Streetwise Professor

December 12, 2012

HFT: Whose Gnu is Gored, or Not?

Filed under: Commodities,Derivatives,Economics,Exchanges,HFT,Regulation — The Professor @ 4:41 pm

I laughed out loud, and very hard, watching this video (from RT, no less, though via Tabb Group) about HFT.  It is an interview with David Greenberg, who spent 25 years trading CL on the floor of the NYMEX.

What made me laugh?  The part (starting around the 1:30 mark) where Greenberg notes that when public news comes out, HFT traders pull their quotes “in nanoseconds.”  But back on the floor, there would be brokers who would be quoting customer limit orders, and “before his clerk could grab him on his neck, I could go ‘SOLD!'”

Let me translate.  Floor traders had a speed advantage over customers off the floor who were trading by limit order.  When market-moving news came out, floor traders like Greenberg could exploit their speed advantage, and trade against stale customer limit orders that were entered before the information was released. In so doing, the locals, due to their time-and-space advantage, took money from customers.

Yeah, it didn’t happen in a nanosecond, but that doesn’t mean jack.  What matters is that even on the floor, the faster took money from the slower: seconds, nanoseconds, whatever.  This was true in 1990, 1890, and hell, in 1790 or 1690 in the Osaka rice market.  Locals on the floor had a speed advantage over those off the floor, which they exploited ruthlessly .  And this inevitably resulted in wider markets, as off-floor traders quoted wider spreads precisely because of their vulnerability to being picked off.

Not to go all Einstein on you (as if), but speed is relative.  The stale quote problem is not a function of the absolute speed with which some traders can react, but the relative speed.  Humanoid locals in the pit were pitifully slow, compared to robot traders-especially customers who had to play telephone (literally) to yank their orders.  But that doesn’t mean that predatory trading-taking advantage of the slowest gnu in the herd-was less severe on the floor than in an electronic market.  What drives the losses from stale quotes is relative speed.  And I would argue that relative speed differences were even greater in the floor days than now.

And what ticks off old-timers like Greenberg is that the easy pickings aren’t there for the taking anymore.  HFT traders, through their tremendous speed, and their ability to scrape numerous sources of electronic information, can pull their quotes in an instant when market-moving news comes out.  They thereby protect themselves from being picked off.

Which is precisely why they can quote very tight markets.  And which is precisely why guys like Greenberg hate them.  They have ruined a total racket.  How dare they?!?!

Greenberg also talks about how in the floor days prices would move in stages to a new level after information was released.  Now the movement is much faster.  That’s bad how, exactly?

One could argue that if HFT completely withdraw their quotes, that the market will overshoot.  Prices move a lot because HFT traders totally pull their quotes.   Once the information has been digested, they quote again, and presumably the new quote level is between the pre-information release price and the quote/price immediately following the pulling of HFT quotes.

This has a testable prediction: price reversals should be larger in electronic markets than floor markets.  Or to refine the test: price reversals in the aftermath of big price moves (in response to the release of particularly salient information) should be bigger in electronic than floor markets.  To refine the test: the magnitude of price reversals should vary directly with the prevalence of HFT.

This all brings to mind two conversations, held more than 10 years apart, with a legendary trader.  A guy who made 100s of millions of dollars.  In about 2000, this trader told me he was ecstatic about the advent of electronic trading because he was “tired of getting raped by the floor.”  (Exact quote.)  In 2012, he was lamenting the advent of electronic trading because he couldn’t keep up with HFT.

Keep this in mind when you hear laments about HFT, especially from market veterans.  It’s all about whose gnu is gored, or about how the gnus have become so fast that it’s hard to gore them anymore.

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  1. Professor, I saw it. It made me laugh as well since I think, in fact, implicitly he is endorsing HFT.

    Comment by MJ — December 12, 2012 @ 11:29 pm

  2. Interesting testable prediction, thanks…

    Comment by Green as Grass — December 13, 2012 @ 8:47 am

  3. This is getting to be like a broken record. Being a geezer of inordinate proportions, I can remember May Day – deregulation of commissions on stocks: the wailing could not be believed (and many had good reason). Then it was option exchanges – destroy the equity business – then off floor 2nd, 3rd 4th markets, etc. etc. etc., to quote Yul Brynner. Creative Destruction at work – the sound you hear are rents going poof.

    Comment by Sotos — December 13, 2012 @ 11:07 am

  4. @ SWP

    BTW – it’s not like Andy Hall to moan…

    Comment by Green as Grass — December 13, 2012 @ 11:22 am

  5. As an old veteran floor trader that supported electronic trading at a board level, I concur with some of your analysis, but would add some color to it as well. My beef with HFT isn’t speed. It’s co-location (so I suppose my beef is with the exchanges). They took the floor trader advantage away and handed it to a smaller, select group of electronic traders. You used to get proximity advantage through leasing or buying a membership. (and you had to fight a bit for a spot closer to order flow). Now it’s sold. To be an efficient HFT trader, it’s a 50M investment. Whether that’s “good” or “bad” is not material, but higher start up costs have effects on markets.

    I also dislike the quote stuffing and the bullcrap that goes on. In a human pit traded environment, those bad guys would have been fined, or ignored by the community effectively putting them out of business. Because of co-location and the millisecond advantage, HFT traders are allowed to implement strategies that are not unlike the strategies old order fillers employed-running stops and trading against the deck. I remain unconvinced the marketplace is better because of pure electronic trading.

    Markets are far different than they were prior to electronic trading. When I supported it back in the 1990’s, my thought was better access for everyone, faster reporting and a more level playing field. Instead, we have a tiered playing field and different people playing games-with exchanges taking some of the consumer surplus that used to reside with its members.

    Comment by Jeff — December 16, 2012 @ 8:58 am

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