Rob Park at SFI

"Logic and Intent: Shaping Today's Financial Markets"

  • Started program trading with a spread algo between Deere and Caterpillar, under the assumption that fundamental drivers were similar and spreads will revert to mean. 
    • In executing this algo, felt orders were being copied by someone else.
  • Today, 70% of total US volume is algos.
  • How do algos introduce risks?
    • Problems occur when you can’t predict.
  • The algo ecosystem: the number of possibilities grow exponentially when algos interact with other algos.
    • 1 runaway algo problem. Example-on Amazon there was a $1 million book. Someone raised the price in marketplaces of another ever so slightly and that triggered a cascade where this book ended up listed for $20 million (the story of how this happened is fascinating and told here)
    • 2 Flash crash – unpredictable interaction of algos
  • What is an algorithm? It is a sequence of logic statements. All algos are created by humans. They do what people intend them to do. Intent=important. Humans are driven by incentives, algorithms are driven by human intent.
    • The technologist needs to understand the human goal, or else risk is introduced into the system.
  • IEX introduced a 350 microsecond delay on an order reaching the exchange.
  • The broker’s dilemma: brokers were matching orders between buyers and sellers, so brokers created dark pools. Broker A gets the buy, Broker B gets the sell, what’s the incentive for Broker A to trade with B?
  • In today’s market there are 11 exchanges, 40+ dark pools (IEX right now is a dark pool, but will try to become an exchange eventually).
  • Exchange dilemma: exchanges facilitate issuers with investors. Exchanges are supposed to be neutral to all participants, but now are for-profit companies who build services for specific customers. This is not the intended purpose of exchanges, and biases these exchanges towards one kind of participant (HFTs) over another.
  • There have been three generations of market algos so far:
    • 1 automatic traders flow, algos execute upon traders’ ideas, helping these traders focus on “their work” as opposed to execution
    • 2 gaming automatic trader-based algos. These algos took advantage of transparent inefficiencies in the first generations functionality.
    • 3 counteract generation 2. A trader who wants to buy size needs to game level two algos in order to hide intent and execute efficiently.
  • Participants send orders, but they don’t arrive at the actual exchange at the same time.
  • At the micro level, markets are deterministic (opposite of physics).
  • Latency arb—in a distributed system, race conditions matter. HFT aims to exploit the race. Exchanges need to know where the market is before pricing a transaction.  Introducing the 350 microsecond delay through a fishing-line like fiber. In doing so, assume the order is not fast. And then figure out where the market is.
  • Resistance to IEX so far has come from 2nd generation algo programmers. 


On HFT, Liquidity, and the Flash Crash

“I think the notion that liquidity of tradable common stock is a great contributor to capitalism is mostly twaddle.  The liquidity gives us these crazy booms, so it has as many problems as virtues.” –Charlie Munger
Today it seems like CNBC has designated high frequency trading and liquidity collectively as the topic du jour.  I find this slightly amusing, because the talking heads on TV and in my Twitter feed who I'd label as perma-bears are the ones complaining most loudly and frequently about market structure, liquidity and HFT.  Market structure is unquestionably something I view to be a problem, although the more long-term investors in the marketplace, the less short-term liquidity is actually all that important anyway.  Short-term liquidity creates profitable trading opportunities, but it in no way impacts the quality (or lack thereof) of an individual long-term investment.  

Liquidity in this context takes on a different meaning than what I think it really should mean.  We have used the term to drive spreads to within a penny on the bid and ask, but has moving from quarter to nickel to penny spreads changed the capacaty for individuals or institutions to make long-term investments?  Liquidity does seriously matter in terms of creating systemic opportunities for investment, but only to a point.  An entire marketplace without good liquidity increases the cost of investment substantially and that's not a good thing, yet, at the end of the day, none of these complaints about HFT are dealing with the fundamental question anyway.  We have plenty of systemic liquidity upon which any long-term investor could accumulate or distribute a substantial ownership interest, but we have a marketplace that is harder to make short-term money off of price spreads.  Those are two different questions.
On the day of the Flash Crash, before it was even dubbed the Flash Crash, I wrote a pretty emotional and frustrated rant, lashing out on HFT and supplemental liquidity providers.  I still think my statements from that day sum up the spectrum of my feelings about HFT.  Without getting into it any further, here's my post from May 6th, 2010, the day of the Flash Crash in its entirety:

So there's a report going around that a Citigroup trader hit the "b"illion button instead of the "m"illion and I just want to right off that bat make clear that not only do I not buy that story, but I am absolutely certain that it is not THE cause behind today's collapse.  I believe today's collapse is a confluence of factors that generated the perfect storm of volatility, chaos and panic.  Here are a few of those factors:

  1. Global fear levels are elevated amidst talks of a Greece default and trouble in Spain.
  2. Markets traded aggressively higher off of the February lows without a substantial pullback.  This led to large pent up selling demand.  People were waiting for the first downtick to sell, and when the selling begat selling.
  3. With high frequency trading accounting for an ever-increasing percentage of total market volume, when the volatility storm, hit the computers shut off.  I was staring right at it in the Level IIs...the bids in just about every stock disappeared.  There was no liquidity.
  4. Proctor and Gamble (PG) alone dropped almost $25 points from its intraday highs.  With the Dow being a price-weighted index--with each components $1 move correlating to 7.2 Dow points--PG alone accounted for 180 of the Dows nearly 1,000 point crash.  That's insane for a stable company.   I'm not a huge Cramer fan, but I LOVE what he had to say live on TV: "if that stock is there just go buy it...that's not real...just go buy it!"  Major props to Cramer for speaking some truth and bringing sanity to the panic.

Now just for some personal thoughts during all this and a rant: I got terribly scared today.  The speed with which the market dropped 700 Dow points, I could not help but think the worst.  My head was running wild.  Was there a terrorist attack?  A coup in Greece?  Hedge fund blowup?  Bank failure?  Sure enough there was not a single new story.  Nothing in the world changed!  Well not entirely true.  Trillions of dollars moved around, but absolutely NOTHING really changed.  The state of the economy and I'm sure investor and consumer confidence all took major hits today, but really, NOTHING CHANGED!  Sure it was perfectly explicable that there were sellers and the market went down today, but what happened?

I want to rant about #3 from my list of causes.  A considerable portion of high frequency trading is run by "supplemental liquidity providers."  These SLP's are supposed to be the good HFT programs which step in when bidders leave the market.  They are supposed to provide liquidity when there is none.  SLP programs run each and everyday and are incredibly profitable for their firms.  Sure enough, the largest such service provider and NYSE's primary partner in the SLP initiate is none other than Goldman Sachs.  Where was the liquidity?  What happened!?!?  These SLPs run each and everyday, yet today when liquidity evaporates they're not there?  I saw it.  There were NO BIDS!  Where were you Goldie when we need you?   Not necessarily saying it happened on purpose, but maybe just maybe we'd be better off bringing back a human specialist as opposed to a money-making machine.  HFT is not good liquidity and doesn't seem to play itself out in a market-neutral manner.  It steamrolls on itself.

What an absolutely insane day.  I really cannot explain the emotions that run through while staring at capitalism spontaneously combust and rebound in a matter of minutes.  Yeah we had our 2008 when everything melted down, but that was a process.  There was news.  Things happened.  This was 2008 and 2009 combined into one 5 minutes bar on a candlestick chart.  What a joke.  If this was a computer glitch then bring back the specialists.  It makes everything seem so fake and unreal.  Since when was an economy measured by green and red digitized numbers flashing on a computer screen?  What ever happened to REAL things?  Innovation, production, etc.  Today was/is ridiculous and is a sign of the lack of progress we have made since this "financial crisis" began.

End Rant.