Letter To The Editor

As many of you know by now, Jim McTague from Barron’s has a new book out, Crapshoot Investing (Shameless plug: Jim features Themis Trading in a few chapters), which focuses on the dangers of high frequency trading as well as the regulations that helped create what we like to refer to as the Franken-market. In this week’s Barron’s, there was a letter to the editor which commented on the excerpt from Jim’s book that Barron’s published. This letter was written by a former manager of a NYSE specialist firm, William Silver. What struck us about the letter was that the author focused on two points which HFT proponents somehow always overlook. Before we comment further, please read Mr. Silver’s letter:

To the Editor:

The excerpt from Jim McTague’s book Crapshoot Investing published in the May 2 issue exposes a practice that contains far more hidden risk than regulators recognize.

Two effects of high-frequency trading are worthy of further exploration. First, the volume in most issues is vastly inflated by HFT activity, and many computer models being used to acquire and liquidate large positions are built on false liquidity assumptions. This is no problem when markets remain calm. However, once there is a rush for the exits, institutional holders will find that their assumptions on liquidity were incorrect, and we will then experience another “mini crash.”

Second, the millions of high-frequency trading buy transactions executed at .0001 over the bid, or HFT sell orders executed at .0001 under the offer, are probably depriving millions of customers of a completed transaction at their price.

As a former manager of an NYSE specialist firm, I remember when specialists were criticized, and sometimes disciplined, for “pennying” the bid or offer, which referred to the practice of improving on the price a buyer or seller received by only a penny better than otherwise available. The philosophy, at the time, was that the price improvement wasn’t sufficient to justify keeping a potential “natural” buyer, or seller, from being the counterparty.

Sadly, public investors have become an endangered species as the exchanges rush to embrace the needs of the high-frequency traders in a regulatory race to the bottom.

William Silver
New York City

Mr. Silver hit the nail on the head with this letter. First, the inflated volumes that HFT create due to their rebate games may be giving a false sense of security to institutional investors. Let’s take a stock like Ford (F) as a hypothetical example. Ford has an average daily volume of 70 million shares. But how much of that 70 million shares a day is real volume with a true transfer of ownership versus just quick, flip rebate traders. There are many large holders of Ford and the stock usually trades with a penny spread and in a tight range all day. Let’s say something happens in the market and some large holders decide to exit their positions. When they start to sell, they will be pretty quickly sniffed out and all that HFT liquidity could quickly disappear. Those liquidity suppliers could turn into liquidity demanders very quickly like we experienced on May 6, 2010. This is what Mr. Silver refers to as a “rush for the exits.”

The second point in his letter is also overlooked, especially by your friendly neighborhood online broker. Here he is referring to the “internalizers” that pay retail brokers for their order flow. These internalizers cherry pick the “dumb” retail flow and constantly step ahead of displayed liquidity for the meaningless price improvement of $0.0001/share. The displayed liquidity provider who is helping the price discovery process is constantly being disadvantaged by these internalizers. These are the same internalizers who on May 6th chose to decline many of the orders that they usually pay for and instead shipped them to the public displayed market. This avalanche of orders helped fuel the rapid decline that we saw on May 6th.

Finally, we think Mr Silver summed up his letter brilliantly with this line:

“Sadly, public investors have become an endangered species as the exchanges rush to embrace the needs of the high-frequency traders in a regulatory race to the bottom.”

Thanks for writing this letter, Mr. Silver, and we encourage others to follow your example.