HFT and Exploiting a Loophole

The WSJ had an article on how HFT traders exploit a loop hole at the $CME.  Some shrug it off as if it’s no big deal.  To others it is a big deal.

The crux of the issue is called “latency”.  Latency is the the gap in time from when the computer issues information to the time other computers read and begin to interpret that information.

High Frequency Trading firms have some of the most powerful computers on earth.  Nothing wrong with that-it’s a cost of doing business.  Speed pays.   There is nothing wrong with speed in the marketplace.

In the old days of floor trading, floor traders had the “latency” advantage.  Being in a pit, we could act on orders before the outside world.  Within the pit, we used to fight for pit space to be closer to larger order fillers.  That was our internal battle for latency.

It wasn’t always fair.  In fact, many times it was unfair and some traders earned outsize profits simply because of where they stood.

Can the same be said for computerized trading?  Maybe.  HFT firms have sunk millions of dollars into high powered computers, and paid exchanges for an edge.  Life isn’t always fair.

However, there are a couple of rubs.  The major exchanges in the US still have a membership system in place.  As a member, you get certain core rights and one of those is to trade at the lowest price.  People dole out thousands of dollars for this right-yet the exchange has disenfranchised them by setting up an artificial price discrimination system.  The co-location that they sold belongs to the members.

Additionally, I was always under the impression that computerized trading would level the playing field.  As it has evolved, it hasn’t.  It’s tiered the playing field even worse than it was.

We can complain about the way the current system works all we want.  But what we should be talking about is how to fix it in terms of competitive and transparent markets.

Let everyone have the same exact access in terms of speed.  Then the competition becomes about who can figure out the market better than the next guy.  The free money accruing to market participants because of speed will go away.

The market will be better as a result.


A long time ago, old floor traders were talking about this very thing.  We were considered cranks and luddites for saying something was wrong with the market.

Most critics focus on speed-which is the wrong way to focus.  Focusing on who gets information when is the tip of the spear when it comes to competition.

In the old days of the trading floor, it was illegal to front run orders.   It was also illegal and unethical to look at a customer desk, see the order get flashed into the pit, and act on it.  Essentially that is the advantage that co-location gives traders today.

Ironically, the fact that HFT traders are making outsize returns because they have access to information before the rest of the marketplace further proves Gene Fama’s efficient market hypothesis.

In the past, I have written that most HFT traders are ethical-but many are not. The abuse is far worse on the SEC side of the marketplace than the CFTC side.  Old floor traders policed their own bad apples. HFT traders need to do the same to theirs.  They understand more about the systems and orders than anyone else, and are the ones that should take up the challenge and do something about it.

The conundrum for them becomes the CFTC .  The CFTC as presently staffed is a horrible regulator.  If some upstanding HFT houses began regulating their own community, the CFTC would step in and shut them all down.

We don’t just have a hyper politicized market when it comes to things like Medicare et al-virtually every part of the regulatory framework in the Federal government has become highly politicized in the last four years.

I hope some traders weigh in down in the comments.  The advantage given one class of traders vs other classes of traders has changed the way consumer surplus is divided.  It has cost millions to one faction, benefitting another.

As I said before, electronic trading was supposed to level the playing field.  It hasn’t.


CHICAGO, May 1, 2013 /PRNewswire/ — CME Group, today released the following statement in response to today’s Wall Street Journal article:

While there can be instances of inconsistencies with any technology, CME Group is continually making improvements to our trading platform to increase efficiencies, including variability between the time a firm or customer receives its trade confirmation and it appears on the public data feed.  Out of the more than 300 million messages that come into our platform each day, there may be times when customers can experience a latency of a few milliseconds between the time they receive their trade confirmations and when that information is accessible on the public feed.  However, these instances are not consistent and vary across asset classes.

At CME Group, our goal is to bring variability as close to zero as possible and we have made significant steps to address latencies related to trade confirmations.  At the end of last year, we strengthened the overall performance of our CME Globex trading platform by reducing order response times and limiting variability within and across asset classes.  In the first quarter of 2013, we upgraded our match-engine hardware.  Through the remainder of this year, we will be implementing additional hardware, software and architectural upgrades – all designed to further reduce potential discrepancies in processing times, make the overall system performance more predictable, and enhance the CME Globex trading experience for our customers.

Funny, years ago when floor traders told CME officials of the problem, they said there was no problem.  In the ensuing years, membership values have plummeted, lease prices have plummeted, and traders have left, or become far less profitable.

Floor traders weren’t bitching about the HFT’s per se.  They were sure that some electronic traders had access to market data ahead of others in the marketplace.  That created a situation where the advantaged traders could profit before anyone else.  Millisecond advantages mean millions in profit.

In the beginning of the debate, I even found it hard to believe that CME would advantage one class of trader over another.  But they did.

CME management consistently denied that there was an advantage. They said that no one could read the tape ahead of anyone else.  In member meetings, they said it was a non issue or that we were crazy.  Turns out, the old floor traders were right.

Who knows what would have happened if CME would have created a level playing field from the get go.  Maybe the same effect.  But, we won’t know and when they had the chance to do something earlier-they ignored it.

If CME gave the advantage freely to each and every person/entity that bought or rented a membership, then it would be like the old floor trading days.  But they didn’t.  They sold co-location, disenfranchising members.   One of the reasons you bought a membership was access and proximity to order flow.

Now that they have been wounded by Corzine and other factors, they are listening-but only because of the Wall Street Journal article.  CME volume was down 11% last year.  Is it simply Corzine, or do market participants think they aren’t getting a fair shake and exiting?

My opinion is broad based highly diverse marketplaces create more volume than concentrated ones.  CME is creating a concentrated marketplace.

There are plenty of people I know that are risking millions of their own dollars to trade each and every day.  They are holding positions, taking risk, and trading.  They always knew they were risking more than the average person in the market, but now they know they need to redefine how much they risk since they are at a competitive disadvantage.

There is only one thing that true traders and risk takers want in the marketplace-a level playing field; equal access to the market.  If they lose money on a regular playing field, so be it.  At least the fight is fair.

It’s not a fair fight in any marketplace today.  Not one.


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