It was the summer of 2008. I was 22 years old, and it was my second week working in the crude oil and natural gas options pit at the New York Mercantile Exchange (NYMEX.) My head was throbbing after two consecutive weeks of disorientation. It was like being born into a new world, but without the neuroplasticity of a young human. And then the crowd erupted. “Yeeeehawwww. YeEEEeeHaaaWWWWW. Go get ’em cowboy.”
It seemed that everyone on the sprawling trading floor had started playing Wild Wild West and I had no idea why. After at least thirty seconds, the hollers started to move across the trading floor. They moved away 100 meters or so and then doubled back towards me. After a few meters, he finally got it, and I’m sure he learned a life lesson. Don’t be the biggest jerk in a room filled with traders, and especially, never wear triple-popped pastel-colored Lacoste shirts. This young aspiring trader had been “spurred.”
In other words, someone had made paper spurs out of trading receipts and taped them to his shoes. Go get ’em cowboy.
I was one academic quarter away from finishing a master’s degree in statistics at Stanford University and I had accepted a full time job working in the algorithmic trading group at DRW Trading. I was doing a summer internship before finishing my degree, and after three months of working in the algorithmic trading group in Chicago, I had volunteered to work at the NYMEX. Most ‘algo’ traders didn’t want this job, because it was far-removed from our mental mathematical monasteries, but I knew I would learn a tremendous amount, so I jumped at the opportunity. And by learn, I mean, get ripped calves and triceps, because my job was to stand in place for seven straight hours updating our mathematical models on a bulky tablet PC as trades occurred.
I have no vested interests in the world of high-frequency trading (HFT). I’m currently a PhD student in the quantum information group at Caltech and I have no intentions of returning to finance. I found the work enjoyable, but not as thrilling as thinking about the beginning of the universe (what else is?) However, I do feel like the current discussion about HFT is lop-sided and I’m hoping that I can broaden the perspective by telling a few short stories.
What are the main attacks against HFT? Three of them include the evilness of: front-running markets, making money out of nothing, and instability. It’s easy to point to extreme examples of algorithmic traders abusing markets, and they regularly do, but my argument is that HFT has simply computerized age-old tactics. In this process, these tactics have become more benign and markets more stable.
Front-running markets: large oil producing nations, such as Mexico, often want to hedge their exposure to changing market prices. They do this by purchasing options. This allows them to lock in a minimum sale price, for a fee of a few dollars per barrel. During my time at the NYMEX, I distinctly remember a broker shouting into the pit: “what’s the price on DEC9 puts.” A trader doesn’t want to give away whether they want to buy or sell, because if the other traders know, then they can artificially move the price. In this particular case, this broker was known to sometimes implement parts of Mexico’s oil hedge. The other traders in the pit suspected this was a trade for Mexico because of his anxious tone, some recent geopolitical news, and the expiration date of these options.
Some confident traders took a risk and faded the market. They ended up making between $1-2 million dollars from these trades, relative to what the fair price was at that moment. I mention relative to the fair price, because Mexico ultimately received the better end of this trade. The price of oil dropped in 2009, and Mexico executed its options enabling it to sell its oil at a higher than market price. Mexico spent $1.5 billion to hedge its oil exposure in 2009.
This was an example of humans anticipating the direction of a trade and capturing millions of dollars in profit as a result. It really is profit as long as the traders can redistribute their exposure at the ‘fair’ market price before markets move too far. The analogous strategy in HFT is called “front-running the market” which was highlighted in the New York Times’ recent article “the wolf hunters of Wall Street.” The HFT version involves analyzing the prices on dozens of exchanges simultaneously, and once an order is published in the order book of one exchange, then using this demand to adjust its orders on the other exchanges. This needs to be done within a few microseconds in order to be successful. This is the computerized version of anticipating demand and fading prices accordingly. These tactics as I described them are in a grey area, but they rapidly become illegal.
Making money from nothing: arbitrage opportunities have existed for as long as humans have been trading. I’m sure an ancient trader received quite the rush when he realized for the first time that he could buy gold in one marketplace and then sell it in another, for a profit. This is only worth the trader’s efforts if he makes a profit after all expenses have been taken into consideration. One of the simplest examples in modern terms is called triangle arbitrage, and it usually involves three pairs of currencies. Currency pairs are ratios; such as USD/AUD, which tells you, how many Australian dollars you receive for one US dollar. Imagine that there is a moment in time when the product of ratios is 1.01. Then, a trader can take her USD, buy AUD, then use her AUD to buy CAD, and then use her CAD to buy USD. As long as the underlying prices didn’t change while she carried out these three trades, she would capture one cent of profit per trade.
After a few trades like this, the prices will equilibrate and the ratio will be restored to one. This is an example of “making money out of nothing.” Clever people have been trading on arbitrage since ancient times and it is a fundamental source of liquidity. It guarantees that the price you pay in Sydney is the same as the price you pay in New York. It also means that if you’re willing to overpay by a penny per share, then you’re guaranteed a computer will find this opportunity and your order will be filled immediately. The main difference now is that once a computer has been programmed to look for a certain type of arbitrage, then the human mind can no longer compete. This is one of the original arenas where the term “high-frequency” was used. Whoever has the fastest machines, is the one who will capture the profit.
Instability: I believe that the arguments against HFT of this type have the most credibility. The concern here is that exceptional leverage creates opportunity for catastrophe. Imaginations ran wild after the Flash Crash of 2010, and even if imaginations outstripped reality, we learned much about the potential instabilities of HFT. A few questions were posed, and we are still debating the answers. What happens if market makers stop trading in unison? What happens if a programming error leads to billions of dollars in mistaken trades? Do feedback loops between algo strategies lead to artificial prices? These are reasonable questions, which are grounded in examples, and future regulation coupled with monitoring should add stability where it’s feasible.
The culture in wealth driven industries today is appalling. However, it’s no worse in HFT than in finance more broadly and many other industries. It’s important that we dissociate our disgust in a broad culture of greed from debates about the merit of HFT. Black boxes are easy targets for blame because they don’t defend themselves. But that doesn’t mean they aren’t useful when implemented properly.
Are we better off with HFT? I’d argue a resounding yes. The primary function of markets is to allocate capital efficiently. Three of the strongest measures of the efficacy of markets lie in “bid-ask” spreads, volume and volatility. If spreads are low and volume is high, then participants are essentially guaranteed access to capital at as close to the “fair price” as possible. There is huge academic literature on how HFT has impacted spreads and volume but the majority of it indicates that spreads have lowered and volume has increased. However, as alluded to above, all of these points are subtle–but in my opinion, it’s clear that HFT has increased the efficiency of markets (it turns out that computers can sometimes be helpful.) Estimates of HFT’s impact on volatility haven’t been nearly as favorable but I’d also argue these studies are more debatable. Basically, correlation is not causation, and it just so happens that our rapidly developing world is probably more volatile than the pre-HFT world of the last Millennia.
We could regulate away HFT, but we wouldn’t be able to get rid of the underlying problems people point to unless we got rid of markets altogether. As with any new industry, there are aspects of HFT that should be better monitored and regulated, but we should have level-heads and diverse data points as we continue this discussion. As with most important problems, I believe the ultimate solution here lies in educating the public. Or in other words, this is my plug for Python classes for all children!!
I promise that I’ll repent by writing something that involves actual quantum things within the next two weeks!