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Up In Smoke – Go Ahead and Inhale!

12

June, 2012

 

Those of you on Twitter may know that my avatar (@ThemisSal) is a “smoking kid”, which is my way of poking fun of the many industry-sponsored academic studies that remind me of the tobacco-company studies that years back concluded that smoking was not harmful. However I may have to give up my avatar to the author of this study on High Frequency Trading by the University of California at Berkeley’s Xin Guo.

In this study Guo details what he calls a “smoking strategy”, where market makers place orders/quotes inside of the NBBO, only to yank them when an investor order is lured to interact with them. They then plug the investor at inferior prices. It is kind of like Lucy pulling the football away from Charlie Brown at the last second, and Guo graphically describes the process in his paper:

The study emphasized how the strategy works because of the speed advantages the HFT market makers have, of course due to their technological prowess and colocation. My first reaction upon reading the study/paper was one of amusement. That changed when I started thinking that the practice is so accepted and known, that graduate students at premier universities waste time studying this process, with an eye towards making the game more successful.

We have a tremendous lack of leadership in Washington and in our industry. Regulators are aware of issues regarding fairness everywhere in our business, and yet do not act to correct them. And Stock Exchange CEOs encourage these “smoking games” by providing the tools needed to play them, and then pretend that there is no damage to investors from their doing so. And everyone wonders why $300 billion has left equity mutual funds since the Flash Crash over two years ago.

So pull out a smoke, light em up, and inhale. All is good – spreads have never been more narrow, nor liquidity as lush.

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