago, had not done so. Instead, he explains why this scalping activity has flourished and been amplified since REG NMS.

“The problem with HFT is that these strategies shouldn’t work at their current scale and volume, and have only come to dominate the market through the carefully crafted advantages provided by the electronic exchanges for these specific HFT strategies – advantages such as special order types and preferred order engine matching practices.”

This book needs to be on your reading list. While some market structure specialists will continue to defend our market structure, and continue to proclaim that our problems are media-created, you as traders know better. You know what you see on the battlefield day in and day out. And after reading the above books, and finishing with Bodek’s book, you will undoubtedly resent their proclamations – that is if you do not already. After reading the above books, you will know that they should know better as well.

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