Friday, October 12, 2012

Pure Predation—High Frequency Trading

In the movie The Sting, Newman and Redford run a scam on an oily gangster by getting him to bet on a horserace that has already been run.  They do this by delaying the ticker feed to their fake gambling parlor.  If this sounds a lot like the scam of high-frequency trading, it's because it IS a lot like high-frequency trading.

And like in The Sting, it's often fun to cheer for the HFT rogues because their marks are such bad guys.  This is a Predator-Predator fight so picking someone to cheer for must be based on something other than who is the bigger crook.  But HFT has the interesting side effect of further demolishing any claims for legitimacy the various stock exchanges may ever have had.  When you are selling a "service" as ephemeral as stock trading, legitimacy is a very important asset.  So when you have lost a guy like Mark Cuban, you have probably lost your legitimacy—an asset crooks never learn to properly value.

Mark Cuban Torched The NYSE And Other Stock Exchanges For Their Role In High Frequency Trading

Linette Lopez | Oct. 2, 2012

Mark Cuban's disdain for high frequency trading (HFT) is no secret, and today, as the SEC discusses ways to ensure that it does not create more volatility in the market, Cuban has a platform to speak out about the issue.

Actually, "speak" doesn't do Cuban's CNBC spot justice. He comes out swinging against pithy reforms that he believes would do nothing to curb the dangers of HFT (like kill switches) and says stock exchanges are to blame for all of this.
It's really just the NYSE protecting their own... they're the root of this problem despite the fact that people don't want to admit it....they're a for-profit entity now as opposed to being a non-profit entity in the past and they're doing what every for-profit entity does — They're trying increase their sales protecting their best customers and to do this they're creating all these different kinds of order types. How many order types do you need? Well in the case of the NYSE and other exchanges they create as many as they can to try to get more algorithmic trading to try to enhance more volume and even to pay for that volume... The root of the problem is what's going on at all the exchanges and all the algorithmicly driven trading is just a symptom of that.
So what does Cuban think we should do about all of this?
You can pare it at the edges with measures like kill switches which "do nothing."

Or you say, "we're done, there's no investor confidence... maybe you go back and change the rules and make these exchanges non-profit again, though I don't know how you're going to do it."

Bottom line: Cuban says we have to do something or we're going to see something much worse than a Knight Capital or a 2010 Flash Crash. "There's no such thing as bug free software," he said.

"When you have algorithms trying to out battle other algorithms to to get a trading edge there's no way to know what the results will be... There are more trades that happen in the blink of an eye...that's just the reality of technology. And they're trying to make it faster." more
See Also

What Is High-Frequency Trading? Here's What The Whole Debate Is All About In Plain English
There's A Hot New Global Trend, And High-Frequency Traders Should Be Very Afraid
A Technical Glitch Halts Trading On A Major Exchange
Here is Cuban explaining why HFT is pure Predation.  If it doesn't have value, it cannot be anything else.

There Is Absolutely NO VALUE To High Frequency Trading

Mark Cuban, Blog Maverick | Sep. 23, 2012

Wall Street doesn’t know what business it is in. Regulators don’t know what the business of Wall Street is. Investor/shareholders don’t know what business Wall Street is in.

The only people who know what business Wall Street is in are the high frequency and automated traders. They know what business Wall Street is in better than everyone else. To traders, whether day traders or high frequency or somewhere in between, Wall Street has nothing to do with creating capital for businesses, its original goal. Wall Street is a platform. It’s a platform to be exploited by every technological and intellectual means possible.

The best analogy for traders ? They are hackers. Just as hackers search for and exploit operating system and application shortcomings, high frequency traders do the same thing. A hacker wants to jump in front of your shopping cart and grab your credit card and then sell it. A high frequency trader wants to jump in front of your trade and then sell that stock to you. A hacker will tell you that they are serving a purpose by identifying the weak links in your system. A trader will tell you they deserve the pennies they are making on the trade or the rebate they are getting from the exchange because they provide liquidity to the market.

I recognize that one is illegal, the other is not. That isn’t the important issue.

The important issue is recognizing that Wall Street is no longer serving the purpose what it was designed to. Wall Street was designed to be a market to which companies provide securities (stocks/bonds), from which they received capital that would help them start/grow/sell businesses. Investors made their money by recognizing value where others did not, or by simply committing to a company and growing with it as a shareholder, receiving dividends or appreciation in their holdings. What percentage of the market is driven by investors these days ?

I started actively trading stocks in 1992. I traded a lot. Over the years I’ve written quite a bit about the market. I have always thought I had a good handle on the market. Until recently.

Over just the past 5 years, the market has changed. It is getting increasingly difficult to just invest in companies you believe in. Discussion in the market place is not about the performance of specific companies and their returns. Discussion is about macro issues that impact all stocks. And those macro issues impact automated trading decisions, which impact any and every stock that is part of any and every index or ETF. Combine that with the leverage of derivatives tracking companies, indexes and other packages or the leveraged ETFs, and individual stocks become pawns in a much bigger game than I feel increasingly less comfortable playing. It is a game fraught with ever increasing risk.

So back to the original question. What business is Wall Street in?

Its primary business is no longer creating capital for business. Creating capital for business has to be less than 1pct of the volume on Wall Street in any given period. (I would be curious if anyone out there knows what percentage of transactions actually return money to a company for any reason). It wouldn’t shock me that even in this environment that more money flows from companies to the market in the form of buybacks (which i think are always a mistake), than flows into companies in the form of equity.

My 2 cents is that it is important for this country to push Wall Street back to the business of creating capital for business. Whether it's through a use of taxes on trades(hit every trade on a stock held less than 1 hour with a 10c tax and all these problems go away), or changing the capital gains tax structure so that there is no capital gains tax on any shares of stock (private or public company) held for 1 year or more, and no tax on dividends paid to shareholders who have held stock in the company for more than 5 years. However we need to do it, we need to get the smart money on Wall Street back to thinking about ways to use their capital to help start and grow companies. That is what will create jobs. That is where we will find the next big thing that will accelerate the world economy. It won’t come from traders trying to hack the financial system for a few pennies per trade.

And solutions won’t come from bureaucrats trying to prevent the traders from hacking the system. The only certainty when bureaucrats step in is that the law of unintended consequences will smack us all in the head and the trader/hackers will find new ways to exploit the system that makes them big money and even more money for the big institutions that develop products for the other institutions that are desperate to play the game.

Regulators have got to start to recognize that traders are not investors and vice versa and treat them differently. Different regulations. Different tax structure. Different oversight. Individual investors and the funds that just invest in stocks and bonds are not going to crash the market. Big traders who are always leveraging up and maximizing the number of trades/hacks they make will always put the system at risk. We need to recognize that they do not serve much of a purpose other than to add substantial risk to the global economy. That their stated value add of liquidity does not compensate the US and World Economy nearly enough for the risk of collapse they introduce into the system.

Wall Street as a whole needs to be in the business of creating capital for companies and selling shares to investors who believe they are shareholders. The Government needs to create simple and obvious incentives for this business and extract compensation from the traders/hackers for the systemic failure risk they introduce.

There will be another flash crash, and probably a crash far worse than the May 2010 flash crash simply because there are too many players looking for the trillion dollar score. They can’t all win, yet how many do you think wouldn’t risk everything, even what is not theirs, for that remote chance to score big ? Put another way, there is zero moral hazard attached to any trade. So why wouldn’t traders take the biggest risk possible ?

There is value to trading automation. It is here to stay. There is absolutely NO VALUE to High Frequency Trading. None. We need to bring our markets back to their original goals of creating capital for business. It’s impossible to guess how many small to medium size companies have been held back from growing and creating jobs and wealth because of lack of access to capital from the stock market. It’s not impossible to know that our economy has suffered because Wall Street equity markets are no longer a source of equity for helping companies grow, it is not a platform for hackers and that needs to change. Quickly. more

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