Streetwise Professor

August 5, 2009

Either There are a Lot of Suckers Born Every Minute or . . .

Filed under: Economics,Exchanges — The Professor @ 9:46 pm

The controversy over high frequency trading and flash orders and dark pools does pose one very serious puzzle that is encapsulated in this article from Bloomberg:

The U.S. Securities and Exchange Commission’s move to ban so-called flash orders may help  NYSE Euronext take back market share of U.S. stock trading at the expense of three-year-old rival Direct Edge Holdings LLC.

Senator  Charles Schumer said yesterday the SEC will seek to stop the practice in which some brokers get a split-second advantage in viewing requests to buy and sell stock, after discussing the issue with Chairman  Mary Schapiro. NYSE Euronext, the only one of the top four U.S. exchanges that doesn’t use flash orders, has seen its portion of the nation’s share trading slip to 30.3 percent in the second quarter from 35.5 percent a year earlier, while Direct Edge’s doubled since November.

. . . .

Direct Edge, based in Jersey City, New Jersey, used its early lead in flash trading to take business from rivals. The company is the fastest-growing equity market in the U.S., helped by its three-year-old  Enhanced Liquidity Provider program, which handles the most flash trades.

Even excluding flash orders,  Direct Edge matched 11.2 percent of U.S. stock trades in July, making it the third- largest U.S. equity market by volume, according to data compiled by Bloomberg. That may help fuel growth if regulators start a broader review of off-exchange trading, Chief Executive Officer  William O’Brien said in an interview yesterday.

If these practices are so deleterious, then how come Direct Edge and other platforms that facilitate HFT, particularly through the use of flash orders, have been gaining market share?  Why would more and more market users submit orders to venues, which if the complaints about these practices are to be believed, allow them to be raped by HFTs?  Are they suckers?  Given that these are institutional investors for the most part, methinks not.

This is an interesting tidbit:

Flash systems trace their roots as far back as 1978 to efforts by exchanges to electronically replicate how a trader might yell an order to floor brokers before entering it into the system that displays all bids and offers.  Markets have evolved since the days of floor brokers’ dominance, with computer algorithms now buying and selling shares 1,000 times faster than the blink of an eye.

That is, on the floor, a broker holding a limit order (an order to buy or sell at a particular price or better) could first attempt to execute the order by soliciting interest in the trading crowd.  If someone in the trading crowd was willing to trade a price at the limit or better, the deal would get done.  If not, the order would go into the specialists book.  That is, the floor broker first “flashed” the order to the trading crowd to see if he could get the customer a better execution.

The hysterics about HFT in general, and flash trading in particular, could represent special pleading by the NYSE to hobble competitors.  So, I treat a lot of the criticism with a very critical eye.

And generally, although competitive success does not necessarily indicate the provision of a better value, it usually does.  So when a particular system gains market share, the presumption should be that is providing value.  Show me otherwise.  I’m open minded.

One last thing on HFT.  Krugman said that it’s bad in part because only those who invest in the technology can compete.  (Looking for the link).  Which is true of, oh, I don’t know, computers, cars, software, flea collars, and just about anything you can name.  You know, it’s called competition.  It’s in all the textbooks.  You can look it up.

The relevant question is whether the technology is used to create value, or to extract a rent.  Both things are possible, but you serious analysis is required to figure out which.  There are some aspects of HFT that do suggest rent seeking, others that suggest value creation.  Krugman needs to work a lot harder to make a persuasive case to show that it’s the former, and not the latter.

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1 Comment »

  1. […] links: “hysterics about HFT… and flash trading in particular, could represent special pleading by NYSE…” – Streetwise Professor The dash to flash – FT HFT correlations at BarCap – […]

    Pingback by FT Alphaville » Nasdaq and BATS to stop offering flash trading — June 4, 2010 @ 12:26 pm

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