Equity Trading
The Fallout from Flash Boys
Michael Lewis’ novel Liar’s Poker is required
reading for any aspiring trader. The entertaining
novel follows his career at Salomon Brothers and
also the role that firm played in creating
mortgage bonds in the 1980’s. It also depicted
some iconic moments on trading desks including
two senior members of Salomon Brothers
challenging each other to games of Liar’s Poker 1
for ungodly sums of money even by today’s
standards. Mr. Lewis’s latest novel, Flash Boys,
has become the talk of equity markets, Asset
Owners, investment consultants, mutual fund
boards and the trade press. Mr. Lewis described
how high frequency trading (“HFT”) has
essentially taxed all other investors by using
better technology to front run client orders. This
tax adds no value to any investor and essentially
has “rigged” the markets. While there has been
endless commentary on his novel, the only
certain outcome from this controversy is that Mr.
Lewis will sell a lot of books.
Thanks to Mr. Lewis, the HFT debate, which has
festered for many years within market structure circles,
has reached the wider financial community and
general public. While the general public will simply
chalk this up as another reason to vilify Wall Street,
Asset Owners must understand what, if anything, they
can do as Fiduciaries to protect the assets within their
plans. To understand the current debate we must
understand what is causing these issues, the
differences between various high frequency trading
strategies, the effects on all market participants and
what can be done to prevent the abuses.
Important Terms
The financial industry is littered with acronyms and
terminology that market participants throw around as
if everyone knows what they mean. We have started
with a brief glossary aimed at translating some of the
jargon into meaningful terms.
Liar’s Poker is a game where the serial numbers on dollar bills are
used to play a game of poker. As with poker, bluffing can be an
important strategy in winning.
What is the SIP? SIP stands for Security Information
Processor. The SIP receives data from national
exchanges which is aggregated to determine the
NBBO. The NBBO is then disseminated to subscribers.
Current market rules require all trading to be done at
or better than the NBBO. 2
What is the NBBO? NBBO stands for National Best Bid or
Offer. These are the best current prices for a broker to
buy or sell a stock. The best bid is the highest price
someone is willing to buy a stock (bid) and best offer is
the minimum price someone is willing to sell a stock
(offer).
What are Dark Pools? Dark pools are private liquidity
pools which are not open to the public nor provide
information about orders within their venue to the SIP.
What are Flash Orders? The process of flashing orders
begins when an order is sent to an exchange
although it could not be executed via that exchanges
current NBBO. That order is subsequently “flashed” via
a direct data feed to clients of that exchanges direct
data for potential execution. The broker sending the
order is not aware their order was sent to all clients of
that exchange.
What does routing mean? The decentralization of
trading has forced the industry to develop routers that
determine where an order is sent for execution. While
brokers must not violate market rules, routers can be
set to maximize internalization (prioritizing that brokers
own dark pool), route to the venue that will maximize
the rebate back to the broker dealer or route to the
exchange with the lowest cost for that order type
amongst others.
What is the maker/taker pricing model? An
exchange/venue pricing system that pays customers
to provide liquidity (maker) and charges customers a
fee for taking the liquidity of the maker. The maker’s
rebate is less than the taker’s fee which constitutes
profit for that venue.
1
2
There are limited exemptions to this rule.
Equity Trading
The Fallout from Flash Boys
Who is required to provide information to the SIP?
National Market Exchanges register as such with the
SEC. There are currently 16 exchanges in the United
States. 3 These are often referred to as “Lit” markets as
their prices are transparent unlike dark pools.
A Brief History
Current market microstructure can be traced back to
multiple rule changes with the Regulation National
Market System (Reg NMS), which was enacted in
2007, being the most important. The key rule change
was the order protection rule or trade through rule. It
essentially forced brokers to execute at the best price
available across all markets (at this point in time the
NYSE and NASD dominated total volume although
regional exchanges existed and posted to the
consolidated quote system). While executing at the
best price seems obvious, high frequency trading
(HFT) can trace its roots back to this rule. Consider the
following quote for stock XYZ:
(Venue: Bid – Offer | Shares Bid x Shares Offered)
Venue 1: 100.00 – 100.10 |50,000 x 50,000
Venue 2: 100.01 – 100.09 | 100 x 100
Prior to the enactment of Reg NMS, most institutional
traders who were looking to sell a block of XYZ would
ignore Venue 2 and execute on Venue 1. They
would ignore Venue 2 because there were only 100
shares bid for the stock while executing on Venue 1
would allow them to execute 50,000 shares in one
transaction. Reg NMS effectively forced traders not to
ignore Venue 2 and execute 100 shares at the
superior price before routing to Venue 1 for the 50,000
shares.
This rule change essentially transformed the US from
two dominant market centers (NASDAQ and NYSE) to
a much more fragmented market where startup
electronic exchanges could compete on a level
playing field with the two industry giants because their
liquidity could no longer be ignored. In a similar
timeframe, the exchanges transformed from nonprofit entities to for profit entities. As such, they were
no longer unbiased utilities for execution. Two key
changes that occurred due to the change in business
model was the maker or taker pricing models and the
business of selling preferential treatment to market
participants. Preferential treatment comes in the form
of direct data feeds and co-location space that are
sold at a premium. The direct data feeds and colocation space have created an uneven playing field
in the form of lower latency and the ability to react to
market information quicker.
Unintended Consequences
Competition is the life-blood of free markets. The
thought process behind Reg NMS was that increased
competition will decrease bid/ask spreads for all
investors. 4 This will lower transaction costs and
essentially decrease the compensation currently
being made by the market makers at the time and
return this ‘tax’ to its rightful owner. What was never
envisioned when this rule was adopted was latency
arbitrage. Latency arbitrage is the advantage certain
market participants from purchasing direct data feeds
and co-location. The unfair playing field leads to
what we call disappearing liquidity effect. The
disappearing liquidity effect is illustrated below:
Venue 1: 100.00 - 100.02 | 2,000 X 2,000
Venue 2: 100.00 - 100.02 | 2,000 X 2,000
Venue 3: 100.00 - 100.02 | 2,000 X 2,000
Venue 4: 100.00 - 100.02 | 2,000 X 2,000
Venue 5: 100.00 - 100.02 | 2,000 X 2,000
Five exchanges with the same quote would lead you
to believe you can buy/sell 10,000 shares at the
current bid or offer by taking the liquidity on all five
venues. What actually happens however is when a
trader attempts to purchase 10,000 shares, he or she
would often transact on 2,000 or 4,000 shares (they
would transact in the venue who receives that
message first) but not be filled on the total 10,000
shares as the other volume disappeared in the microsecond it takes for an order to reach all exchanges.
The price would then move away from where that
trades wanted to execute. This happens because the
It should be noted that spreads have decreased significantly since
this time and transaction costs have declined as well.
4
3
http://www.sec.gov/divisions/marketreg/mrexchanges.shtml
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Equity Trading
The Fallout from Flash Boys
HFT firm would see the buyer of 10,000 shares lift the
first 2,000 shares (from the first venue it reaches) and
then compete against that order. Competition for
that order can manifest in many different manners
such as cancelling orders the HFT firm is trying to
execute in that stock or buying ahead of that order.
The reason why each exchange is not accessed at
the same exact time is due to the time it takes the
information to travel through the cables carrying the
information.
Defense of HFT
The antagonists of Flash Boys are all HFT firms 5 who are
labeled as scalpers who have rigged the market at
the cost of the small retail investor and pension plans
across the globe. The one-sided nature of the story
has led to a fierce defense from the high frequency
industry. 6 The most common points noted by HFT firms
are the following:
I.
The IEX Solution
The protagonist of Flash Boys is Brad Katsuyama the
former head of RBC’s trading desk and President of
IEX (IEX is a shortened version of “Investors
Exchange”). Katsuyama, like many market
participants, was keenly aware of the disappearing
liquidity issues that constantly occurred. IEX’s solution
is to level the playing field for all investors executing
within their dark pool. They would do this by:
1.
2.
3.
Ensure no order has a latency advantage
over others. All orders on IEX are delayed 350
milliseconds which eliminates any latency
advantage.
Limit the amount of order types. There are
hundreds of orders types than can be used to
release and order to a liquidity venue with
some of these order types designed so no
executions occur.
Eliminate rebates associated with different
order types. All orders executed on IEX pay
the same rate for execution. This essentially
eliminates the HFT strategy of attempting to
profit from rebate arbitrage.
IEX has been very successful as a startup dark pool
executing over 40 million shares per day at last count.
They have been able to attract this sizable market
share because of both believers in their model, some
of whom have invested in IEX, and the publicity from
Flash Boys.
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II.
III.
Everything they are doing is within the
confines of the market and perfectly legal (for
now!)
There are many different HFT strategies that
do not involve “latency arbitrage” and these
strategies add liquidity to the market and
lower transaction costs for everyone (Harbor
agrees with this point and the issue
associated with regulating abusive HFT
strategies out of the market is to ensure
liquidity creating strategies are not effected)
High frequency strategies increase market
efficiency by driving securities to their fair
market value by removing short term pricing
anomalies often caused by larger orders.
(again we agree with respect to a limited
number of strategies).
Predatory HFT Strategies
In general, HFT is a catch all term that defines
automated trading strategies that rely on high speed
execution and large volumes. These strategies
attempt to make small profits as many times as
possible in a given day (think a fractional of a penny
millions of times a day). Holding periods are
measured in seconds and rarely are positions held
overnight. To improve the market microstructure we
need to rid ourselves of predatory strategies that are
simply a tax on investors. The most egregious
strategies in our view include the following:
While his name never appears in the novel, the climatic ending of
Flash Boys in combination with some internet searching will lead you
to the person who is believed to be the face of the HFT industry.
6 CNBC’s interview of Katsuyama and BATS (liquidity venue who is
accused in Flash Boys of arming predatory HFT firms) President William
O’ Brien demonstrates the animosity amongst market participants in
this debate. http://www.cnbc.com/id/101544772
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Equity Trading
The Fallout from Flash Boys
Latency Arbitrage – This is a fancy term for front
running. The NBBO is determined by the SIP, which
receives data from all protected exchanges. The SIP
takes a certain amount of time to determine the
NBBO. Firms executing latency arbitrage buy direct
data fees from each of the execution venues and
essentially calculate their own NBBO and do it quicker
than the SIP. HFT firms know what the NBBO will be in
the future as they are a fraction of a second quicker.
It is essentially like betting on a Sunday football game
while you are reading Monday’s paper. You cannot
lose. Who wins from Latency Arbitrage?
1.
2.
The firms who execute these strategies
essentially have risk free profits.
The exchanges benefit because their direct
data feeds at co-location space are sold to
HFT firms at a premium.
Liquidity Providing HFT Strategies
Not all HFT strategies are toxic and some add to the
liquidity and efficiency of markets. For many years
market makers and specialists were the liquidity
providers for the market. In some respects, certain HFT
strategies have replaced market makers in creating
liquidity. This is done through high velocity strategies
which we believe lower transactions costs for all
participants. Some examples of these strategies are:
1.
2.
Who loses?
1.
All investors. It is a zero sum game – what they
make is essentially a tax on anyone trading.
Momentum Ignition Strategies – This is a fancy term for
creating a lot of commotion in the market that could
potentially trick traders/algorithms into thinking the
stock is moving quickly. This is the equity trading
version of yelling fire in a dark theater. HFT firms will
create a staggering amount of orders in a short period
of time giving the appearance of a potential shift in
the momentum of a given stock (very few are
executed as they are cancelled very quickly and
many are activated with a market type that is
designed not to be executed). This can often cause
algorithms used by most market participants to
increase its trading. HFT firms profit from the short term
volatility. In less liquid stocks, HFT firms can trigger stop
loss 7 orders which will further move a stock
temporarily.
There are many more HFT strategies that are not a tax
on the investor. The more important point is that not
all HFT strategies are bad and some have assisted in
lowering transaction costs for all investors.
Harbor Recommendations
It is the view of Harbor Analytics that the following
changes will limit the “tax” on trading caused by
predatory HFT strategies:
1.
Stop loss orders are limit orders entered below (above for short
positions) the current value of a security which attempts to limit ones
downside. Once the stock reaches the stop loss limit, the order
becomes a market order which is immediately executed. Market
orders can have large short-term impact for illiquid stocks.
7
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Passive Market Making – Passive market
making attempts to buy on the bid and sell on
the offer constantly across many stocks across
the trading day. The HFT firm also will attempt
to profit from rebates from exchanges in these
strategies.
Security Arbitrage – Firms for many years have
attempted to profit from fair value differences
between futures, exchange traded funds and
the physical stocks that underlie these
products. Similarly, ADR’s that trade in the
same market periods (US/Europe, US/
Canada etc.) can be simultaneously
purchased and sold for small profits. Lastly,
highly correlated securities that dislocate on a
given day can create a temporary long/short
trade until the aberration disappears. These
strategies create liquidity to the market and
lower transaction costs for all participants.
A charge for cancel and replace orders
which is based on the ratio of executions to
orders placed. Many market participants are
frustrated by disappearing liquidity. The
disappearing liquidity is caused by HFT firms
who have no intention of executing at the
Equity Trading
The Fallout from Flash Boys
2.
3.
prices they have posted. They are simply
fishing for information that can be used to
step ahead of bona fide orders or trying to
create an appearance of upcoming
momentum. Our suggestion is to charge for
cancel and replace orders once your ratio
(Cancel and Replace Messages vs. Actual
Executions) for a trading day reaches a
certain point. Simply charging for cancel and
replace of orders is unfair as market
participants do this all the time as the market
changes and their price level or strategy
changes. Also charging for cancel and
replace orders once they reach a certain
point will be a tax on the largest firms who
conceivably will have the largest amount of
orders. The intent of this rule would be to
eliminate trading strategies where firms are
fishing for information and routinely cancel 9095% of their orders on a daily basis. This would
be extremely difficult to implement given
exchanges would have to band together to
make this effective but something that would
eliminate a powerful tool for predatory HFT
firms.
Ban flash orders. Many exchanges already
have banned this order type which has no
value to investors.
End direct data feeds. The advantage firms
have by creating a faster SIP is unfair.
What can an Asset Owner do?
There is very little direct action Asset Owners can take
at this point because predatory HFT’s are not violating
any regulations or laws. Unlike the FX scandal that is
still playing out in courts, Asset Owners do not have
much recourse in this debate. A prudent Fiduciary
should:
I.
Join the debate. Because institutional asset
owners have the largest amount of capital,
and thus the largest tax from predatory
strategies, they should be voicing concerns
on what should be implemented to eliminate
this cost.
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II.
III.
IV.
Measure your transaction costs and ensure
your managers are aware that you monitor
their trading closely. Transaction costs are
the usually the largest cost associated with
managing a strategy and a direct impact to
alpha.
Ensure trading is an important part of
manager due diligence. Those managers
who have limited resources and focus little on
trading will ultimately fail.
Understand the process each manager
undertakes in routing of their orders. Our guess
is some managers completely leave this to
their brokers which can be a mistake. While
we expect that the popularity of IEX will cause
for copy-cat exchanges or potentially
improvements to the IEX model, an Asset
Owner should ensure that their managers are
staying current on the routing of their orders
and potential opportunities (i.e. block crossing
networks) that will lower cost and completely
avoid HFT.
Litigation
As with all controversy in financial services, the plaintiff
bar will strike. Pension plans will soon, or already have,
receive solicitations to sue their money managers for
NBBO violations. While NBBO violations have little to
do with the current HFT debate, the scrutiny will allow
these firms to get more Asset Owners interested. The
firms will assert that they have lost significant value
due to these violations and are entitled damages.
The problems we see with this approach are as
follows:
1.
Data. Custodian banks do not maintain time
stamped trade data for all orders executed
by money managers. Similarly, most money
managers do not maintain accurate time
stamps for all “child” orders it executes. A
child order is essentially the individual
executions that make up the large block that
was purchased or sold. If this data is not
readily available, it will make the analysis and
ability to prove fault difficult.
Equity Trading
The Fallout from Flash Boys
2.
3.
Culpability. Who will be sued? Managers are
using best of breed algorithms to route their
orders to the market for best execution. If
NBBO violations occur, are they really the fault
of the money manager?
Broker Dealers. Broker dealers who internalize
trading are required to enact policies and
procedures to ensure all orders are compliant
with Reg NMS. Because any violations that
are not exempt must be reported, a process
already exists to measure NBBO violations.
The goal of many of these firms will be to create a
large enough distraction for any financial services firm
they engage to settle a lawsuit. We believe if there
are any recoveries they will be small and not worth
the effort.
Summary
Michael Lewis will sell a lot of books as he should.
There is no doubt that Flash Boys is very entertaining
particularly for those actively involved with equity
trading. The regulatory response is less certain.
Obvious cures for eliminating latency arbitrage will
have consequences to other market participants
(particularly the exchanges who profit from selling
direct data feeds) who are not simply taxing other
investors.
What will change is that all market participants will
become more sensitive to the issue and we expect
new liquidity venues to arise that will protect client’s
orders from the current market structure problems.
About Us
Harbor Analytics is a consulting firm that provides
expert quantitative support to clients and investment
consultants during the transition management process
and the on-going monitoring of managers trading.
We focus on the total cost of trading, the alpha
impact caused by trading and the probability of the
manager being able to consistently generate alpha
given its management and trading style.
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Contact:
info@harboranalytics.com
781.875.1451
Legal Disclaimer
You may only use this communication for internal
purposes and you may not amend or forward without
written consent from Harbor Analytics, LLC. The
communication is background information and should
not be considered a solicitation for any investment
strategy nor are we providing investment advice. Our
opinions are subject to change without advanced
notice. These are solely the opinions of the author.
© Harbor Analytics, 2014