Comments Off on High-Frequency Trading Finally Draws Some Scrutiny
I remember having a discussion with a friend, back in August of 2009, when I told him that he would soon hear quite a lot about “high-frequency trading”. It took a bit longer than I expected for that to happen. The release of the book, Flash Boys by Michael Lewis caused quite a stir. Many of the book’s harshest critics emphasized that what Lewis “exposed” was actually an old story. Much had already been written about high-frequency trading (HFT) years earlier.
In fact, here at TheCenterLane.com, I spent some time discussing that subject in the summer of 2009: here and here. I wrote about it on a few subsequent occasions in 2010: here, here and here. More important, in March of 2013, I discussed how HFT had motivated me to avoid using stop-loss orders because of the “mini flash crashes”, engineered by HFT miscreants.
Despite the cries of Wall Street apologists that Flash Boys was an “old story” which was no longer applicable to the present-day trading environment, Kevin Cook has written a few interesting things on HFT for Zacks Investment Research. Cook explains how HFT is being used right now as well as how to cope with this situation. I was particularly startled by Kevin Cook’s list of ten algorithm programs, which have exploited investors and traders with price behavior manipulation.
Although Attorney General Eric Hold-Harmless has promised to take action against HFT, I’m not holding my breath.
Since that time absolutely nothing has changed. In fact, the SEC has allowed the stock market to become an even more dangerous place for “retail investors” (mom and pop) to keep their life savings.
The use of “limit orders” has become a joke. The only reason for using a limit order is to let your enemies (the predatory traders) know the maximum extent to which you will allow yourself to be screwed on a trade. Since July of 2009, I have discussed the threat posed to retail investors by the use of High-Frequency Trading (HFT) systems. Computers – programmed with predatory algorithms – can engage in “computerized front-running” through the use of “flash orders” to force your own limit order to be executed at its most extreme expense to you. I discussed this situation in more detail on May 18, 2010.
I rarely use “stop loss” orders. They are used by investors to limit their loss if a stock price sinks. The investor specifies a stop price (based on a percentage of the purchase price which is the maximum amount the investor is willing to lose on the stock). If the stock eventually drops to the price in the stop order, the transaction is initiated and the order goes out to the exchange as a market order – to be filled at the best available price at the time. In other words, there is no guarantee that the order will be filled at the price specified in the stop order. In the “flash crash” on May 6 of 2010, many investors lost their shirts because their stop orders were executed and by the time the investors tried to repurchase the stocks, the prices rebounded to where they were before the flash crash. Worse yet, by the time their stop orders were actually filled, the stock prices had dropped tremendously. Not only did those investors lose money on the stop orders for no good reason – but many chose to buy back their stocks at the pre-crash prices. As a result, they lost twice as much money just because of an emotional attachment to the stock. (Emotional attachment to a particular stock is a bad investment habit.) Since that time, a number of “mini flash crashes” have been engineered by predatory traders on particular stocks, forcing investors off their positions to take losses, which ultimately benefit the predators, who use stealthy tactics to reap those profits without being caught.
Stock exchanges have explicit rules for canceling “clearly erroneous trades” and for triggering so-called circuit breakers that halt trading. None of the trades mentioned in this story met that criteria.
Generally, trades can be canceled if they fall 5% to 10% from the last trade, but the rules vary, depending on the market cap of a company and its trading volume.
Investors still have to notify the exchange within 30 minutes if they want their trade to be canceled.
And because many of the wild swings aren’t extreme enough to be considered “clearly erroneous,” individual investors may not even be aware that certain trades are being executed.
Although the article noted that “(t)he SEC continues to make changes to try to combat the frequency and impact of the mini flash crashes”, there is apparently nothing being done by the SEC to prevent the predatory engineering of those crashes. The SEC is apparently doing nothing to allow investors to unwind trades triggered by those crashes. More important, the SEC is doing nothing to track down and prosecute the culprits responsible for engineering and profiteering from these events.
By now, you are probably more than familiar with the “backdoor bailouts” of the Wall Street Banks – the most infamous of which, Maiden Lane III, included a $13 billion gift to Goldman Sachs as a counterparty to AIG’s bad paper. Despite Goldman’s claims of having repaid the money it received from TARP, the $13 billion obtained via Maiden Lane III was never repaid. Goldman needed it for bonuses.
On August 21, my favorite reporter for The New York Times, Gretchen Morgenson, discussed another “bank bailout”: a “secret tax” that diverts money to banks at a cost of approximately $350 billion per year to investors and savers. Here’s how it works:
Sharply cutting interest rates vastly increases banks’ profits by widening the spread between what they pay to depositors and what they receive from borrowers. As such, the Fed’s zero-interest-rate policy is yet another government bailout for the very industry that drove the economy to the brink.
Todd E. Petzel, chief investment officer at Offit Capital Advisors, a private wealth management concern, characterizes the Fed’s interest rate policy as an invisible tax that costs savers and investors roughly $350 billion a year. This tax is stifling consumption, Mr. Petzel argues, and is pushing investors to reach for yields in riskier securities that they wouldn’t otherwise go near.
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“If we thought this zero-interest-rate policy was lowering people’s credit card bills it would be one thing but it doesn’t,” he said. Neither does it seem to be resulting in increased lending by the banks. “It’s a policy matter that people are not focusing on,” Mr. Petzel added.
One reason it’s not a priority is that savers and people living on fixed incomes have no voice in Washington. The banks, meanwhile, waltz around town with megaphones.
Savers aren’t the only losers in this situation; underfunded pensions and crippled endowments are as well.
Many commentators have pointed out that zero-interest-rate-policy (often referred to as “ZIRP”) was responsible for the stock market rally that began in the Spring of 2009. Bert Dohmen made this observation for Forbes back on October 30, 2009:
There is very little, if any, investment buying. In my view, we are seeing a mini-bubble in the stock market, fueled by ZIRP, the “zero interest rate policy” of the Fed.
At this point, retail investors (the “mom and pop” customers of discount brokerage firms) are no longer impressed. After the “flash crash” of May 6 and the revelations about stock market manipulation by high-frequency trading (HFT), retail investors are now avoiding mutual funds. Graham Bowley’s recent report for The New York Times has been quoted and re-published by a number of news outlets. Here is the ugly truth:
Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.
The pretext of providing “liquidity” to the stock markets is no longer viable. The only remaining reasons for continuing ZIRP are to mitigate escalating deficits and stopping the spiral of deflation. Whether or not that strategy works, one thing is for certain: ZIRP is enriching the banks — at the public’s expense.
In the wake of the stock market’s “flash crash” on May 6, there have been an increasing number of reports that retail investors (“Ma and Pa”) are pulling their money out of stocks. Beyond that, some commentators have stepped forward to speak out and advise retail investors to steer clear of the stock market, due to the volatility caused by “high-frequency trading” or HFT. One recent example of this was Felix Salmon’s video message, which appeared at The Huffington Post.
HFT involves a practice wherein firms are paid a small “rebate” (approximately one-half cent per trade) by the exchanges themselves when the firms buy and sell stocks. The purpose of paying firms to make such trades (often selling a stock for the same price they paid for it) is to provide liquidity for the markets. As a result, retail investors would not have to worry about getting stuck in a “roach motel” – not being able to get out once they got in – after buying a stock. Many firms involved in high-frequency trading (Goldman Sachs, RGM Advisors, Tradebot Systems and others) have their computer servers “co-located” in the same building as the exchange, in order to get each of their orders processed a few nanoseconds faster than orders coming from further distances (albeit at the speed of light). The Zero Hedge website has been critical of HFT for quite a while. They recently published this informative piece on the subject, pointing out how HFT firms caused the catastrophe on May 6:
. . . when the selling in size commences they all just shut down. So much for providing liquidity when it is needed.
At The Market Ticker website, Karl Denninger explained how HFT platforms often use “predatory algorithms” to drive a stock’s price up to the full extent of a customer’s limit order (a practice called “frontrunning”):
Let’s say that there is a buyer willing to buy 100,000 shares of BRCM with a limit price of $26.40. That is, the buyer will accept any price up to $26.40.
But the market at this particular moment in time is at $26.10, or thirty cents lower.
So the computers, having detected via their “flash orders” (which ought to be illegal) that there is a desire for Broadcom shares, start to issue tiny (typically 100 share lots) “immediate or cancel” orders – IOCs – to sell at $26.20. If that order is “eaten” the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40. When it tries $26.45 it gets no bite and the order is immediately canceled.
Now the flush of supply comes at, big coincidence, $26.39, and the claim is made that the market has become “more efficient.”
Nonsense; there was no “real seller” at any of these prices! This pattern of offering was intended to do one and only one thing – manipulate the market by discovering what is supposed to be a hidden piece of information – the other side’s limit price!
The extent to which frontrunning takes place was the subject of a recent conversation between Larry Tabb of Tabb Group and Erin Burnett on CNBC. The Zero Hedge website provided this analysis of the video clip:
The funniest bit of the exchange occurs at 3:35 into the clip, when Tabb publicly discloses that front-running is not only legal but occurs all the time on open exchanges. When Erin Burnett, who unfortunately still thinks that the Deutsche Mark is used in Germany, asks who is doing the front running, Tabb says “It could be anyone.”
A recent piece by Josh Lipton at the Minyanville website focused on the activity of retail investors since the recent “flash crash”:
Specifically, during the past week through May 12, your friends and neighbors pulled $2.8 billion out of US stock funds, according to the latest data from the professional number crunchers at Lipper FMI.
To put that stat in context, we called up Robert Adler, the head of Lipper FMI Americas, for a chat this morning. He tells us that’s the most investors have pulled out, in fact, since March 11, 2009.
At the same time, says Adler, investors plowed $16.6 billion into money-market funds. “That’s the first inflows money market funds have seen in the last 16 weeks,” he says.
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“There was an about-face this past week by investors,” Adler says, noting that such outflows from both equity and bond funds, and a sharp reversal in money market funds, demonstrate a clear and dramatic shift in sentiment.
The analyst is quick to emphasize, however, that one week doesn’t make a trend. “We have to wait another week to see whether this was simply event driven or if this is the beginning of a new trend,” he says.
The current risk-aversion experienced by retail investors is compounded by the ugly truth that stocks are currently overvalued. Shawn Tully of Fortune made this very clear in a May 17 commentary, wherein he provided us with a sage bit of prognostication:
Here’s how I see the odds. The chances are about one in three that we suffer a huge, wrenching correction in the next year or two similar to the one in 1987. That possibility is so high because stocks are so startlingly expensive. Another high probability event is that markets go on a long sideways grind, with smaller drops along the way. What’s extremely unlikely is that the market rises substantially from current levels and stays there for any extended period.
Whatever happens in the next couple of years, the odds are overwhelming that investors who buy stocks today will reap puny returns for 10 years. For example, if you’d purchased shares at today’s PE of 22 in early 2003, you would have gotten a return of around 3% a year, barely enough to compensate for inflation, let alone buy the blood pressure medication you’d need to survive the scary ride of stock ownership.
Now let’s look out a decade or two. The evidence is extremely strong that price matters, and matters a lot: except in rare cases, buying stocks when they are pricey — when the Shiller PE exceeds 20 — leads to puny returns ten years later.
Not that you’d ever know that from the happy talk from Wall Street. So screen the noise out, and follow the numbers. They’ll eventually get better for investors. But to get back there, we may revisit October of 1987.
Considering the unlimited number of awful news events unfolding in America and around the world right now, we could be headed for a market crash much worse that that of October, 1987. Cheers!
On April 15, I discussed the disappointing performance of the Financial Crisis Inquiry Commission (FCIC). The vapid FCIC hearings have featured softball questions with no follow-up to the self-serving answers provided by the CEOs of those too-big–to-fail financial institutions.
In stark contrast to the FCIC hearings, Tuesday brought us the bipartisan assault on Goldman Sachs by the Senate Permanent Subcommittee on Investigations. Goldman’s most memorable representatives from that event were the four men described by Steven Pearlstein of The Washington Post as “The Fab Four”, apparently because the group’s most notorious member, Fabrice “Fabulous Fab” Tourre, has become the central focus of the SEC’s fraud suit against Goldman. Tourre’s fellow panel members were Daniel Sparks (former partner in charge of the mortgage department), Joshua Birnbaum (former managing director of Structured Products Group trading) and Michael Swenson (current managing director of Structured Products Group trading). The panel members were obviously over-prepared by their attorneys. Their obvious efforts at obfuscation turned the hearing into a public relations disaster for Goldman, destined to become a Saturday Night Live sketch. Although these guys were proud of their evasiveness, most commentators considered them too cute by half. The viewing public could not have been favorably impressed. Both The Washington Post’s Steven Pearlstein as well as Tunku Varadarajan of The Daily Beast provided negative critiques of the group’s testimony. On the other hand, it was a pleasure to see the Senators on the Subcommittee doing their job so well, cross-examining the hell out of those guys and not letting them get away with their rehearsed non-answers.
A frequently-repeated theme from all the Goldman witnesses who testified on Tuesday (including CEO Lloyd Bankfiend and CFO David Viniar) was that Goldman had been acting only as a “market maker” and therefore had no duty to inform its customers that Goldman had short positions on its own products, such as the Abacus-2007AC1 CDO. This assertion is completely disingenuous. When Goldman creates a product and sells it to its own customers, its role is not limited to that of “market-maker”. The “market-maker defense” was apparently created last summer, when Goldman was defending its “high-frequency trading” (HFT) activities on stock exchanges. In those situations, Goldman would be paid a small “rebate” (approximately one-half cent per trade) by the exchanges themselves to buy and sell stocks. The purpose of paying Goldman to make such trades (often selling a stock for the same price they paid for it) was to provide liquidity for the markets. As a result, retail (Ma and Pa) investors would not have to worry about getting stuck in a “roach motel” – not being able to get out once they got in – after buying a stock. That type of market-making bears no resemblance to the situations which were the focus of Tuesday’s hearing.
Coincidentally, Goldman’s involvement in high-frequency trading resulted in allegations that the firm was “front-running” its own customers. It was claimed that when a Goldman customer would send out a limit order, Goldman’s proprietary trading desk would buy the stock first, then resell it to the client at the high limit of the order. (Of course, Goldman denied front-running its clients.) The Zero Hedge website focused on the language of the disclaimer Goldman posted on its “GS360” portal. Zero Hedge found some language in the GS360 disclaimer which could arguably have been exploited to support an argument that the customer consented to Goldman’s front-running of the customer’s orders.
At Tuesday’s hearing, the Goldman witnesses were repeatedly questioned as to what, if any, duty the firm owed its clients who bought synthetic CDOs, such as Abacus. Alistair Barr of MarketWatch contended that the contradictory answers provided by the witnesses on that issue exposed internal disagreement at Goldman as to what duty the firm owed its customers. Kurt Brouwer of MarketWatch looked at the problem this way :
This distinction is of fundamental importance to anyone who is a client of a Wall Street firm. These are often very large and diverse financial services firms that have — wittingly or unwittingly — blurred the distinction between the standard of responsibility a firm has as a broker versus the requirements of an investment advisor. These firms like to tout their brilliant and objective advisory capabilities in marketing brochures, but when pressed in a hearing, they tend to fall back on the much looser standards required of a brokerage firm, which could be expressed like this:
Well, the firm made money and the traders made money. Two out of three ain’t bad, right?
The third party referred to indirectly would be the clients who, all too frequently, are left out of the equation.
A more useful approach could involve looking at the language of the brokerage agreements in effect between Goldman and its clients. How did those contracts define Goldman’s duty to its own customers who purchased the synthetic CDOs that Goldman itself created? The answer to that question could reveal that Goldman Sachs might have more lawsuits to fear than the one brought by the SEC.
TheCenterLane.com offers opinion, news and commentary on politics, the economy, finance and other random events that either find their way into the news or are ignored by the news reporting business. As the name suggests, our focus will be on what seems to be happening in The Center Lane of American politics and what the view from the Center reveals about the events in the left and right lanes. Your Host, John T. Burke, Jr., earned his Bachelor of Arts degree from Boston College with a double major in Speech Communications and Philosophy. He earned his law degree (Juris Doctor) from the Illinois Institute of Technology / Chicago-Kent College of Law.