The defeat of robots: the ups and downs of high-frequency trading (Part 2)

Original author: Matthew Philips
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[ The first part ]

The decrease in the volume of stock markets may, to some extent, be related to the fact that high-frequency trading discourages investors from investing in securities, which is especially noticeable after the event of May 6, 2010, called Flash Crash, when the decision made by computers to sell a large number of futures caused a massive collapse in market prices. The Dow Jones Industrial Average fell 600 points in about 5 minutes. When there was a jump in prices, most high-frequency traders who worked in the market that day got rich. And those whose cars did not work that day were accused of aiding a collapse and lack of liquidity, as the fall accelerated due to the fact that relatively few high-speed traders were ready to buy stocks, the price reduction of which was growing under the pressure of those who wanted them to sell.

Over the next two years, Flash Crash was the greatest shame of high-speed traders. Then, last August [ article dated 2013 - approx. perev. ], the failure befell Knight Capital. Traders called this nightmare “the Knightmare”. Until about 9:30 a.m. on August 1, 2012, Knight could claim the title of the greatest HFT company and the largest trader in the US stock market. 17% of the volume of all trades on shares quoted on the New York Stock Exchange and about 16% of trades on shares of companies from the Nasdaq listing passed through it.

When the exchanges began their work on August 1, the new trading software, installed shortly before by Knight, broke down and began aggressively buying shares of 140 companies from the New York Stock Exchange listing. That morning, in about 45 minutes, Knight mistakenly acquired and sold $ 7 billion worth of shares - at a rate of approximately $ 2.6 million per second. Each time after the purchase, the Knight algorithm raised the price at which he was ready to make a new purchase, and other companies were only happy to offer him shares at this new price. At the end of the day on August 2, as a result of bidding, Knight lost $ 440 million, or about 40% of the amount the company was valued before the incident.

Knight was acquired by Getco, one of the leading high-frequency market makers in Chicago, and has been among the fastest HFT companies for many years. However, there was apparently nothing to compare with Getco: on April 15, Getco announced that its revenue over the past year had declined by 90%. The company, with 409 employees, earned just $ 16 million in 2012, disparate from $ 163 million in 2011 and $ 430 million in 2008. Getco and Knight declined to comment on this story.

Getco's problems say a lot about the other misfortune of high-frequency trading: they now pay much less for speed than before. Firms spend millions on gaining a millisecond advantage, constantly updating their computer fleet and paying huge amounts of money to keep their servers as close as possible to exchange servers in large data centers. As soon as the exchanges realized how valuable milliseconds are, the value of these fees soared. The cost of quotation update tapes has also risen. During the time that firms spent millions trying to accelerate by a millisecond, the market itself accelerated, but not trader companies. And as a result, their profits fell.

“Speed ​​has become a mass phenomenon,” says Bernie Dan, CEO of Chicago-based Sun Trading, a large high-frequency market maker.

No one knows this better than Steve Swanson. By the time he put Citi in 2010, there was serious competition in the field of high-frequency trading. The more firms flooded the market with their high-speed algorithms, hunting for manifestations of inefficiency, the more difficult it was to make money on it - especially when trading volumes began to decline steadily since investors ceased to trust stocks and began to invest more and more money in bonds. Svenson competed for day-to-day declining profits with hundreds of other high-speed traders who turned out to be just as quick and no less smart than he was. In September 2012, TCV decided not to conduct the final round of investments. A month later, Svenson closed the project.

With a decrease in profitability and a decrease in the presence of HFT companies in the markets, regulators began to show interest in what was happening. In January, Gregg Berman, a Princeton physicist who has worked for the Securities and Exchange Commission (SEC) since 2009, was promoted and led the newly created SEC Analytics and Research Department. Its main task was to provide the Commission with “first-person” information about what high-frequency traders actually do. Until that moment, the agency relied on the industry, and sometimes even on a financially-oriented blogosphere to understand the work of high-frequency trading. A few months after the events, called Flash Crash, Berman met with representatives of dozens of trading companies, including high-frequency traders. He was amazed at how enormous amount of data they operate on and how much their understanding of markets is more accurate than his knowledge. He realized that he needed more high-precision systems and technologies - and that it was easiest to get them from the high-frequency traders themselves.

Last fall, the SEC said it would pay Tradeworx HFT company $ 2.5 million for the possibility of using its data collection systems to create a basic platform for a new market surveillance program. The system, code-named Midas (Market Information Data Analytics System) examined market data from 13 US stock exchanges.
The Midas system began work in February. With its help, SEC was now able to track abnormal situations in the market, such as wrapping quotes, and notice them before they appear on the Nanex and ZeroHedge blogs. If Midas noticed something strange, Berman’s team could take a closer look at the auction information, examine it millisecond after millisecond. About 100 people used the Midas system at SEC, including the core group of quonts, developers, programmers, and Berman himself.

“At the office, Gregg’s group is called the League of Outstanding Gentlemen,” said Brian Bussey, deputy director of the SEC's derivatives and trading practices department, during a February panel discussion. “This group does not include lawyers, but current experts and market researchers.”

At that moment, it was too early to declare anything, but, apparently, Midas had already found evidence of a "dirty game." In March, the Financial Times published information that the SEC had provided some of the FBI data to further investigate stock market fraud by a number of HFT firms. The Commission declined to comment on this fact.

March 12, the opening day of the annual meeting of the Futures Industry Association at the Boca Raton Resort & Club, employees of the Commodity Futures Trading Commission from the USA, Europe, Canada and Asia also organized a meeting behind closed doors. There was one question on the agenda: "Risk control of high-frequency trading."

Europeans have already tried to limit the ability of high-frequency traders. France and Italy have introduced a kind of trading tax. The European Commission has begun disputes about the introduction of fees for transactions in the Eurozone.

In the US, Bart Chilton, Commissioner of the Commodity Futures Trading Commission, has been discussing the possibility of introducing additional restrictions on traders. In the evening after the conference, sitting at a table on the hotel's veranda, he explained his point of view. According to Chilton, the Commodity Futures Trading Commission has identified some “curious activity” in the markets that could “cause serious concern and be illegal.” Chilton, who calls high-frequency traders “cheetahs,” believes that the Commission needs to reconsider what it means by market manipulation.

According to the standard of the Commodity Futures Trading Commission, a market manipulating company must occupy a significant share of a market and be considered large enough to be manipulated. For example, a company that owns a 20% stake in a firm can potentially manipulate that firm. Since high-frequency traders rarely keep their positions unchanged for more than a few seconds, they account for only 1-2 percent of the market, but due to the enormous influence of the speed of trading, they can often influence prices no less than their larger competitors - in particular, when in their midst begins what Chilton calls "food rabies" during the growth of volatility.

“We need to lower the bar so that cheetahs fall under it,” says Chilton. “The question is whether a revision of standards will help track cheetahs manipulating markets.”

Not so long ago, the Commodity Futures Trading Commission introduced its own high-tech market surveillance system, which is able to track the activity of traders within hundredths of a second and calculate which particular company trades. As a result, the Commission became interested in the potential fact of manipulating and “laundering” trading in natural gas markets: companies illegally traded with themselves to create a nonexistent hype.

In May, Chilton proposed introducing a fee of 0.06 cents on futures and swaps trading. This tax should reduce activity in the markets, and the money raised can go to finance the Commission's investigations. Democrats in Congress are ready to go further. Job Senator Tom Harkin and Oregon State Representative Peter DeFazio want to introduce a fee of 0.03% of almost every transaction in most US markets.

With decreasing profits, HFT companies are increasingly resorting to what is called "momentum trading." Using methods similar to those that helped Swenson 25 years ago, momentum traders predict market movements and make large purchases / sales. Such a strategy may turn out to be profitable, but it carries enormous risks. Other high-frequency traders use sophisticated programs to analyze news feeds and headlines in an attempt to profit from this. Some even follow Twitter feeds: evidence of this was the sudden collapse of the market after a message about the bombings in the White House was published on April 23 from the hacked Twitter account of the Associated Press. This is probably the only thing that remains for HFT companies.

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