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September 2010

Thursday, September 30, 2010

Preventing an HFT Witch Hunt

Posted by John Bates

 "For a charm of powerful trouble,

Like a hell-broth boil and babble


Double, double, toil and trouble,

Fire burn, and caldron bubble."

William Shakespeare.


There is no shortage of news about the evils of high frequency trading these days; almost as if the whole thing is turning into a witch hunt. According to Wikipedia: "A witch-hunt is a search for witches or evidence of witchcraft, often involving moral panic, mass hysteria and lynching". I don't think we will get so far as lynching, but a certain amount of hysteria and moral panic are certainly present in the marketplace.


NY Senator Charles Schumer is keeping HFT in the headlines, recently claiming the players pulled out during the flash crash "leaving a dearth of liquidity and exacerbating market volatility." Last week SEC Chairman Mary Schapiro told the Security Traders Association (http://tinyurl.com/37rmo68) that she was concerned about not just HFT but also whether high frequency players should be regulated in "key aspects of their market behavior, including quoting and trading strategies.”


She also expressed concern over execution algorithms: “Even with checks for ‘fat finger’ errors and other problems, these algorithms can quickly generate a volume of orders that swamps the immediately-available supply of liquidity for a stock.”


And most recently, the Investment Company Institute, a trade association for fund managers, is said to be meeting in Washington, D.C. to push for a plan to restrict high-frequency trading. Some ICI leaders contend that HFT profits may come partly at the expense of ordinary investors (http://tinyurl.com/35b2xnl).


I'd like to turn the fire down under the witch's cauldron and avoid a witch hunt. Like witches, HFT is not evil - just misunderstood. Witches of lore used the tools at their disposal, whether eye of newt or toe of frog, to get the job done. There was never much evidence that the job in question was evil-doing, but they were persecuted nevertheless. The same can be said of HFT and algorithmic trading. They are just some of the trader's tools that help to get the job done efficiently, and are also misunderstood.


Algorithmic trading and HFT are less like witchcraft and more like gold mining. When gold is discovered a rush ensues and everyone descends upon the territory. Then they have to pan for gold in rivers or dig to find the hidden seams of gold. Using algo and HFT trading firms are always seeking out new opportunities and trying to mine the gold before others descend.


I'm not saying that there are no issues with HFT. It can scale the capabilities of a trader hundreds or thousands of times - which can of course increase trading risk accordingly. But rather than burn the witch, or HFT, we need to find ways to control the risk.


High frequency pre-trade risk capabilities will help. Using a real-time pre-trade risk firewall it is possible to continuously recalculate risk exposures while monitoring trades as they go to market -  and determine what impact they would have on pre-defined risk limits.


Using back-testing and market simulation is another; before algos go live it is possible to see how they would perform in production. Real-time market monitoring and surveillance allows more rapid response to potential crises and market abuse – potentially allowing rapid action to prevent or minimize any market impact. Finally, keeping an audit trail of market data and potential abuse cases is also important. Tick databases can be used here.


The thing to remember is that HFT and algo traders are not evil witches. There are many positive aspects of algorithms and HFT. They minimize market impact of large trades, lower the cost of execution, make more open and efficient markets, allow trading venues to evolve faster, encourage entrepreneurship and increase trader productivity, among many other things. Rather than organize an HFT witch hunt and run around shouting and carrying torches it would be much more productive to look at how HFT can benefit from effective controls. We must be careful not to over-regulate and damage this important economic engine.


Monday, September 27, 2010

Mystery Solved, but Questions Remain

Posted by John Bates

Scooby Doo and the gang have been investigating the spooky mystery of the "phantom orders" on CME and they found out that the culprit was... wait for it.... The CME! Turns out the exchange plugged in some new contracts to try them on for size and they mistakenly went live and bam! they got traded.

According to the FT, CME Group said it had “inadvertently” posted test orders intended for its quality assurance procedure on Globex (http://tinyurl.com/23bpfjj). CME said the company tests its systems as a matter of course and it had not determined whether human error or a computer glitch caused the mistake.

The FT said the mistaken order flow began at 3:38pm ET time on Monday, September 13th and lasted for six minutes. Futures brokers noticed oddly anomalous spread price activity during that period, when trading is usually slow.

CME said it was working with the customers that somehow managed to trade these contacts in those six minutes, and says it won't "bust" the transactions. Fair enough. But the mistake shows how the exchange lacked adequate monitoring technology to see that some test contracts had entered the live environment - and were being traded.

This six minute phantom orders mystery is solved, but the very fact that it occurred supports my argument that brokers, traders and exchanges need to have more advanced capabilities to detect problems and abuse as they happen, and recommend actions to take in response. The Mystery Machine got to the bottom of the case, but it was not fitted with the latest real-time surveillance equipment. It seems, like Velma, the CME temporarily lost their glasses!

Wednesday, September 15, 2010

I Would’ve Got Away With It Too - It If It Wasn’t for You Pesky Kids….

Posted by John Bates

Strange things are happening in the markets! As you know if you’ve been following this blog, quite a few scares, horrors and apparitions have been sighted in equities, futures, FX and oil markets over the last few months. But fortunately the Mystery Machine has rolled into town and Scooby, Shaggy and the gang are investigating…


The latest spooky mystery is “phantom orders” that appeared to scare participants on the CME (read more about it here). For 6 minutes on Tuesday unexplained orders, that could have been caused by a “fat finger” error or an “algo gone wild”, caused CME to use Rule 587 which gives them powers “including without limitation, closing the market, deleting bids and offers, and/or suspending new bids and offers”. So although they weren’t sure what was going on – the CME were at least able to respond.


Another report this week shows how those involved in alleged market abuse are starting to be unmasked. Last week I wrote a blog posting called “Algos Can Get Stuffed” which was also featured on the Tabb Forum. In it I talked about the possibility of firing orders into the market with the intention of misleading the market or slowing the market down – and even how some link this phenomenon with the flash crash. This week a trading firm called Trillium was fined by FINRA for using illegal trading practices (read more about it here).  Trillium was fined $1m for sending orders aimed at deceiving investors. Nine traders entered buy and sell orders in patterns that aimed to manipulate the prices of instruments. And they did this 46,000 times! This “layering” enabled Trillium to trade at a profit once they’d manipulated the price.


These 2 incidents show that awareness of the problems we’ve been writing about on this blog have increased radically. Trading venues are more aware that algos gone wild and fat fingers can cause market panics and manipulate prices. Regulators are more aware that high frequency trading can be used as a weapon for market manipulation.


But we can’t rest on our laurels. Maybe we got lucky this time. As market data volumes continue to increase we need to have more advanced capabilities to detect problems and abuse as it’s happening, and recommend actions to take in response. Let’s ensure the Mystery Machine is fitted with the latest real-time surveillance equipment. Let’s enable the gang to unmask more villains at the haunted “high frequency manor” inspiring the legendary outburst of “I would’ve got away with it if it wasn’t for you pesky kids….”

Wednesday, September 08, 2010

Algos can get stuffed!!

Posted by John Bates

As regulators continue to look into the causes of the May 6th flash crash, some high frequency trading approaches are coming under scrutiny. In particular the concept of “quote stuffing”, where algorithms send so many orders into the order book that the market cannot possibly respond, has come under fire from market participants and the press.


The SEC, having reportedly decided that quote stuffing probably did not have a major role in the flash crash, is now taking aim at the practice to see if it puts some investors at a disadvantage by distorting stock prices (http://tinyurl.com/264kr3o). The CFTC is looking at data from database developer Nanex and mulling how to address quote stuffing in futures markets (http://tinyurl.com/3a7w7sv).


Meanwhile, concerning incidents continue to happen in the market. As recently as last week there was an incident that caused Christopher Steiner at Forbes to write a story called “Did we dodge another flash crash on September 1st?” The story describes how on September 1st at 10am quote volumes ballooned - as they did on May 6th. In fact quotes reached 275,000 per second, as opposed to 200,000 on May 6th. Unlike the flash crash though there wasn’t a dramatic fall in prices. However, the bids and offers did cross for a time – leading to high frequency traders taking advantage of arbitrage opportunities. This data was exposed again by firm Nanex – and left the market wondering if quote stuffing by high frequency traders was behind the spikes.


The world is waking up to the fact that high frequency and algorithmic trading have quietly become part of the market fabric, and the world does not seem to be too happy about it. HFT and algorithms are being "demonized" said the FT article, and I agree. I also think the hype is overblown.


Once trading became automated, trading strategies naturally morphed to take advantage of the available technology and higher speeds. High frequency statistical arbitrage techniques can also mean more order cancellations, some of which may - wittingly or unwittingly - fall into the quote stuffing category. Those involved in intentional quote stuffing as a strategy need to be held to task. But to demonize all strategies or call for banning them is a step backward. What is needed is a framework by which to police them - and to prevent them from going wrong. The technology to do this is already available. For example, an area I’ve had a lot of experience in is the use of complex event processing to provide a platform for high frequency, multi-venue market surveillance. With such a system quotes can be monitored to determine how many quotes per second there are on each ticker symbol, the ratio of quotes to trades, when large spikes are emerging and many other interesting real-time analytics and patterns that it’s useful to track in real-time.


But regulation of high speed trading practices has fallen short to date. Regulators have not had the funds, the technology, the power or the expertise to follow and control high speed trading. However, it is good to see that progress is now being made. CFTC commissioner Bart Chilton wrote last week in an article entitled Rein in the cyber cowboys: “There may be some cyber cowboys out there and they could be giving respectable traders a bad name”. His colleague CFTC commissioner Scott O'Malia told Reuters last week that, if traders are flooding the market with orders with the intention of slowing others down, the regulator would consider addressing quote stuffing under new rules in the financial regulation bill that deal with disruptive trading practices.


It is possible that quote stuffing is causing more problems that just slowing down the natural flow of trades. Trading behavior patterns suggest that these quotes are a distraction to other traders. There are patterns evident where the quote "stuffer" continuously traded first - possibly by distracting others. And the disruption can cause the bid and offer to cross – providing a nice arbitrage opportunity for those who are not distracted! All of this needs to be looked into further. I fully support the CFTC and SEC's efforts to get to the bottom of not just the flash crash, but HFT and algorithmic trading practices. They are now integral in the equities and futures markets, and increasingly so in FX, fixed income and energy. What we need is better policing of the markets to protect the honest ranchers from the cyber cowboys.