[A long-standing obsession of Tyler Durden at Zero Hedge broken down for us non-traders.]
[Part of what makes it more fun is that it seems quite possible that many people think (a) this is the sort of program Sergey Aleynikov wrote for Goldman, which is why they were so upset about it being stolen, and (b) this contributed substantially to GS's high earnings.]
<begin blog post>
http://market-ticker.denninger.net/archives/1259-High-Frequency-Trading-Is-A-Scam.html
High Frequency Trading Is A Scam
The Market Ticker
Friday, July 24. 2009
Posted by Karl Denninger in Regulatory at 08:22
High Frequency Trading Is A Scam
The NY Times has blown the cover off the dark art known as "HFT", or
"High-Frequency Trading", perhaps without knowing it.
It was July 15, and Intel, the computer chip giant, had reporting
robust earnings the night before. Some investors, smelling
opportunity, set out to buy shares in the semiconductor company
Broadcom. (Their activities were described by an investor at a major
Wall Street firm who spoke on the condition of anonymity to protect
his job.) The slower traders faced a quandary: If they sought to buy
a large number of shares at once, they would tip their hand and risk
driving up Broadcom's price. So, as is often the case on Wall
Street, they divided their orders into dozens of small batches,
hoping to cover their tracks. One second after the market opened,
shares of Broadcom started changing hands at $26.20.
The slower traders began issuing buy orders. But rather than being
shown to all potential sellers at the same time, some of those
orders were most likely routed to a collection of high-frequency
traders for just 30 milliseconds -- 0.03 seconds -- in what are
known as flash orders. While markets are supposed to ensure
transparency by showing orders to everyone simultaneously, a
loophole in regulations allows marketplaces like Nasdaq to show
traders some orders ahead of everyone else in exchange for a fee.
In less than half a second, high-frequency traders gained a valuable
insight: the hunger for Broadcom was growing. Their computers began
buying up Broadcom shares and then reselling them to the slower
investors at higher prices. The overall price of Broadcom began to
rise.
Soon, thousands of orders began flooding the markets as
high-frequency software went into high gear. Automatic programs
began issuing and canceling tiny orders within milliseconds to
determine how much the slower traders were willing to pay. The
high-frequency computers quickly determined that some investors'
upper limit was $26.40. The price shot to $26.39, and high-frequency
programs began offering to sell hundreds of thousands of shares.
But then the NY Times gets the bottom line wrong:
The result is that the slower-moving investors paid $1.4 million for
about 56,000 shares, or $7,800 more than if they had been able to
move as quickly as the high-frequency traders.
No. The disadvantage was not speed. The disadvantage was that the
"algos" had engaged in something other than what their claimed purpose
is in the marketplace - that is, instead of providing liquidity, they
intentionally probed the market with tiny orders that were immediately
canceled in a scheme to gain an illegal view into the other side's
willingness to pay.
Let me explain.
Let's say that there is a buyer willing to buy 100,000 shares of BRCM
with a limit price of $26.40. That is, the buyer will accept any price
up to $26.40.
But the market at this particular moment in time is at $26.10, or
thirty cents lower.
So the computers, having detected via their "flash orders" (which ought
to be illegal) that there is a desire for Broadcom shares, start to
issue tiny (typically 100 share lots) "immediate or cancel" orders -
IOCs - to sell at $26.20. If that order is "eaten" the computer then
issues an order at $26.25, then $26.30, then $26.35, then $26.40. When
it tries $26.45 it gets no bite and the order is immediately canceled.
Now the flush of supply comes at, big coincidence, $26.39, and the
claim is made that the market has become "more efficient."
Nonsense; there was no "real seller" at any of these prices! This
pattern of offering was intended to do one and only one thing -
manipulate the market by discovering what is supposed to be a hidden
piece of information - the other side's limit price!
With normal order queues and flows the person with the limit order
would see the offer at $26.20 and might drop his limit. But the
computers are so fast that unless you own one of the same speed you
have no chance to do this - your order is immediately "raped" at the
full limit price! You got screwed, as the fill price is in fact 30
cents a share away from where the market actually is.
A couple of years ago if you entered a limit order for $26.40 with the
market at $26.10 odds are excellent that most of your order would have
filled down near where the market was when you entered the order -
$26.10. Today, odds are excellent that most of your order will fill at
$26.39, and the HFT firms will claim this is an "efficient market."
The truth is that you got screwed for 29 cents per share which was
quite literally stolen by the HFT firms that probed your book before
you could detect the activity, determined your maximum price, and then
sold to you as close to your maximum price as was possible.
If you're wondering how this ramp job happened in the last week and a
half, you just discovered the answer. When there are limit orders
beyond the market outstanding against a market that is moving higher
the presence of these programs will guarantee huge profits to the banks
running them and they also guarantee both that the retail buyers will
get screwed as the market will move MUCH faster to the upside than it
otherwise would.
Likewise when the market is moving downward with conviction we will see
the opposite - the "sell stops" will also be raped, the investor will
also get screwed, and again the HFT firms will make an outsize profit.
These programs were put in place and are allowed under the claim that
they "improve liquidity." Hogwash. They have turned the market into a
rigged game where institutional orders (that's you, Mr. and Mrs. Joe
Public, when you buy or sell mutual funds!) are routinely screwed for
the benefit of a few major international banks.
If you're wondering how Goldman Sachs and other "big banks and hedge
funds" made all their money this last quarter, now you know.
<end blog post>
That last sentence refers to the fact that not only is 73% (!) of all volume on the NYSE now HFT, but the same strategy is being applied to lots of other markets (futures, options, etc.) Tyler Durden has some back of the envelope calculations where he concludes that *all and then some* of Goldman's record $3.44B profit last quarter could be coming from this super grift:
http://zerohedge.blogspot.com/2009/07/goldmans-4-billion-high-frequency.html
He also provides further details for those interested. Two other things in particular that he touches on are:
1) In addition to stealing money from our mutual funds, with what seems like what should be an illegal technique, if HFT is 3/4 of market volume, then without question it's moving the market. And the big run-up of 2009 may be just the newest Ponzi game, set to burst spectacularly when this mechanism goes into reverse.
2) In re that amazing figure of the proportion of NYSE trading that is HFT -- We used to know it exactly until a month ago when the SEC suddenly stopped providing the data without providing any reason. Which Tyler Durden considers another blatant act by Government Sachs to stop people like him from exposing them.
And as Jordan pointed out to me when it happened, you could say the same of the nabbing of GS's computer guy by the FBI. What exactly what it that made that a federal case? Besides that GS was incommoded?
Of course, if this really was the source of such a huge part of their earnings, you could imagine why they were so agitated.
I must admit, that although Tyler Durden is way better at math than me, I tend to think that at least some of GS's earnings have to have come from having 2 of their major competitors (Bear Stearns and Lehman) put to sleep in the last year, and the general fear in the markets, which widens spreads. Surely those things must have contributed to earnings, and I would think substantially.
Although that observation bring up one last thing on the Government Sachs beat: that those two competitors died when the government said it was absolutely "powerless" to them to commercial banks and save them. Until 2 weeks after Lehman desmise it found it could in GS's case.
It's probably just a coincidence. They might have died in a different order, and it's probably the view of the abyss that opened after Lehman that changed the government's mind.
But certainly lots more fun grist for agita!
Michael