Streetwise Professor

May 1, 2013

Time and Space Advantages in Trading: Meat vs. Machines

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 10:00 pm

The most recent controversy over HFT stems from this WSJ story about the CME.  In a nutshell, computerized traders receive confirmations of their trades before information about those trades is disseminated to the market at large.  As in a few milliseconds before.  But in an electronic world, a few milliseconds can be decisive.

One example of a particularly informative trade is when an away-from-the-market limit order is executed.  This means that a market order of sufficient size to blow through the quote size at the inside market was submitted.  Given that orders and communicate information, and that the bigger the order, the more informative it is, knowing before anybody else that such an order has been executed can provide valuable information.

The implications of this depend on how the information is used.  A trader (or, more accurately, a bot) that gets this information can use it to take liquidity aggressively.  For instance, it can use information gleaned from a big, price-moving crude oil buy to submit an aggressive order in heating oil or RBOB, thereby picking off resting limit orders that cannot adjust to the new information.  Or, as the WSJ article suggests, the bot can use the information derived from the NYMEX CL trade to take liquidity from ICE Brent or NYMEX lookalike futures.

This kind of trading exacerbates information asymmetries, and all else equal, increases spreads, reduces depth, and increases trading costs for the uninformed.

But the “all else equal” part of the statement doesn’t necessarily hold.  This presumes that the amount of capital devoted to HFT is constant.  But that’s not true in the long run.  If these sorts of advantages generate profits, that will attract more capital into HFT.  Moreover, note that the strategy just outlined involves placing limit orders, and then reacting when those limit orders are executed.  Competition to get the information advantage will lead to more aggressive quotes, and quotes in bigger size.  In the long run equilibrium, this competition will dissipate the rents from the information advantage.

Therefore, if there is any reason to reduce this speed advantage (either by slowing down some traders or speeding up the dissemination of trade execution information to the market at large), it is to prevent the investment of excessive capital into HFT.  The effect on spreads and depth in equilibrium is ambiguous.

Moreover, there are other possible uses of the information advantage that are clearly socially beneficial.  An HFT market maker-who is likely making markets in a variety of contracts-can utilize the information to revise limit orders either in the market in which the execution occurred, or in other markets, especially those that are closely related (again, consider the CL/HO or CL/RB example).  Using the speed/information advantage in this way reduces the HFT market maker’s vulnerability to getting picked off, and makes it willing to supply liquidity more aggressively.  This tends to reduce trading costs, and does not lead to the rent seeking that in the long run equilibrium tends to result in an inefficiently large HFT presence.

We also need some perspective here.  I consider it beyond hilarious that the WSJ has a video embedded in the online version of the story that has many images from the floor.  (And these days, one of the floor’s main functions is to provide visuals for stories on trading-especially the trader’s-head-in-his-hands shot on days when the market falls a lot.  Pictures of servers aren’t nearly so dramatic.)

Why hilarious?  Well, the floor was the epitome of time and space advantages to a select few.  A select few who paid for the privilege.  I remember distinctly a trader telling me: “Why do I spend $500,000 on a seat? Because I get to see the price before anybody else.”

Exactly.  The floor was the meat version of colocation.  Or the carbon based life form version, if you like.  Those on the floor could see the execution prices, and bids and offers, and order flows, that those off the floor could not.  They profited accordingly.  Which is why the marginal guy on the floor-the least efficient trader-was willing to pay hundreds of thousands of dollars in some cases to get on the floor.

In 2002 or so I wrote a paper titled “Upstairs, Downstairs” (still a working paper) which showed that floor traders earned a rent as a result of their time and space advantage: upstairs traders could not supply liquidity as effectively as floor traders due to their information disadvantage, and this meant that floor traders faced limited competition in supplying liquidity.  Moreover, exchange limits on membership meant that entry could not dissipate these rents.  But by reducing the time disparities between liquidity suppliers advantage, electronic trading increased liquidity supply: upstairs traders were no longer operating under a time and space handicap.  Trading costs and rents decline. And that decline in rents is precisely why floor traders fought electronic trading so fiercely for years.

So yes, in today’s electronic markets some traders have a speed advantage.  But this disparity is nothing when compared to that which existed in the floor days.

Which is why I can’t really get all that spun up over the WSJ story, or most of the other stories about how unfair markets are.  Everything is relative.  No, the playing field isn’t perfectly level today, and along the lines of yesterday’s post, it may be in the interest of the CME to take measures to make it more level.  They say that they are.  But arguably the field is more  level than it has ever been.  It’s certainly far more level than in the heyday of the trading floors.  Don’t get nostalgic for the days when market makers were meat, not machines.  The table was tilted in their favor, bigtime.  Much more than today.

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  1. Craig, we agree on most of the major points, but I don’t think this is a non issue for a few reasons. I blogged about it yesterday at, so I am not hiding anything.

    First, it’s important for people to realize that there are distinct differences between the CFTC regulated marketplace and SEC, especially as it pertains to high speed trading and market structure. Since we are talking CME, it’s important to confine discussions to the CFTC side.

    Second, I agree, floor traders had an advantage. It’s why I paid $530,000 for a seat. It’s why seats were almost 1M in value in 1994. However, floor traders were also a self policing community which the electronic world is not. Even with all the shenanigans on the floor, it was mostly a decent honest place to work. And if it was out of line, the community got rid of it.

    Third, CME has consistently denied there was a discrepancy. Every time floor traders confronted them, they denied it. When you bought a membership, or leased one, you were first. CME took that core right-and resold it in terms of co-location–>disenfranchising and deliberately harming members. No big deal some might say-demutualization took that away. Members were paid in other ways.

    Members were also at a macro information and capital disadvantage to the big banks and funds. But, because of speed, the floor trader could cope. Today, there is no out when you have a bad trade on. In the old days, books were thicker and markets moved in a way that you could limit your loss. That’s the key to survival believe it or not-limiting losses-not making easy money.

    Except, CME has set up a tiered marketplace with a minmum of two tiers of price discrimination. One for those that pay to co-locate and everyone else. The co-locaters see data before anyone else-proving the efficient market hypothesis. Since it’s hyper expensive to co-locate and setup powerful computers to take advantage-distribution is limited.

    The effect is that last year CME volume is down 11%. The pool of traders is smaller. The volume has consistently dropped since 2008. That could be a function of the financial crisis, but it might be knowledgable customers leaving or altering the way they manage risk.

    There are big problems in both sets of marketplaces. Electronic trading was supposed to level the playing field. Instead it just shifted who had the advantage. I don’t think the market is anymore efficient than it was before-it might be less efficient in many contracts. (Hogs for example)

    My solution would be to have a barrier so everyone can get the same information at the same time. Let’s compete on the same playing field. Until then most of the trading population is shooting spitballs at battleships.

    Comment by Jeff — May 2, 2013 @ 9:37 am

  2. @Jeff-A lot to chew on. A couple of quick comments. 1. I didn’t say that floor traders were doing anything dishonest. They just made money off their time-space advantage. They paid for the privilege. I imagine colo HFT firms say the same. The main difference is the source of that time and space advantage. 2. With demutualization, the member/owner distinction has been blurred. Or put differently, whereas back in the day, members were the owners, and CME management deferred to them, now it defers to the shareholders. Before, CME was dedicated to maximizing the income of the members. Now it’s maximizing shareholder income. Revenues from sale of colocation are driving the CME. In some sense, the concept of “membership” is an anachronism. That’s a feature of a mutual exchange. For-profit, demutualized exchanges are a totally different animal.

    IMO, the playing field has never been totally level, and never will be.

    Re the loss of volume. Yes, the financial crisis has a lot to do with it. Volumes are down in everything. With the CME in particular, MF Global and Peregrine have taken their toll. And if you are right, and the decline in volume is due to the departure of knowledgeable customers fleeting an unfair market, CME would have the incentive to level the playing field Yes, that would cost some colo revenues, but if you are right, that would be more than offset by the increase in volume from those knowledgeable customers.

    The ProfessorComment by The Professor — May 2, 2013 @ 4:16 pm

  3. I didn’t mean to say you were saying floor traders are dishonest-but as a former floor trader I am hyper sensitive to the folks that just think we ran roughshod over customers and were lucky.

    I was an early advocate of demutualization because of the archaic committee system we had. Plus, we could unlock value. My opinion is that the exchange has focused too much on providing shareholder value and corrupted its marketplace. It has zero concern for traditional market participants-including retail.

    If you check the volume/stock price they have done a really bad job of returning value to shareholders as well. CME has become the most stuck in the mud flat footed company I can think of. Fortunately for them, there is a massive regulatory hurdle, combined with high startup costs that curb competition. They are ripe.

    Comment by Jeff — May 2, 2013 @ 4:38 pm

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