HFT Algos Are Here to Stay

Posted by Jeff Carter
on September 6th, 2012

Those of us in the trading community can bitch about algorithmic trading all we want. But the simple fact is it’s here to stay. I am not against computer trading, but I am very concerned with the way it is managed.

Currently, the markets are relying on regulators and exchanges to get it right. This is a massive mistake. It’s central planning. Do you want HFT regs written and approved by the likes of Gary Gensler and Bart Chilton?

The best system is to design something where the market regulates itself. That’s why a pit was so great. It was self regulated by the members that had a vested interest in running a clean market.

On the SEC side of the equation, the entire market apparatus is messed up. It’s a joke. There is so much room to manipulate and screw over customers. It’s no wonder why they have left the marketplace and are parking their cash.

An order comes in to a discount broker. It gets sold to a hedge fund or bank that internalizes it, trades against it for a few pennies. An order comes through an executor. They sell it, or send it to a dark pool where it gets traded against for a profit.

All the rules around shorting and borrowing stock are avoided. There is no uptick rule to protect companies. Banks take the opposite side of and internalize their own customer order flow. The SEC side of the market is an abject mess, but it’s all legal and standard operating procedure.

The CFTC side is a little cleaner. At least all the orders have to hit a central order book and all of them have a chance to get executed. The problems lie in how the exchanges allow the game to be played.

Allocation algorithms allow HFT traders to show huge size on the bid and offer, get a piece and then pull their order before getting filled. Conversely, a point and click trader can’t trade large volume because they can’t get filled if they make the market. All the algos join them and they get diluted.

What really stinks is the way the exchanges are actively killing the trading floor. For example, they will help HFT firms co-locate, but they won’t let locals that own their memberships use headsets to communicate from the second step of the pit to a person on a machine. People or trading firms that have bought/leased memberships aren’t allowed to co-locate like the HFT firms are. Exchange policy puts them at a speed and execution disadvantage.

Additionally, the exchanges apply all the same rules for all the same markets. Even though all of them are not alike. For example, when it was only open outcry there were different hours markets were opened and closed. When I first started on the floor in 1986, FX Markets opened at 7:30, and then had staggered closes from 1:05-1:30. They changed that. But to this day, the hog market ($HE_F) isn’t like the Crude Oil ($CL_F) market, yet they have the same trading hours.

Exchanges are only concerned with one thing, the bottom line. Because they are a fixed cost business, the more volume they push through the more money they make. They don’t care about the integrity of the marketplace or what different markets needs are. If you watch thinly traded markets, scary things happen in the overnight trade with increasing regularity. That causes traders to put less on. In thinly traded markets, a large percentage of the volume is pure noise from the HFT traders. It’s not actual risk being transferred back and forth.

Since MF Global and PFG, confidence has plummeted further. CME Group’s ($CME) volume was off 40% in a year over year comparison; August 2011 vs August 2012. Meanwhile, bull markets are supposed to be awesome for volume, and we are higher for sure.

SPY data by YCharts

In case you are wondering, Dodd-Frank didn’t contemplate these sorts of things. It won’t either. There was a golden opportunity for true market reform. Instead, Obama and the Democrats ran the other way and are about to way over regulate the marketplace in favor of the big boys.

Long time traders know the markets are screwed up. We can talk about it all we want. But until the structures of the marketplace are corrected so that it’s flat, it will continue to be anti-competitive and drive people away.

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