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John Fullerton

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Good Knight HFT

Posted: 08/15/2012 1:22 pm

The futile debate between market fundamentalists and those who claim you can't stop "progress" on the one hand, and proponents of tighter government regulation and oversight on the other, continues on with no resolution in sight. From too-big-to-fail banks, a second front is now opening -- this one focused on the structure and regulation of equity trading in the United States. This latest battle is emerging in the wake of Knight Capital Group's technology debacle, which required an emergency infusion of capital that wiped out shareholders and nearly sunk the firm. The Knight crisis arrived on the heels of Nasdaq's Facebook IPO fiasco and the failed IPO of trading firm Bats Global Markets, Inc. And let's not forget the "flash crash" we know about, and the many smaller "flash crashettes" that have escaped our notice.

It is time to put an end to the tedious and useless debates. The false choices they represent would be apparent to us if only we were to remove our ideological blinders. Neither side of the argument, we would then realize, is without merit and neither side without flaw.

In A Guide for the Perplexed, E.F. Schumacher explained that there are two kinds of problems in the world. Convergent problems get solved over time when we throw enough intellect and logic and at them. Mathematics and science are the realms of such convergent problems.

Divergent problems are problems whose answers diverge into opposites the more the problem is clarified. Logic cannot solve divergent problems. Like choosing between justice and mercy, or freedom and equity, the debate between free markets and regulation will never be resolved, no matter how much we shout at one another. Divergent problems must be transcended.

"A refusal to accept the divergency of divergent problems causes (wisdom) to wither away, and when this happens, the "clever animal" is more likely than not to destroy itself."
- E.F. Schumacher

We can transcend this particular debate by asking the right question: what is the purpose of secondary trading, that is, the trading of existing shares, in the stock market? When we achieve that clarity of purpose, we can then design a market structure to serve it, taking into account the system's unique dynamics and feedback loops, and the technological context of our moment in time.

Any thinking person outside of Wall Street as well as many Wall Street veterans have long ago concluded that our equity markets have spun dangerously out of control, undermining the vital investment facilitation function they are designed to serve in the real economy. Just as finance has moved from servant to master of the real economy with disastrous consequences, a parallel phenomenon has emerged in what has become the financial system's most powerful enabling mechanism, as technology has moved from servant to master of the financial markets themselves.

Like most financial commentators, I can't claim to fully understand the structure of modern, technology-driven equity markets. But I do know one thing: in the name of progress, enabling technologies have been allowed to corrupt the legitimate purpose of equity trading. Unfortunately, our financial system no longer distinguishes between means and ends. Equity trading is now understood as an end in itself -- a big business at that -- rather than a support system serving the needs of the investment business, which is its legitimate purpose.

It was inevitable that computers would replace humans in the execution and settlement of trades, particularly in equity markets that are comprised of thousands of stocks in the US alone. Technology has driven down trading costs, increased transparency, and as a result, enhanced liquidity. This has all been to the good, all else being equal. However, all else has not been equal, and, the benefits of technology have often been grossly exaggerated. This has been particularly true of the benefit of enhanced liquidity, which a flawed ideology equates with efficiency. Jamie Dimon, Chairman and CEO of JPMorgan, recently boasted that American capital markets are the most liquid and efficient in the world, suggesting that this criteria alone defines success in modern finance. Yet what he failed to acknowledge is that liquidity is a means, not an end.

While we worship at the alter of efficiency, few economists (and even fewer bank CEOs) understand that efficiency represents a tradeoff with resiliency. The efficiency mantra is simply part of the flawed ideology. Interfere with efficiency (of secondary trading of stocks), the ideology tells us, and you will harm growth.

The truth is that particular types of trading are illegitimate theft, and in conflict with the purpose of trading as a supporting part of a healthy investment business, and that's where we should focus our response. Insider trading is illegal. Front-running customer order flow and market manipulation are certainly unethical, against the rules, and can be illegal. Such illegitimate trading has been with us for eons. Prior to the technology arms race in trading, trade execution at the institutional level was overall an honest, mundane activity, relegated to the boiler room of the investment business.

Technology changed that, making it harder if not impossible to discipline the illegitimate trading that now occurs under the guise of electronic market making. Today, it is virtually impossible to separate legitimate electronic market-making by firms such as Knight from illegitimate proprietary high-frequency trading ("HFT"), some of which is nothing more than the electronic, high speed version of old-fashioned front running of customer orders, and highly sophisticated market manipulation. Outside Wall Street, we call this theft. These practices are detailed in Broken Markets, by HFT "whistle-blowers" Sal Arnuk and Joe Saluzzi, principals of Themis Trading, LLC, in Jersey City, where much of the HFT underground operates.

The scale of this theft is stunning, although it's impossible to know how much of the $8 billion per year that Tabb Group estimates HFT generates in profits comes from illegitimate front running and market manipulation. It's likely to be significant, since legitimate market making is a very low margin business. Even the firms involved blur the distinction between legitimate market making and what can be, but is not necessarily, illegitimate proprietary trading. Here's how Knight describes "market making" on their website:

Market Making includes all global market making across regions and asset classes. In addition to the electronic market making in U.S. equities, the segment includes cash market making, designated market maker (DMM) services at the NYSE, market making in European equities and U.S. options, and non-client quantitative trading.

Is "non-client quantitative trading" proprietary HFT occurring side by side legitimate market making? Yes. Is it illegitimate? I have no idea, but it certainly can be, and such trading was undoubtedly linked to Knight's near death experience last week.

No regulation will ever be devised to ensure such events "never happen again" and responses to Knight for better model testing sound downright silly. To choke off illegitimate high frequency trading, we need a new tool to act as a particular and targeted feedback loop in the system to discourage, if not eliminate, the insidious aspects of HFT.

That tool is a financial transaction tax, a policy measure that I and others have written and spoken about many times before and that has gained support in many financial centers other than the United States and the United Kingdom. Such a tax will make uneconomic much of the illegitimate HFT, improve the structure and function of markets, improve market resiliency, and therefore improve the trust in markets. It will have a modest efficiency cost, bother active traders, and drive certain ideologues crazy. Real investors will continue to enjoy reductions in trade execution costs resulting from advances in technology compared to a decade ago, and their legitimate fear of catastrophic collapse will be reduced significantly.

For a stunning graphic of the insanity that HFT has come to represent, I highly recommend viewing the interactive chart Carla Seaquist shared with me from a piece by Felix Salmon of Reuters. The story inside the graph is complex and demands further study, but the graphic is brilliant.

 
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