A friend of mine, who is clearly an avid reader of all things financial, has recently showered me with commentary stemming from the SEC’s January request for comment on equity market structure. Starting on page 45 of this 74-page release, the SEC describes various issues surrounding High-Frequency Trading (HFT) and poses a comprehensive set of questions for the public to answer.
I was particularly struck by the descriptions of two HFT directional strategies which can effectively manipulate the market – order anticipation and momentum ignition:
“Order Anticipation Strategies. One example of an order anticipation strategy is when a proprietary firm seeks to ascertain the existence of one or more large buyers (sellers) in the market and to buy (sell) ahead of the large orders with the goal of capturing a price movement in the direction of the large trading interest (a price rise for buyers and a price decline for sellers). After a profitable price movement, the proprietary firm then may attempt to sell to (buy from) the large buyer (seller) or be the counterparty to the large buyer’s (seller’s) trading. In addition, the proprietary firm may view the trading interest of the large buyer (seller) as a free option to trade against if the price moves contrary to the proprietary firm’s position…
….An important issue for purposes of this release is whether the current market structure and the availability of sophisticated, high-speed trading tools enable proprietary firms to engage in order anticipation strategies on a greater scale than in the past.”
“Momentum Ignition Strategies. Another type of directional strategy that may raise concerns in the current market structure is momentum ignition. With this strategy, the proprietary firm may initiate a series of orders and trades (along with perhaps spreading false rumors in the marketplace) in an attempt to ignite a rapid price move either up or down. For example, the trader may intend that the rapid submission and cancellation of many orders, along with the execution of some trades, will “spoof” the algorithms of other traders into action and cause them to buy (sell) more aggressively. Or the trader may intend to trigger standing stop loss orders that would help cause a price decline. By establishing a position early, the proprietary firm will attempt to profit by subsequently liquidating the position if successful in igniting a price movement…”
There was at least one public submission that insisted that firms using HFT regularly use these directional strategies to generate unfair and substantial profits. On April 16, 2010, a “R T Leuchtkafer” posted an extensive response to the SEC’s request. The commenter is emphatic in insisting that HFT needs tighter regulation because of the way in which it manipulates the marketplace and preys on slower institutions and traders. The commenter singles out the NASDAQ’s proprietary data feed called TotalView-ITCH “…that specifies exactly where hidden interest lies and whether it is buying or selling interest” as a key enabler of HFT’s ability to snatch ill-gotten gains from the stock market. (Click here for a list of all public comments)
I highly recommend reading the entire post, but quote below a few snippets I found particularly poignant, telling, and sometimes infuriating. Reuters also printed a story called “Who’s afraid of high-frequency trading?” that covers many of these issues and complaints as well as the rebuttals from those inside the industry.
“HFT firms claim they add liquidity and they do when it suits them. (Remove the effects of very active penny stocks like Citi and AIG from crisis and post-crisis SP500 spread and depth studies and you can dispute HFT liquidity claims.) At any moment when they are in the market with nonmarketable orders by definition they add liquidity. When they spot opportunities or need to rebalance, they remove liquidity by pulling their quotes and fire off marketable orders and become liquidity demanders. With no restraint on their behavior they have a significant effect on prices and volatility. For the vast majority of firms whose models require them to be flat on the day their day-to-day contribution to liquidity is nothing because they buy as much as they sell. They add liquidity from moment to moment but only when they want to, and they cartwheel from being liquidity suppliers to liquidity demanders as their models rebalance. This sometimes rapid rebalancing sent volatility to unprecedented highs during the financial crisis and contributed to the chaos of the last two years. By definition this kind of trading causes volatility when markets are under stress.”
TotalView-ITCH as an enabler
“The complete details of limit order books can be used to predict short term stock price movements. An order book feed like TotalView-ITCH gives you much more information than just price and size such as you get with the consolidated quote. You get order and trade counts and order arrival rates, individual order volumes, and cancellation and replacement activity. You build models to predict whether individual orders contain hidden size. You reverse engineer the precise behavior and outputs of market center matching engines by submitting your own orders, and you vary order type and pore over the details you get back. If you take in order books from several market centers, you compare activity among them and build models around consolidated order book flows. With all of this raw and computed data and the capital to invest in technology, you can predict short term price movements very well, much better and faster than dealers could 10 years ago. Order book data feeds like TotalView-ITCH are the life’s blood of the HFT industry because of it and the information advantages of the old dealer market structure are for sale to anyone.”
Momentum ignition and order anticipation strategies as manipulation
“Imagine a HFT market maker that needs to buy to rebalance. It removes its inside offer, posts multiple offers away from the market to induce other selling interest, and starts buying when that induced interest shows up (hopefully at lower prices). This is a momentum ignition strategy executed by algorithm. What concepts allow for the prosecution of such manipulative algorithms? How many investigations have closed when a firm deadpanned ‘that’s the way the algorithm works’ as if manipulation is OK when it is fully automated and scienter cannot be attributed to an individual trader?
Order anticipation is the fully automated version of keeping an eye on Tommy when you know Tommy handles institutional order flow. You relax when Tommy is eating lunch. When Tommy finishes lunch and walks over to a dealer post, you follow and listen in. Today, instead of keeping an eye on Tommy you listen in to TotalView-ITCH and look for hidden orders, or you reverse engineer matching engine behavior and sniff out reserve orders.”
“With pure price/time priority we have a market structure that offers significant advantages to certain participants. Market centers charge those participants large data and co-location fees to improve their advantage. Those participants are paid to replace regulated intermediaries but are themselves essentially unregulated and there is no meaningful application of anti-manipulation statues even though a strategy can be plainly manipulative, and there is no concept of ‘scienter in the machine’. Market centers have created order book data feeds and provide detailed information about hidden trading interest, and HFT firms use detailed order book feeds to reliably predict short term price movements and to arbitrage the slower National Market System.”
Be very, very careful out there!
Full disclosure: no positions