Alpha Plumbing – Oliver Wyman Paper


Let’s keep this note short.

Many of our notes to you have outlined the hidden dangers and alpha loss resulting from your orders traveling through the Sausage Factory. We won’t list them all here for sake of space, but we invite you to go back through your inbox and drag up the note titled It Take a Prosecutor from March 18th 2014. We also invite you to glaze again at the piece we wrote outlining Fred and Ethel’s New Smart Order Router. The key theme in all of these notes is simply that captive order flow is a key to HFTs extracting alpha at investors’ expense, be it retail internalized flow or institutional captive algo flow.

This morning we want to highlight an excellent report from the consulting firm Oliver Wyman, titled The Hidden Alpha In Equity Trading. Their charts and explanations are excellent, and the report is laid out extremely well; we consider it a high priority read. Section 3 lays out high frequency trading strategies, and how they interact with your brokerage algorithms and SORs:

Active HFT strategies attempt to game SORs by learning the sequence by which they interact with various venues. The goal of the HFT is to discover a large institutional order that is trying to source liquidity from these venues. Understanding this, some SORs have been designed to try and avoid negative impact from HFT. : Although some SORs attempt to avoid negative impact from HFTs, each SOR leaves a pattern, and skilled HFTs can detect that pattern and use that information to their advantage. Each of these patterns can be a clear signal to an HFT that a large block order is trying to trade.

Simply stated, HFTs are quite adroit at understanding the intricate plumbing details of each broker’s SOR and dark pool. Many of them are also colocated at the brokers’ dark pools. They have a road map of the route your child orders all take; it has been provided to them. The HFTs are given the map, and given access to your captive order flow as a “free option”. In return they pay a rebate or “finder’s fee” back to the broker, who benefits from those economics, as well as the “added liquidity” that the broker can use to advertise its pool. Be sure to see the exhibits on page 9 and 11.

Please put this paper top of your list of reads this week; it is quite good.