Tuesday, January 12, 2010

In Defense of The Case Against HiFTers

In principal, I am reticent to contradict Burton Malkiel because I respect him, large, but I feel that I must raise a few salient points in regards to his recent FT Op Ed. He says essentially that over the years, trading costs have fallen (which is true); market-makers are useful (also reasonably true with caveats); he then nebulously defines HFT as computers closely proximate to the exchange that buy and sell quickly (OK he's dumbing it down guessing some WSJ readers also peruse the FT); then he debunks HFT as being synonymous with flash order predators (I'll charitably leave this as uncontentious given the numerous flavours of HFT); claims HFT is misunderstood (probably true because I think he, too, misunderstands it); and finally in the unsubstantiated non-sequitir says "they" (HFTers) are The Good Guys; They are The Guys who SAVE you money; They are the de-facto market-makers and if they steal they seem to only steal from other traders and not from individual or long-term investors. To which I say: "...Whooaah there bossy...."

The implied argument is that HiFTers are genuinely providing liquidity and therefore, in the process, bearing substantial risk and therefore deserving of return for the useful function of providing temporal liquidity. That's a fine-and-dandy justification for market-making one I find uncontentious.

But really the question that must be asked is: "Are HiFTers (c) truly market-makers in the classical (and it must be said, useful) sense??" From all my experience, assimilating everything I have seen on by and sell sides, by comparison to market-makers in the past, and even some present market-makers such as Tom Petterfy's Timber Hill, I think the answer is "categorically not", and the esteemed Dr Malkiel is essentially wrong. I believe, HiFTers, in the main, are NOT reversion oriented (in the Princeton-Newport, Thorpian sense), warehousing risk, until the opposite side emerges. They are, in the main, making a market NOT to price the temporal cost of warehousing risk to capture spread, but rather to sniff out the direction of order flow and predate it. They are, in effect, inverting the purposefulness and utility of market-making with respect to liquidity. As a result, one might even wonder whether Dr Malkiel is perhaps on some HiFTers advisory board or consultancy payroll. Granted, I have no figures to support my assertion, only my long experience in the trenches - but then neither does Dr Malkiel cite any numerical support for his assertions. We are left in a substantiation stand-off, my tangible market experience vs. Dr Malkiel's academic reputation.

Idealists would like to see bona fide buyers and sellers match directly, thereby disintermediating parasitical traders, where "bona-fide" is defined as those with a non-feedback-based orientation. Thoughtful apologists accept the virtue in this ideal, but then suggest that, practically, institutional herding makes it unlikley bona-fides are able to find the other side when and where they want it. Here again apologists narrowly define HifTers as liquidity providers rather than disruptive front-runners. And while I accept the possibility that periodic herding effects might swamp the more typical opinion and participant diversity of market order flow, I think the argument is spurious since the contribution of HiFTers as faux-market-makers remains negative sum for both bona-fide buyers and sellers where HiFTers intermediate.

Some justify HiFTing by arguing "so what if they are parasitical front-runners, as the activity help market prices more quickly move towards something resembling a short-term equilibrium". I find this path of argument a tad more useful, yet, all it does is push the argument into the realm of "is informationless feedback trading itself useful or desirable??" If they were convergent upon longer-term equilibria, I would be far more sympathetic, but amplifying divergent trends is certainly detrimental to efficiency sympathies (and justifications), and the front-running HiFTers seem just as likely to push something away from these arguably more important equilibria than towards them, making the argument irrelevant at best.

Still others (particularly from the BD community) justify their HiFTing by "Internalization" of order flow, proudly (though still somewhat disingenuously) suggesting there are no resulting casualties, and customers in any event get the best execution, but this is likely smoke and mirrors, in the same way that restricted access US Govt secs inter-dealer brokers always had inside markets relative to prevailing markets available to non primary dealers. Discretionary and/or limit orders embedded in the books of electronic exchanges visible or known to broker-dealers (as they are/were to monopolistic specialists) are used NOT to execute the customer at the best price, but help the HiFTing firm capture so-called riskless spread at the expense of their customers' best execution. Low body count and conflict of interest, indeed - as they take from the customer pennies at a time.

The descriptive argument with the most apt potential to mirror the actual dynamic is one where a host of HiFTers predate large or several large orders, buy up everything out there in front of them who then flip the appropriate sized parcels to the hapless buyer at an elevated price reflecting the same spread and market impact that a traditional market-maker, block-trader or specialist-of-old would have yielded, the only difference being that instead of Vinnie or Mario licking his finger and making his price, it is now some UNIX programmers who implemented it as a complex algorithmic system that forms an ecosystem to do the same. This may or may not be true, or rather was probably not true in the short-run when profits were fat but probably will in the longer-term where competition eventually shrinks inverting the opportunities back to reversion, where they converge upon the true price of providing liquidity adjusted for some return on capital. But between here and there, there is likely increased cost for bona-fide investors and short-term price volatility. Judging by the scramble for UNIX developer talent, and number of entrants ditching "longer-frame" warehousing for shorter-term order-sniffing and pseudo-front-running, the scrum is intensifying, and the denoument has yet to be reached.


Eric Hirschberg said...

HFT is a byproduct of the rules and mechanisms of the capital markets. It exists because, in the world of Darwinian finance, it can. If we want it to go away, we need to create a system of rules and regulations that would make it disadvantageous to play. Assignation of a moral construct around it, doesn't seem to make any sense to me.

Charles Butler said...

Take away the 'moral construct' and Cass would have to fold up the tent.

Eric Hirschberg said...

Hi Charles,
I'm not saying our friend should abandon moral construct. I am saying that in this particular case it is a futile exercise. It will exist until it is regulated away, or it's profitability is cannibalized by another system.

"Cassandra" said...


While I admit that I have my doubts as to the utility of at least what might be called the less useful HiFTing, the purpose of the post was less to indict the HiFTers than to highlight what was essentially a shallow and unsubstantiated defence of the undertaking by an eminent academic, Dr Malkiel.

But perhaps I shouldn't have taken Dr Malkiel's indictment so seriously, since his motivations appear to be ideologically-driven (hence the lack of substantiation in the Op-Ed), following in the foot-steps of his wrong-headed defence of market self-policing in his 2002 WSJ editorial just prior to the acceleration of self-regulation's erstwhile greasing of the shadow financial system's great leveraging by financial institutions who, were fully capable and motivated to know better and thus police themselves.

Phillip said...

Thinking about frontrunning reminded me of Christopher Hollis in his 1935 book Two Nations: A Financial Study of English History:

The old-fashioned Swinburnian radical who saw in the priest and the king the two enemies of the people is dying fast. The true enemy is he whom Mr. H. G. Wells so happily calls the "smart Alec," the man to whom the whole end of life is the extraction of money from the pockets of his fellow-citizens by a variety of tricks. Priests and kings may have had their faults, but at least they are symbols of a power that is not of this world; they are reminders of values that the "smart Alec" has never known. And with all his pomposity what is the high financier but a "smart Alec" in a top-hat?

Anonymous said...

HFT losers couldn't value a stock if they had a time machine... so they play games with other fools playing games. They do it to make the chart readers think they have a new secret to trading, when all they have is another false prophet.

Mike Sankowski said...

You misunderstand the nature of market making. It has always been to sniff out order flow. At least, when I was a market maker at the CME, that's what we did.

Market makers entire job is to try and front run orders. That's how you make money as a market maker.