HFT Wagon Circling

Joseph Saluzzi (jsaluzzi-at-ThemisTrading.com) and Sal L. Arnuk (sarnuk-at-ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (www.themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.

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Response to pro-HFT Editorial by Lobbying Group FIA’s Lenterman

Be warned! This note has numerous links to articles and sources. We hope that doesn’t discourage you, particularly during slow times, to read them!

With all the focus on the negative effects of high frequency trading, and more importantly the conflicted web of trading destinations that feed it, the summer of 2012 has tuned into a public relations nightmare for HFT firms and stock exchanges. Books like our own Broken Markets and Patterson’s Dark Pools, as well as numerous articles in the mainstream financial press – such as this one in the Dallas Morning News titled Small Investors Ripped Off by High Frequency Trading – have placed high speed trading not only in the crosshairs of regulators, but more importantly the investing public.

It is not surprising, therefore, to see pro-HFT arguments reiterated amid this sea of scrutiny, especially from members of the HFT lobbying organization, the Futures Industry Association’s (FIA) Principal Traders Group (PTG). The latest attempts at HFT defense arrived yesterday in the form of two editorials: Remco Lenterman’s High Frequency Trading is not the Devil Behind Every Market Mishap and Quantlab Cameron Smith’s High Frequency Trauma – What Unintended Consequences Are in Store as Regulators Target HFT.

We have debated Cameron Smith in the past, specifically after he wrote an editorial in Traders Magazine in which he likened HFT criticism to a mother, whose drowning son was saved by a sailor, criticizing that sailor for not saving his hat. Our retort asked Cameron to not pi$$ on our shoes and then tell us it’s raining. Cameron in his latest pro-HFT lobbying piece says nothing new – he just reiterates that transaction costs have come down remarkably for investors. Our only advice to Cameron would be to please read the treasure trove of studies that do not support his statement.

We would like to take the remainder of this note to address Remco Lenterman’s (managing director at Dutch HFT Firm IMC, and chairman of the European Principal Trader’s Association) editorial. Remco makes these points. Again. Like the Energizer Bunny:

–          1) HFT was not the cause of the Flash Crash, and they actually helped that day by absorbing the initial sell orders. Even the US regulators said so!

–          2) HFT cancellations and revisions taking place faster than the NASDAQ opening cross algo (2 milliseconds) had nothing to do with Facebook’s botched opening.

–          3) HFT critics just fabricate opinions without facts to back them up.

–          4) HFT does not cause volatility.

–          5) HFT lowers transaction costs, reduces spreads, and increases liquidity. – ask Vanguard!

And so we must yet again call him out on his assertions.

–          1) HFT was responsible for the Flash Crash, and not a Midwestern mutual fund. That fund had a 9% of volume sell order in perhaps the most liquid instrument in financial markets that executed via limit orders placed above the market, and executed the vast majority after the market bottomed and was rebounding. Read the NANEX dissection of events of that day. Also read RTL’s very thorough and fact-supported guest chapters about the Flash Crash in our book, Broken Markets.

–          2) Again, while of course the NASDAQ exchange is to blame for not having its systems robust enough to handle its largest customers and their warp speed, Bob Griefeld himself points to the root cause of the Facebook fiasco being cancellation and revision traffic occurring at the microsecond level – i.e. HFT (we have yet to meet humans who can enter and revise orders in speeds measured in millionths of a second).

–          3) Critics of HFT, including us, have diligently sought out independent academic studies that refute the benefits of HFT. Again see the bibliography of such studies on our website.

–          4) HFT does cause volatility. See the CFTC’s own Kirilenko’s study here.

–          5) This unoriginal and tired argument has many flaws. Spreads have barely narrowed since 2006 pre Reg NMS, and they have especially not narrowed since the 2009 alleged HFT peak. The constant comparison of today’s spreads with the 25 cent spreads of 1995 is disingenuous. Also Vanguard’s fastest growing business, ETFs, depends on the “liquidity” provided in quotes markets by HFT Authorized Participants. Citing them as a poster boy for institutional investing is not as powerful as it might have been if Vanguard were the same firm it was under retired Jack Bogle, who criticizes HFT and the explosion in ETF proliferation often. And finally, regarding the “increased liquidity narrow spread” defense, please gander at Nanex’s analysis of message traffic between 2008 and 2012 – High Frequency Quote Spam. Erik Hunsader points out that while quote traffic (bids, offers, cancellations) has increased 13-fold, trade traffic remains unchanged!

Sounds to us like lobbying groups upset by the declining profit margins  of their own business models are pulling out all the stops now. Thankfully their sound bites have muted effect, as investors around the world have become more educated about the HFT liquidity pi$$ing down on their shoes.