Streetwise Professor

April 5, 2014

Pinging: Who is the Predator, and Who Is the Prey?

Filed under: Economics,Exchanges,HFT,Politics,Regulation — The Professor @ 11:59 am

The debate over Lewis’s Flash Boys is generating more informed commentary than the book itself. One thing that is emerging in the debate is the identity of the main contending parties: HFT vs. the Buy Side, mainly big institutional traders.

One of the criticisms of HFT is that it engages in various strategies to attempt to ferret out institutional order flows, which upsets the buy side. But the issue is not nearly so clearcut as the buy side would have you believe.

The main issue is that not all institutional orders are alike. In particular, there is considerable variation in the informativeness of institutional order flow. Some (e.g., index fund order flow) is unlikely to be informed. Other order flow is more informed: some may even be informed by inside information.

Informed order flow is toxic for market makers. They lose on average when trading against it. So they try to determine what order flow is informed, and what order flow isn’t.

Informed order flow must hide in order to profit on its information. Informed order flow uses various strategies based on order types, order submission strategies, choice of trading venues, etc., to attempt to become indistinguishable from uninformed order flow. Uninformed order flow tries to devise in strategies to signal that it is indeed uninformed, but that encourages the informed traders to alter their strategies to mimic the uninformed.

To the extent that market makers-be they humans or machines-can get signals about the informativeness of order flow, and  in particular about undisclosed flow that may be hitting the market soon, they can adjust their quotes accordingly and mitigate adverse selection problems. The ability to adjust quotes quickly in response to information about pending informed orders allows them to quote narrower markets. By pinging dark pools or engage in other strategies that allow them to make inferences about latent informed order flow, HFT can enhance liquidity.

Informed traders of course are furious at this. They hate being sniffed out and seeing prices change before their latent orders are executed. They excoriate “junk liquidity”-quotes that disappear before they can execute. Because the mitigation of adverse selection reduces the profits they generate from their information.

It can be frustrating for uninformed institutional investors too, because to the extent that HFT can’t distinguish perfectly between uninformed and informed order flow,  the uninformed will often see prices move against them before they trade too.  This creates a commercial opportunity for new trading venues, dark pools, mainly, to devise ways to do a better way of screening out informed order flow.

But even if uninformed order flow often finds quotes running away from them, their trading costs will be lower on average the better that market makers, including HFT, are able to detect more accurately impending informed orders. Pooling equilibria hurt the uninformed: separating equilibria help them. The opposite is true of informed traders. Market makers that can evaluate more accurately the informativeness of order flow induce more separation and less pooling.

Ultimately, then, the driver of this dynamic is the informed traders. They may well be the true predators, and the uninformed (or lesser informed) and the market makers are their prey. The prey attempt to take measures to protect themselves, and ironically are often condemned for it: informed traders’ anger at market makers that anticipate their orders is no different that the anger of a cat that sees the mouse flee before it can pounce. The criticisms of both dark pools and HFT (and particularly HFT strategies that attempt to uncover information about trading interest and impending order flow) are prominent examples.

The welfare impacts of all this are unknown, and likely unknowable. To the extent that HFT or dark pools reduce the returns to informed trading, there will be less investment in the collection of private information. Prices will be less informative, but trading will be less costly and risk allocation improved. The latter effects are beneficial, but hard to quantify. The benefits of more informative prices are impossible to quantify, and the social benefits of more informed prices may be larger, perhaps substantially so, than the private benefits, meaning that excessive resources are devoted to gathering private information.

More informative prices can improve the allocation of capital. But not all improvements in price efficiency improve the allocation of capital by anything near the cost of acquiring the information that results in these improvements, or the costs imposed on uninformed traders due to adverse selection. For instance, developing information that permits a better forecast of a company’s next earnings report may have very little effect on the investment decisions of that company, or any other company. The company has the information already, and other companies for which this information may be valuable (e.g., firms in the same industry, competitors) are going to get it well within their normal decision making cycle.  In this case, incurring costs to acquire the information is a pure waste. No decision is improved, risk allocation is impaired (because those trading for risk allocation reasons bear higher costs), and resources are consumed.

In other words, it is impossible to know how the social benefits of private information about securities values relate to the private benefits. It is quite possible (and in my view, likely) that the private benefits exceed the social benefits. If so, traders who are able to uncover and anticipate informed trading and take measures that reduce the private returns to informed trading are enhancing welfare, even if prices are less informative as a result.

I cannot see any way of evaluating the welfare effects of financial trading, and in particular informed trading. The social benefits (how do more informative prices improve the allocation of real resources) are impossible to quantify: they are often difficult even to identify, except in the most general way (“capital allocation is improved”). Unlike the trade for most goods and services, there is no reason to believe that social and private benefits align. My intuition-and it is no more than that-is that the bulk of informed trading is rent seeking, and a tax on the risk allocation functions of financial markets.

It is therefore at least strongly arguable that the development of trading technologies that reduce the returns to informed trading are a good thing. To the extent that one of the charges against HFT-that it is better able to detect and anticipate (I will not say front-run) informed order flow-is true, that is a feature, not a bug.

I don’t know and I am pretty sure nobody knows or even can know the answers to these questions. Which means that strongly moralistic treatments of HFT or any other financial market technology or structure that affects the returns to informed trading is theology, not economics/finance. Agnosticism is a defensible position. Certitude is not.

Print Friendly, PDF & Email


  1. If I understand your argument correctly, the HFT computers need to front-run every order to compensate for insider trading. If that’s true, how did markets work before HFT? Are you saying that the markets are now so corrupt that stealing from other participants becomes acceptable and maybe even beneficial?

    When I meditate on the term “market maker” and think about what it means, I can’t help thinking that you are right. The markets are hopelessly corrupt. The market makers set the price when they are selling, and they can (and do) set a different price when they are buying. This is a classic case of a false market.

    Comment by Albert Meyer — April 5, 2014 @ 12:31 pm

  2. Professor: I think you have nailed it. What is seen as “front running” by one set of traders is seen as prudent management of adverse selection risk by traders on the other side of the transaction. It is a basic feature of all markets and has existed long before computers or algos came upon the scene. Good analysis of this feature, such as what you provide, trumps the good vs. evil assertions have dominated the headlines this past week. Many thanks for this.

    Comment by JAO — April 5, 2014 @ 12:45 pm

  3. @Albert. It’s not to compensate: it’s to avoid.

    See my post from a couple of days ago for how this was done on the floor.

    And the whole point of this post is that it’s not quite so clear who is “stealing” from whom. One interpretation of HFT order anticipation strategies is that they are like locks on doors: they are ways of reducing losses to theft.

    Another point is that “now” is not that different than “before.” Market participants are dealing with the same issues. Only the technological responses to the problems have changed: the problems are as old as the markets.

    The ProfessorComment by The Professor — April 5, 2014 @ 1:49 pm

  4. I think part of the problem in the public discussion of HFT is that the term “front running” is being used rather loosely. Clearly it is being used entirely apart of how we understand the term in its legal sense. Some are using it to describe buying ahead or a buy order or selling ahead of a sell order. Others apply the term to quote revision. In my comment above, I put the term in quotes to reflect the term’s looseness, but just to be clear, I am assuming the term is being applied to quote revision in response to information (including trade and quote information). A market maker who does not efficiently revise their quotes to prudently manage their risk will soon be out of business. The ability to quickly revise quotes is what enables a market maker to offer narrower spreads and quote for larger size. Without this ability, the risk would still exist, but would be likely be managed by wider spreads, which raises the cost of using the market.

    Comment by JAO — April 5, 2014 @ 1:54 pm

  5. Interesting piece in the weekend Australian Financial Review which does attempt to quantify the “Welfare Affect (sic)” and offers a few practical examples and some “certitude” that retail buyers, (“Dumbflow”) do interact with HFT, with the obvious result.

    Sry no link,

    Comment by S Roche — April 5, 2014 @ 3:36 pm

  6. Interesting piece in the weekend Australian Financial Review which does attempt to quantify the “Welfare Affect (sic)” and offers a few practical examples and some “certitude” that retail buyers, (“Dumbflow”) do interact with HFT, with the obvious result.

    Sry no link,

    Comment by S Roche — April 5, 2014 @ 3:36 pm

  7. There is a good article in the weekend edition of the Australian Financial Review which attempts to quantify the “Welfare Affect (sic)” and provides practical examples from which one can derive “certitude” that HFT does seek out and interact with retail, aka “Dumbflow”.

    I venture to suggest a little less of a theoretical approach and more focus on the practical reality, ie is Reg NMS being violated by the practices you are defending, would assist the debate.

    Here is a good starting point:

    Comment by S Roche — April 5, 2014 @ 4:42 pm

  8. Sry for the multiple comments, I am sailing off the coast from Sydney with a lousy connection, maybe you could tidy up? Thx.

    Comment by S Roche — April 5, 2014 @ 4:45 pm

  9. Professor,

    You appear to be claiming that every HFT operator is a market maker. Can you back up that claim? What do you mean when you say “market maker?” If you are talking about official “Designated Market Makers” then you must agree that not every HFT operator is a market maker. If you are saying that a market maker is anyone who provides liquidity by trading in the market, then you are turning “market maker” into a meaningless term, and anyone who wants to steal from other market participants can justify it by saying “But I’m a market maker!”

    As you say in your previous article, “all markets have always been rigged.” If you said “stock markets” then I would agree. The stock market (and our financial system in general) is a complex mechanism for transferring wealth from human beings to corporations (and to the people who control the corporations). This article accuses the “institutional investor” pot of calling the “HFT” kettle black, and you want to say that the HFT kettle is not really all that black. The truth is that the entire “stock market” kitchen is black (corrupt). The fact that the HFT operators are stealing from thieves does not make it any better for the human beings who are now being stolen from by multiple layers of thieves. If you look at what a “market maker” is, and what it does, it becomes obvious that there is no market; there is only a complex system for separating suckers from their money. The suckers are human beings who earn money by working and then invest it into the stock market, either explicitly, or by putting it in a “fund.”

    It may be tempting to argue that the market isn’t corrupt because some individual investors make a profit, but that is a feature of corrupt markets. If there was no chance of winning, nobody would go to the casino. You have to make it look good to get the suckers in the door.

    Comment by Albert Meyer — April 5, 2014 @ 6:33 pm

  10. @Albert. It’s late, and I’m tired. More tomorrow. I will just say, no, I do not claim all HFT is market making. If you look back at some of my older posts on the subject you’ll see that’s the case. I have long said that HFT is not a single thing.

    The ProfessorComment by The Professor — April 5, 2014 @ 7:39 pm

  11. I don’t understand the problem here. This happened on trading floors long before HFT was even possible. I guess the public wasn’t up in arms because nobody was writing scary books about it? And who cares if not all HFTs are market makers? They usually aren’t broker dealers with DMM designations and have no quoting obligations. Even if they were bona fide MMs, no regulator would force them to provide liquidity at their own expense – no matter how much large institutions who don’t want to face the realities and hardships of executing large orders want them too. Self-preservation is not “corruption”.

    Comment by Methinks — April 5, 2014 @ 9:14 pm

  12. Albert,

    Before computers, Market Makers who stood on the floors of exchanges had it a lot easier (and, depending on how liquid the stock was, did a lot of colluding). The orders came to them and a variety of practices were employed to suss out information about orders. That’s not front running. When you submit an order it is public information available to all and Market Makers simply try to read that public information. Front running is when the broker steps in front of a client’s order and it’s highly unethical as well as illegal. Of course, it’s well known on the Street that Goldman regularly steals trades from its informed institutional clients, yet nobody writes books about that actual front running.

    I think the panic over this reading of order flow using computers results from people not knowing that all market makers read order flow and we were trained to do so on when we traded in crowds on the floor. In fact, in a lot of ways, it was easier to do in the era before algorithmic trading. As the professor says: this is nothing new and it’s certainly not nefarious.

    Comment by Methinks — April 5, 2014 @ 9:35 pm

  13. No sweat @S. I will read your links/comments and respond tomorrow.

    The ProfessorComment by The Professor — April 5, 2014 @ 9:47 pm

  14. HFT is not front-running in the same way that breaking into a computer and and stealing private information isn’t technically theft. Before laws were passed to prohibit hacking, it was not illegal. Although it was extremely similar to theft of property, it was not similar enough to be illegal under existing laws. HFT would have been banned long ago were it not for the system of legalized bribery that we call “campaign finance.” If your best argument for the benign goodness of HFT is the fact that it doesn’t exactly match the technical definition of “front-running,” you may as well admit that you are defending theft.

    If you use the issues facing market makers as an excuse to justify HFT, and then agree that not all HFT traders are market makers (and I think you would also have to agree that not all market makers are HFT traders), then haven’t you agreed that the “market maker” argument is bullshit?

    Comment by Albert Meyer — April 5, 2014 @ 10:57 pm

  15. What we are dealing with is criminal insider trading. If the law doesn’t cover this case, it should. Hopefully, the money managers and pension funds will form a strong enough lobby to defeat the predator lobby.

    Comment by vlad — April 6, 2014 @ 12:21 am

  16. Lewis’ “Liars’ Poker” played a strong role in making me go to Wall Street’s fixed income derivative trading. I like him a lot. He is very funny and insightful. A real delight to read.

    Comment by vlad — April 6, 2014 @ 12:24 am

  17. The paper below explains how transient information asymmetries in financial trading can cause wasteful expenditures of real resources (aka welfare losses), and also explains why this effect has been dramatically amplified by the digitization of markets. It also proposes a remedy — the use of randomizing temporal buffers in the order flow.

    I believe this is the only academic paper mentioned in “Flash Boys.” And, while the book explains that IEX opted to use fixed temporal buffers instead, one year ago ParFX in London began trading currencies through randomizing buffers. The technology seems to work as intended. Australian banks, in particular, are very happy with it, because otherwise they are always on the wrong end of a latency race.

    Comment by Brian Mannix — April 6, 2014 @ 2:23 am

  18. Reading public information in the form of orders is not “front running” any more than you making a decision based on what you read on the internet or in a newspaper. Market makers didn’t hack into anything or steal anything, they simply guess based on what is publicly available.. If any market maker sees a huge order coming at him, he’ll move his bid down and always has. Calling that “theft” is, frankly, idiotic because that means that if you place on order based on something you read in an annual report, you’re also stealing. Before you go tossing around accusations, you first have to learn the meaning of words.

    Moreover, it doesn’t matter at all whether all HFTs make markets as a trading strategy or not. Nobody wants to be adversely selected and institutional orders will also move out of the way if they think it’s prudent. That’s why large funds try to work orders slowly, in batches and through dark pools to hide from the market their true order size. I suppose you’ll call working in their own interest in that way “criminal deceit”. And I suppose when you buy a house you always tell the seller the true amount you’re willing to pay from the start because you wouldn’t want him selling to you for less.

    Comment by Methinks — April 6, 2014 @ 4:37 am

  19. “not all HFT traders are market makers (and I think you would also have to agree that not all market makers are HFT traders)”

    oh yes they are. The SEC requires it of any DMM on any exchange. After the flash crash the SEC issued a new regulation that required DMMs to continuously quote in a band around a trading range of the stock (there’s a formula, but the exact formula is not important for this discussion). There’s no way to comply with that regulation without algos and the algos do the same things a HFT shop providing liquidity as a customer firm does. So, the irony here is that after blaming HFT for the flash crash and the hue and cry that followed, the SEC required all of us to become HFT (although, since algorithmic trading is so much more efficient, most DMMs employed algos already). So yeah, to bastardize Milton Friedman’s quote, “we’re all HFT traders now”,

    Comment by Methinks — April 6, 2014 @ 4:59 am

  20. Vlad,

    That book was published just before I came to Wall Street myself. I agree that it was hilarious and parts of it can still inspire uncontrollable laughter. However, it was a not terribly accurate and rather unflattering account of fixed income trading desks. So, I’m curious, what in this book inspired you to seek a career on a Wall Street FI trading desk? Was it the potential to rip customers’ faces off or the promise of being lower than whale sh*t on the bottom of the ocean?

    Comment by Methinks — April 6, 2014 @ 5:11 am

  21. The HFT discussion, at least for equities, seems to always circle back to Reg. NMS. For a reasoned discussion of Flash Boys and how Reg. NMS can be reformed, I recommend viewing this joint interview, conducted by Reuters, with Manoj Narang of Tradeworx and HFT critic Haim Bodek:

    Spoiler alert: they actually agree on a lot with respect to Reg. NMS.

    Comment by Scooter — April 6, 2014 @ 8:05 am

  22. I know it is conspiratorial, but it looks to me like HFT is being set up to be the next scapegoat should anything go wrong in the markets. Everything appears too orchestrated from the book , 60 Minutes to the USAG. We have known about HFT for over five years brought to us courtesy of Congress and now they are worried about it?

    Comment by TomHend — April 6, 2014 @ 1:41 pm

  23. and one other thing, Michael Lewis in Moneyball left out three important parts of the success of the Oakland A’s, Barry Zito, Mark Mulder and Tim Hudson, they were lights out.

    See The Beauty of Short Hops. And forget that Oakland was headquarters for steroids.

    Comment by TomHend — April 6, 2014 @ 1:46 pm

  24. @Brian Mannix: I believe that Lewis also refers to this academic paper, although it is described only as the product of “Berkeley researchers”: Shengwei Ding, John Hanna, and Terrence Hendershott, “How Slow is the NBBO? A Comparison with Direct Exchange Feeds.” The date I see cited is January, 2014.

    Comment by Scooter — April 6, 2014 @ 2:21 pm

  25. Watched the HFT discussion between Manoj and Haim. They did a nice job of bashing Lewis in his absence, but when Manoj and Lewis debated, Lewis wiped the floor with him:

    Comment by Albert Meyer — April 6, 2014 @ 2:29 pm

  26. @Albert Meyer: I thought one of the Bloomberg TV anchors asked a very reasonable question of Brad and Manoj about how they saw the same issue but devised different solutions to changes they were observing in markets. These different methods are well described in The SWP’s post above. It would have led to a great discussion. However, the anchors kept jumping in and interrupting and we never got the question answered by the guests. I disagree with your characterization and think the anchors were the ones who fell short.

    Comment by Scooter — April 6, 2014 @ 2:50 pm

  27. Are bank runs happening in China ?

    Comment by Surya — April 6, 2014 @ 3:33 pm

  28. Something I wonder about:

    Seems to me when you say “informed” order, you mean an order that has information about the movement of the price in the next short amount of time. This would seem to usually be because of some type of inside-type information, whether obtained legally or illegally, for example about an upcoming press release. The value of this type of information decays very quickly, which is why the informed trader can’t just be patient.

    A long term investor who has a correct belief that a firm is undervalued is not “informed” in this sense, because they have no particular idea what the stock will do tomorrow, and they can just patiently accumulate over days or weeks or months. So if Warren Buffet decides in 1988 to start buy shares of Coca Cola, his orders would be labeled “uninformed” buy the definition used here.

    (Perhaps an exception would be a very large or activist investor who intends to buy a significant chunk of the firm, and cannot do so without moving the price, even if they buy fairly gradually. Maybe this would apply to Warren Buffet buying Coca Cola. But the exact same issue would arise even with low speed trading.)

    This seems important, because the kind of long-term “information” that Warren Buffet generates seems much, much more socially useful than someone just correctly “guessing” about an earnings release or a possible merger. I mean, the earnings were going to get released tomorrow anyway, and then everybody would know.

    Am I missing something here?

    Comment by ed — April 6, 2014 @ 11:14 pm

  29. Methinks, this book encouraged me to work for Solomon Brothers’ competitors and as far away from sales as possible.

    Comment by vladislav — April 7, 2014 @ 2:41 am

  30. Vladislav,

    I worked at Solly and it was actually a great firm to work for. However, if you are, as you claim, working in interest rate derivative then you’re on the desk right beside your sales guys. See, if you really worked on such a desk you’d know that sales guys don’t work independently. They need to constantly get prices from traders and they need the traders’ approval to do a deal. So, if you’re working far away from them in interest rate derivatives then your job has nothing at all to do with any trading and you’re either in the tech department or perhaps even in reception.

    Comment by Methinks — April 7, 2014 @ 12:35 pm

  31. “This would seem to usually be because of some type of inside-type information,”

    I don’t know what the professor meant, but that is not necessarily what is generally meant. The money manager’s job is to figure out that which nobody else has – without material non-public information. Some of these buy-side guys are much better at it than others (they often but not always have more resources) and the probability that an order placed by these guys is placed on stronger analysis is much higher. The market basically wants to coattail their genius (just watch what happens when Warren Buffett trades). Since being a better analyst of information theoretically increases the probability that you’ve figured out the direction of the price move, the market generally considers you “informed”. Of course, it could mean a trader trading on material non-public information, but not necessarily.

    Comment by Methinks — April 7, 2014 @ 12:44 pm

  32. Thanks for the reply, but I don’t think you addressed my points (which may be wrong, that’s why I’m asking).

    1. Fast-decaying information is what matters when talking about HFT market makers trying to detect “informed” traders. (If the value of your info doesn’t decay fast, you can be patient. And if this still moves markets because you are Warren Buffet, this would be just the same with low-speed trading as well.)

    2. Fast-decaying information is almost certainly of little social value, relative to slow decaying information.

    Maybe I shouldn’t have used the term “inside-type” information. Insiders can and do have both fast and slow decaying types of information.

    Comment by ed — April 7, 2014 @ 1:21 pm

  33. The video referenced above in which Manoj Narang and “HFT critic” Haim Bodek take turns promoting HFT and bashing Michael Lewis is pretty amazing. Haim Bodek is an “HFT critic” in the same way that Jimmy Savile is a “pedophile critic.” With Haim singing backup “The entire US stock market is not rigged;” “All of this is old news,” Manoj repeatedly shits out steaming turds which lay stinking on the studio floor. Everyone admires these turds and wonders at his amazing ability to produce gold bars out of his ass. For example, blaming Reg NMS for the tricks that HFT operators use to steal from suckers,

    “There’s a very very simple fix to reg NMS that would cure virtually all the ills of the market that people complain about. Things like quote stuffing would disappear. Things like exotic order types like Hide not Slide orders,
    they would have no purpose anymore… Endless fragmentation of the market would go away…”

    …More bullshit…Order Protection Rule…regulators created a loophole… bullshit…

    “That (Reg NMS) created an unlevel playing field (tilted AGAINST the HFT operators). All of these exotic order types that have come up since then are an attempt to ameliorate that and to limit that activity.”

    Both Haim and host Rhonda Schaffler smile and nod as they admire this turd. No criticism is uttered. None. Nobody says a word as he weaves a golden curtain out of pure shit.

    “They (HFT Operators) have had … a very positive effect on the market in the sense that things like quote stuffing have largely gone away.”

    Where is the pushback to this amazing claim? Isn’t anyone going to say anything like “But… HFT operators invented quote stuffing!” Crickets chirp as Manoj continues to sell turds for $1297 per ounce. He goes on to claim that quote stuffing (which has largely gone away now) was never done on purpose; it was just a mistake!

    (Quote stuffing) “was an INADVERTENT ERRONEOUS activity that arose naturally from the behavior of how algorithms work.”

    Wha…? I’m starting to wonder whether I know what an algorithm is. Are algorithms plucked from mysterious trees in the Amazon jungle, and they just work the way they work, and nobody knows why? Are they grown in caves in a special region of France, and they just have these natural behaviors that nobody can control? Stupid me, I thought that algorithms were invented by humans to perform specific operations in response to specific inputs. Amazingly, Haim and Rhonda sit there smiling and nodding as these massive stinking turds pile up on the studio floor.

    Eventually Haim jumps in with some criticism, “I’m very happy with a lot of things Manoj says!” “Lewis was irresponsible.” “Manoj’s firm Tradeworx has commercial solutions.”

    What a great debate! I look forward to the next “Wealth Strategies” debate on Reuters TV, regarding pedophilia, starring pedophile critics Jimmy Savile and Robert H. Richards IV, and David Thorstad.

    Comment by Albert Meyer — April 7, 2014 @ 1:30 pm

  34. I’m deeply agnostic on HFT and positively atheist on algorithmic trading. But I have very strong convictions about fraud: Please tell me how placing an order knowing you will cancel it within 15 milliseconds (before most participants can see or act upon it) is other than fraudulent “ghost bidding”?

    The essence of a market is offer and acceptance. Making an offer that you know cannot be accepted is fraud. Even a fast algo would have trouble getting the bid and returning acceptance before the 15ms cancellation due to network propagation alone. The probe&cancels are just to explore acceptances. Fine, but pay for it with executed trades.

    Any cancel inside a certain window should attract penalties (10bp-1% of trade). That window should be at least 100ms to allow algo exec, or perhaps 2-3 seconds if you believe humans should have a chance..

    Comment by Robert in Houston — April 7, 2014 @ 10:27 pm

  35. Robert, I’m not an expert either, but if you are making a market with tight bid-ask spreads, you really need to have the option to adjust prices continually based on new information. I don’t know about putting an order out “intending” to cancel it, but I don’t see any problem with cancelling it if you get new information. And any time you submit a bid, there is a risk that someone else submitting about the same time will hit it.

    Comment by ed — April 7, 2014 @ 11:39 pm

  36. @Robert: A minimum quote life, while technically possible, will likely have knock-on consequences since a market maker will still need to manage adverse selection risk as the SWP describes in the main body of this post above. This risk does not go away and will be harder to manage if market makers are constrained in their ability to adjust their quotes (cancel and replace) in response to new public information about order flow and market conditions generally. I expect that the result will be wider spreads and this cost will be borne by the users of the secondary market, i.e., individual investors, holders of mutual funds, and holders of pension funds. The question becomes: is the benefit worth the cost? We know the likely cost but the benefit is not clear. That said, on the futures side, venues like the InterContinental Exchange (ICE) have devised ways to reward quoting behavior they see as beneficial to the quality of the markets they host. And they penalize quoting behavior they see as potentially harmful to market quality. SWP has covered this topic some time ago in a series of excellent posts. Here is the link to one:

    Another issue is about who is in the best position to make these decisions about market quality. Is it regulators or the trading venues?

    Intentional disruption of the market through the use of quote stuffing or some other manipulative scheme is illegal and should be detected and deterred aggressively by exchange authorities and regulators. This type of abuse is harmful to all market participants including HFT participants. One of the advantages of electronic trading is that regulators have the ability to replay the entire life cycle of every quote and transaction to help police against abuse. As you might expect, market participants are not shy about flagging suspicious behavior and referring it to the authorities for a deeper dive.

    Comment by Scooter — April 8, 2014 @ 3:46 am

  37. Felix Salmon over at Slate has an interesting review of Flash Boys, although I think he may have benefitted from considering the SWP’s arguments from above:

    Salmon describes the owners of IEX as “very rich investors.” But what is relevant for this thread is not that they are “very rich” but they are informed, alpha-generating, buy-side firms. It makes sense that these firms would try to preserve their informational advantage by trading on ATS platforms (I wont say dark pools) like IEX as a way to prevent information leakage. Alternatively, they could have used efficient executions algorithms or some of the other trading tools that the SWP describes above. In using these execution algorithms and other tools, these firms seek to avoid tipping off the market maker that he is about to have his stale quotes be “adversely selected”(the cat pouncing on the mouse, to use SWP’s analogy). This is what you would expect informed, alpha-generating, buy-side firms to do. In contrast, uninformed (non-alpha) buy-side firms, such as those offering passive index funds, do not have an informational advantage to protect. They may have their own issues, as SWP points out above, but their order flow will not be regarded as toxic by the market maker. This difference may help explain why mutual funds that predominantly offer index products do not seem to be too worked up about HFT and in fact, see advantages for their investors in terms of cost savings. They may be “the dog that didn’t bark” in this debate. Certainly The Vanguard Group, judging from these two recent links below, do not seem too upset with HFT, although they do see ways to improve upon current market structure and want to see trading abuses aggressively policed:

    Comment by Scooter — April 8, 2014 @ 9:15 am

  38. Hat tip to Matt Levine at Bloomberg View for linking to this article which does a good job of describing the loosely-used terms tossed around in the public discussion of HFT. Very helpful:

    Comment by Scooter — April 8, 2014 @ 10:25 am

  39. It seems to me that this book is based on a belief that there was some point in the market where “all traders were created equal,” and that simply isn’t founded in reality.

    Also, I haven’t read the book but I was surprised that 60 min didnt bother addressing Reg NMS issues once.

    I may be wrong, but an issue I would be more concerned about are institutions like Fidelity that start offering (for a ton of $$) some customers “premium” accounts to get a faster connection. Perhaps this practice already goes on.

    Moral of the story, the controversy of HFT seems to be only viewed as such to industry outsiders.

    Comment by Tony — April 8, 2014 @ 10:53 am

  40. @Tony-The criticisms of current market structure generally (not just by Lewis) always suggest that there was some golden age in which individual investors were treated gently, and all playing fields were level. Which is true, nowhere and never.

    The ProfessorComment by The Professor — April 8, 2014 @ 2:28 pm

  41. @Scooter. Absolutely correct. Minimum quote life extends the value of the option that liquidity suppliers provide. This increases the cost of that option. Liquidity suppliers charge for the option premium through the spread. Higher option value=higher spread.

    On the floor, quotes good only as long as “the breath is warm.”

    There are no free lunches. None.

    Exchanges have better incentives to choose the menu and the pricing than do regulators who are subject to public choice pressures.

    The ProfessorComment by The Professor — April 8, 2014 @ 2:37 pm

  42. Methinks,

    You got it right: I worked as a VP in research, developing interest rate derivatives and MBS algorithms. I didn’t deal with the sales too often. Mostly with traders and with analysts on the trading desk. We didn’t sit on the trading floor, but in our separate section. It was indeed much more relaxed. I had a huge office with a nice view. But I also worked in Russia as the head of research and analytics, and I sat with the head of fixed income, next to the traders and salespeople.

    Comment by vladislav — April 8, 2014 @ 3:09 pm

  43. That should read: “interest rate derivatives and MBS pricing and hedging algorithms”.

    Comment by vladislav — April 8, 2014 @ 3:11 pm

  44. Scooter & SWP: The minimum quote life I suggest is very short, certainly not longer “than the breath is warm”. Furthermore, there is a reasonable penalty for early cancellation in case of a true “fat finger”.

    Of course a quote is an option. It is made because someone really wants to trade rather than wait and “hit the bid”. But too short a life and it just suckers the waiters into bidding on cancels. The waiters will leave the market. A market needs a balance of bidders and waiters. HFT favors the bidders, and maddens the waiters since they don’t know if they can actually get anything.

    Comment by Robert in Houston — April 8, 2014 @ 6:24 pm

  45. Robert, Thanks for this. I will give you my view and I hope that The SWP will chime in as well. I think that no matter what the time increment, the same analysis applies. SWP and you have recognized the option value extended to the market from limit orders. The value of this option is directly related to time and can be evaluated over any time interval. The same cost-benefit considerations would apply.

    You also raise the possibility that “waiters will leave the market” if they are “continually bidding on cancels.” First of all, I hope that everybody understands that HFTs make money the same way every other trader does: by buying low and selling high. To do this requires a transaction. HFTs enjoy no benefit from continually revising quotes without a trade. I hope this is obvious, but given this long chain focusing on adverse selection and quote revision, we may lose sight of this. A minimum quote life, such as what you suggest, may create the opposite incentive: liquidity taking will be incentivized at the expense of liquidity providers, which will lead to wider spreads, reduced sizes quoted, and increased execution costs for market end users.

    This begs the next question of who is in the better position to make these cost-benefit determinations (with an objective of improving market quality)–regulators or exchanges? It appears that we have come full circle back to where were. I welcome your thoughts and those of The SWP.

    Comment by Scooter — April 8, 2014 @ 8:26 pm

  46. @ Robert: In your comments on minimum quote life you also discuss cancellations due to “fat finger” errors. I detect some confusion between the cancellation of trades made in error (“fat finger”) versus the cancellation of quotes (cancel and replace quote revision). The risk posed by fat finger errors is best handled by size and price throttles and other pre-trade risk controls both at the firm level and at the exchange level. For trades that are made in clear error, exchanges have policies in place as to when these trades may be cancelled. It is important for market stability how these error policies are constructed. The SEC-CFTC staff report on the Flash Crash of May 6, 2010 notes that several market participants curtailed their trading activity due to uncertainty about the trade cancellation policies across various trading venues. For electronic market makers, confusion about which trades would stand (and which would not) created unacceptable risk, leaving firms exposed to the possibility that carefully constructed risk-neutral positions would suddenly be transformed into risky positions. The SEC has recognized this problem and has acted to address this uncertainty by better coordinating policies across trading venues for cancelling clearly erroneous trades.

    Comment by Scooter — April 9, 2014 @ 4:18 am

  47. @scooter: If the exchanges already have clear “fat finger” error correction policies, then no separate on is required for quote lifetime. As for your other question, who is in a better position to regulate markets, why of course the always-popular and never-captured regulators!
    Every market is regulated by commercial law in addition to institutional rules. Not much recourse to commercial law is necessary when the rules are good. At one time, seatholders were required to push all thrades through the exchange. The existance of dark markets belies the rule.

    Comment by Robert in Houston — April 10, 2014 @ 3:35 am

  48. […] Professor: Who is the Predator, and Who Is the Prey?: “The debate over Lewis’s Flash […]

    Pingback by Washington Equitable Center for GrowthWashington Equitable Center for Growth | Something I Do Not Understand About the Defenders of High-Frequency Trading in the Debate Over HFT: Friday Focus: April 11, 2014 — April 10, 2014 @ 9:46 pm

  49. […] professor Craig Pirrong wrote (what I think is) a very compelling blog posting to the effect that high frequency trading (HFT) actually makes markets more informationally efficient. Professor Pirrong noted, among other things, that the “… bulk of informed trading is rent […]

    Pingback by High Frequency Trading (HFT) | Options, Futures, & Other Derivatives Course Blog — January 29, 2015 @ 6:43 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress