HIGH FREQUENCY TRADING: Machines Primed for Market Exploitation

We live in an ever increasing complex world fueled by technological advances. From the newest gadget, to the latest gizmo, its no secret that advances in the way we apply technology has radically changed the way we behave and interact. No industry has escaped the tsunami of technological change. The way we manage information, the processing we conduct in business, engineering of products, and the way we decide on investing and growing our monies have all seen huge impacts. No more is this evident than in the sector of investing where it is clearly visible how technology has both exponentially created opportunities and explosive avenues for growth. However is there a point where technology becomes exploitative? Is there a point where the core affects of a certain technology application can become harmful? Is there such a thing as an unfair advantage if we truly are evolving for the better? This paper will attempt to identify that we have indeed reached the tipping point by examining a sector of electronic investment strategies called Algorithmic Trading; in particular the segment of High Frequency Trading (HFT). The next pages will examine a brief history of electronic trading, identifying core functions of HFT, reviewing prudent areas where the markets have exhibited erratic behavior, areas where market manipulation can exist, and potential pitfalls. The case is made that High Frequency Trading has proven detrimental to the financial markets, under mining investor confidence and tilting the odds of achieving winning trades in High Frequency Traders favor while removing value driven investment from the average investor. Electronic Trading at a Glance When looking at the investment world these days, its pretty easy to take all the tools that investment bankers, brokers and consumers have as options. We are

consistently bombarded by all sorts of options where trading platforms such as Scottrade, E-Trade, Forex, Bloomberg, Reuters and a whole host of other Managing Information Systems (MIS) can gather and compile data for both reviewing and analyzing of empirical data to lead us to the right trade. However this world is new to our modern society, in fact if it were a human, it would only just be in its mid-teens. Executing trades during the 70s, 80s, and early 90s relied on your best hope of finding a broker that had the best telephone connection line, and trades would physically be exchanged on trading floors. Costs were exuberantly high, with trade execution and fund management fees barring anyone but those in the upper echelon to enjoy the fruits that investing in stock, currency, and commodity markets could produce. So it must come as no surprise as more financial services and electronic systems have plugged into the electronic exchange of trading information, that costs have dramatically decreased. As information gathering, quantifying, has increased, so has the speed and efficiency of delivering such data as price/quotes. These changes have afforded the ability for individuals at the consumer level to enter the financial markets. Where once a single trade could cost you as high as $50 dollars and required a high degree of effort, trades can now be executed for as little as $7, are self authored, and are done in the comfort of your own home, and as of recent, a mobile device. The rise of electronic trading was made possible by the advent and proliferation of the modern computer, networks and heavy investing in the electronic infrastructure that created the ability to transmit data at ultra high velocity. Equally as important was the development of information systems that plugged into these networks in order for such data to be delivered, compiled and analyzed by both experts and

novices. This evolution took place in relatively short time with the greatest advancements coming rapidly after the US Stock tech bubble crash of 2001. Once systems became integrated and information was being cross-pollinated across a spectrum of environments, computers began to be programmed to spot trends, identify opportunities, react to changing environments and execute automated orders without human input. This practice is now known as Algorithmic trading (AT).

Simon Says Algorithm So what is Algorithmic trading? As defined by Investopedia.com: A trading system that utilizes very advanced mathematical models for making transaction decisions in the financial markets.12 This essentially removes the human element altogether leaving for computers to conduct the price discovery of said stocks, currency, futures, derivatives and commodities. Trading in such manner has increased considerably, with the majority of such strategies being implemented by institutional investors whom all trade high volumes of stocks on a daily basis. By modeling price discovery mathematically, computers can take advantage of trading opportunities not yet discovered by their human counterparts and therefore are at an advantage. On an average, Algorithmic Trading (AT) makes up about 50% of the volume traded daily. Within Algorithmic Trading exists a sub-segment now named High Frequency Trading (HFT). This takes the math modeling practice a step further by using extremely fast equipment to generate massive amounts of trades and by also co-locating, the practice of placing your network infrastructure closest to the information source. Firms then invest heavily on the newest and fastest technology to gain a time based edge on trading information and

executing multiple buy/sell orders at a given moment that take advantage of minuscule price differences on assets being traded. So prevalent has this practice become that InvestorDictionary.com has noted in its own definition of HFT that 70% of equity trades in the U.S. 13 accounted for were done using high frequency trading. With such a huge volume of trading, HFT certainly must play a role and an affect the markets, but what role can it be? As far back as 2006 and certainly post collapse of 2008, the markets have been known to act counter-intuitive to the fundamentals as originally intended in free market capitalization and investing structures. Despite exceedingly strong balance sheets reported by the majority of high cap/large market corporations, volativitely in the stock market has increased a whooping 131% since June of 201116. Along with this volatility, its worth mentioning that the S&P has experienced a decline of 12% as of 10/21/201116. Large investment managers with high clout have attributed such volatility to HF Traders and the strategies they have implemented. The markets have thus had to adapt to an ever evolving and hyper-active market. The next sections will highlight the areas that have seen negative impacts due to HFTs practices.

Fundamentalless With HFT, what causes most concern is that such strategies are generally void of any fundamental measures in terms of investing. By fundamentals, we mean exacting investment information, quantifying it, and trading such investments with regards to financials being reported by corporations, government, global economic conditions, and social/political factors. Investing in the financial markets primarily meant that a buy and

hold strategy would generally reward the investor as most stocks would eventually grow into positive numbers and cyclical economies in decline would eventually reverse themselves. As of recent though, investor faith, in particular those investors trading on fundamental strategies have begun to question if this practice is slowly dying off or perhaps may even be dead. HFT trading lacks any foundation in fundamentals. Review of balance sheets, income statements, ratios, market capitalization, are rarely taken into consideration. Generally, the mathematical model is just out to purely and simply determine a difference and/or imbalance in price, exacting a profit no matter how small the yield margin is. The small margin will be more than made up in the high volume of shares traded. Incorporated within each model are statistical identifiers that trigger automated responses to spot trends and as such, the asset being bought or sold really never matters. In high volatility environments, HFT trading firms have been known to exact a profit as high as $60 Million in a given day. The markets have responded by behaving ever and ever less efficiently due to the fact that relatively little or no intrinsic value is attributed to the trade of a stock. In addition to this, volatility in the market has increased with the wild swings that arise when corporations report their quarterly/annual financials. X. Frank Zhang of Yales school of management has noted that stock prices react more strongly to news about fundamentals when HFT is at a high volume, However, the incremental price reactions associated with HFT are almost entirely reversed in the subsequent period. Taken together, the evidence suggests that HFT exaggerates otherwise-sound price reaction. The price swings introduced by HFT also represent direct evidence that HFT increases stock price volatility4. A critical piece by CBS reporter Alain Sherter pondered whether this tilted playing field presents all sorts

of thorny problems, like whether retail investors should even be in the game10 Lets closely examine the volatility created by HFT.

A Crash in a Flash Its no secret that volatility creates opportunities, but of recent the market has exhibited erratic behavior that has caused outright panic and a flight to safety effect from investors. On May 6th ,2010, market followers were all sitting on edge when what is now known as the Flash Crash of 2010 occurred, destroying over 1 trillion of market value in period of about 30 minutes. Such was the huge uproar that an upload to youtube.com, http://www.youtube.com/watch?v=cGYRpANTXWo&feature=related, documenting the event horizon quickly went viral as traders seemingly went out of control in an environment that some described as emotionally apocalyptic. In fact, the market was spared an altogether melt down due to safety measures applied post 2008 collapse that trigger an automatic pause (Circuit Breakers) in trading if more than 10% movement in a member stock occurs within 5 minutes of the last trade. So the question remained on everyones head, what was the catalyst and what caused further exacerbation of market conditions? Four months later, the SEC (Securities and Exchange Commission) and CFTC (Commodities and Futures Trading Commission) issued a report titled Findings Regarding the Market Events of May 6, 2010 that specifically pointed out that HFT trading firms had exacerbated market conditions after, ironically, a mutual fund trading on an algorithmic platform decided to liquidate 4.1 billion worths of futures contracts. Although the mutual fund had done this previously, this time they failed to orderly sell

these contracts, instead placing their algorithm to liquidate these assets at a steady 9% of trading volume. In what was already a somewhat volatile market bearing news of Greek debt, such a significant position sold at once triggered the buy and sell effect of multiple HFT firms, who in turn accelerated the mutual funds selling of these futures contracts, and as quoted in the report HFTs [then] began to quickly buy and then resell contracts to each othergenerating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth23. This lead to a spill over effect and in minutes all equity markets began to decline significantly. HFT seeing that things had gone awry way before anyone and noticing a distinct latency in price quotes, then exited the market, which plunged the market even further as the market(s) liquidity dried up from the loss of HF Traders constant buying and selling. A significantly large accumulation of sell orders in relation to buy orders arose, declining prices even further by panic stricken investors. Although the market quickly regained most of its losses, some prominent fortune 500 companies traded as low as one cent in this period and in some cases have not regained their entire stock market capitalization ever since this event occurred.

Tick By Tick Chart of May 6th Flash Crash of 2010.

Although not as drastic as May 6th, these types of events have actually begun to occur quite commonly. In fact mini flash crashes had previously been monitored, with Forbes.com publishing an article that concluded that there is potentially that someone is introducing a flood of buy/sell orders to the central hubs of the exchanges, and profiting from the latency that such flood produces. The created latency has the problem of precluding to market manipulation, as also pointed out in the same Forbes article, its clear that one trader or perhaps more discovered that by blasting the NYSE, they could introduce added latency in the CQS feed. Knowing that most players were looking at a delayed NYSE feed, anybody in the know could make easy arbitrage plays between the NYSE and other exchanges17. Within such latencies, a trade could net anywhere from $50K to $50M in profits17. Only HFT firms could be capable of both introducing such calculated latencies and profiteering from them. So flash crashes, even in a one stock performance, have the capability of being highly profitable, extremely low risk ventures and thus there is no surprise that flash crash events have increased as the popularity of HFT has also.

Market Takers Proponents of HFT have for the most part defended the practice and their investment prowess by stating that they bring high liquidity to the market, assuring that anyone that wants to buy or sell a stock at any given moment will most likely find a buyer at a reasonable price. However what weve seen from HF Traders is that if the computer cant be trusted, especially in times of high volatility, the human counterpart takes the computer offline, thus their liquidity argument proves baseless as evidenced on

May 6th, 2010. In the exchanges, there are 3 types of investors, Market Makers, Market Takers, and Liquidity traders. Market Makers inheritably are employed to keep the market liquid as their cash flows are crucial, and work as oil to the gears of the markets. As part of their duty they are required to stay in the market especially during volatile periods but in turn enjoy certain informational advantages from the exchanges. However since HF Traders now compose 70% of equity trades, the argument can be made that High Frequency Traders have now become equally important to the market free flow, if not more important. Despite the volumes of trades they impose, they currently have no requirements in regards to liquidity exiting. Its been exhibited that HFT firms will exit the market the moment volatility becomes too much to handle, in essence their algorithms cant account for EVENT situations. Their argument for providing a liquid market is thus rendered useless, as the markets are handed over a sudden loss of liquidity to bear with in situations that HFT firms may have exacerbated. Along with this, HFT firms concentrate solely on large volume trades, meaning institutional trades and as such the majority, if not all, of the liquidity goes to highly capitalized stocks with little to no evidence that liquidity is provided across the market. Ultimately Liquidity traders lose on two accounts: they lose trading surplus to the HFT, and they must offer a higher liquidity discount to market makers to get them to buy their shares.6

Name Your Price Prices of stock have also been influenced by their massive trading volume. In a joint paper by Jaksa Cvitanic, of the California Institute of Technology, and Andrei A. Kirilenko, of the Commodity Futures Trading Commission titled High Frequency

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Trading and Asset pricing, researchers created models based on algorithmic HFT strategies and concluded that the presence of a machine is likely to change the average transaction price, even in the absence of new information22 and the faster humans submit and vary their orders, the more profits the machine makes22. This leaves numerous blocks of stock with prices that are inherently not decided by true equilibrium valuations and thus impacts the average investors especially those in the retail sector by creating pricing disadvantages.

The Proof is in the Spoofing Lastly manipulation can greatly exist in HFT based on new lax regulation that has created Dark Pools, exchanges where investors trade anonymously, particularly HFT traders, in order to exact trades without being identified. There is a certain market strategy at play here, as Institutional Investors and the HF Traders play a game of cat and mouse where one does not want for the other to capitalize or lead to a detriment in value on a given trade. However anonymity can and has lead to Spoofing16, producing a faux interest in the demand of a stock, and Layering16, placing a significant amount of buy orders sequentially, cancelling the initial orders within seconds and executing on the last order for profit, essentially creating false demand. In driving the prices of stock up and down, HFT traders can command the profits on the bid spreads and thus is at its core, pure market manipulation. HFT firms have faced significant fines due to such practices, however these are hard to identify and so the prevalence of such tactics is not certain. An article on the The Atlantics website (a publication) dated August 4th observed the curious algorithms used throughout markets measured in fractions of a second. Titled

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Market Data Firm Spots the Tracks of Bizarre Robot Traders, what was found by a Market Data Analysis Company was that certain algorithmic curiosities and patterns that occur within the algorithms have yet to be identified in terms of rational and seem to defy logic. Even more impressive, the pattern that surfaced on May 6th, 2010 was a knife pattern, as if (and perhaps quite fittingly) cutting through the market, second by nanosecond. These patterns havent been fully explained and perhaps hypothetically several things could be at play. Within the article a noise21 theory was introduced as counterparties would tend to send data out into the trade-sphere to distract other players from identifying trading patterns. This also could be serving as the area/function for quote stuffing, the practice of overloading systems and introducing latency (as discussed earlier in this paper). More research has to happen in order to determine the true function(s) of why these quotes are seemingly being placed without any rational or at least easily identifiable reasons. However it is an area for concern.

The knife algorithm at work on May 6th, during the Flash Crash of 2010.

Although the cat is out of the bag and is too late to be put back in when it comes to HFT, this paper is in no way stating that the practice should be banned outright. We are way past the turning back point. Rather the points highlighted within this paper

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are areas where regulators should bear closer scrutiny to the underlying practices within HFT and should reign in the practices that have proven disastrous to financial markets and have undermined investor confidence. The average investor along with institutional investors and their designated market exchanges have needed to adjust negatively in order to account for the practices introduced by the rapid growth of HFT. Although it is true that HFT does create a more liquid environment where buy and sell orders are both easily met at a reasonable price, these functions are negated easily by the influenced prices of stated assets and the loss of liquidity when HF Traders exit the market in highly volatile environments. The processes in place currently allow for disingenuous and anonymous manipulation as well, and these should be core areas that the SEC and CFTC should be looking to for further regulation. It may just be that the bots will now and forever rule the trading floor, but enforcing strict practices will negate any negative factors introduced by such strategies and they may very well prove to be a strengthening block in the future.

Sources: 1. Alain Chaboud Benjamin Chiquoine Erik Hjalmarsson Clara Vega, Rise of the Machines: Algorithmic Trading in the Foreign Exchange Market, May 13, 2009 2. Bank for International Settlements, Press & Communications, Electronic Trading, Monetary and Economic Department, Bank for International Settlements, (BIS Papers, No 12) August 2002, CH-4002 Basel, Switzerland 3. Bruno Biais, High frequency trading, (Toulouse School of Economics), Presentation prepared for the European Institute of Financial Regulation, Paris, Sept 2011 4. X. Frank Zhang, High-Frequency Trading, Stock Volatility, and Price Discovery, Yale University, School of Management, December 2010, Retrieved
November 15th, 2011, http://ssrn.com/abstract=1691679

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5. Michael Chlistalla, Editor Bernhard Speyer, High Frequency Trading: Better than its reputation?, Duetsch Bank Research, February 7, 2011, retrieved November 18th, 2011, www.dbresearch.com 6. Jonathan A. Brogaard, High Frequency Trading and Volatility, University of Washington, Foster School of Business, October 4, 2011, First Draft: July 16, 2010 7. Andrei Kirilenko, Mehrdad Samadi, Albert S. Kyle, Tugkan Tuzun, The Flash Crash: The Impact of High Frequency Trading on an Electronic Market, May 26, 2011, retrieved November 15th, 2011 http://ssrn.com/abstract=1686004 8. lvaro Carteay and Jos Penalvaz, Where is the Value in High Frequency Trading?, February 28, 2011, retrieved November 15th, 2011 http://ssrn.com/abstract=1712765 9. Albert J. Menkveld, High Frequency Trading and The New-Market Makers, (first version) December 9, 2010, this version: August 14, 2011, retrieved on November 15th, 2011 http://ssrn.com/abstract=1722924 10. Alain Sherter, Death Race: High-Frequency Trading is Speeding Out of Control, May 10, 2010, http://www.cbsnews.com/8301-505123_162-43545505/death-racehigh-freqency-trading-is-speeding-out-of-control/?tag=mncol;lst;2 11. Dan Strumpf, Crude Dropped in a Series Of Mini 'Flash Crashes, 'Wall Street Journal. (Eastern edition). New York, N.Y. May 7, 2011. pg. B.14, retrieved from ProQuest (Academic Database) 12. Algorithmic Trading, Investopedia.com, Dictionary, retrieved on November 15th, 2011, http://www.investopedia.com/terms/a/algorithmictrading.asp#axzz1eJfVdTi6 13. High-Frequency Trading, InvestorDictionary.com, Definition, retrieved on November 15th, 2011, http://www.investordictionary.com/definition/high-frequency-trading 14. Jean Eaglesham, High-frequency trades earn $2.3m fine, New York The Financial Times, September 13 2010, retrieved on November 18th, 2011.http://www.ft.com/cms/s/0/488b7a66-beab-11df-a75500144feab49a.html#axzz1ePiSY5Vk 15. Scott Patterson, A Call to Pull Reins On Rapid-Fire Trade --- Pioneer of Computer Trading Assails Newer Technologies,Wall Street Journal. (Eastern edition). New York, N.Y.: Oct 20, 2011. pg. C.1 retrieved from ProQuest (Academic Database)

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16. Ryan DeCaro, High Frequency Trading and the Recent Market Turmoil, Xpyria, Investment Advisors, retrieved on November 15th, 2011, http://www.xpyriainvest.com/high-frequency-trading-and-recent-marketturmoil#_ftnref2 17. Christopher Steiner, Is Another Flash Crash Inevitable By Year's End And Will It Be Triggered On Purpose?, Forbes.com , 8/30/2010, retrieved on November 15th, 2011 http://www.forbes.com/sites/christophersteiner/2010/08/30/is-another-flash-crashinevitable-by-the-end-of-the-year-and-will-it-be-triggered-on-purpose/ 18. Uploaded by MacSlavo, May 6, 2010 - 1 Trillion Dollar Stock Market Meltdown Panic in the Pits, May 7th, 2010. Audio recording/Flash video, www.youtube.com http://www.youtube.com/watch?v=cGYRpANTXWo&feature=related 19. Ben Popper, Stock Market's Robo-Panic Is Sign of Things to Come, May 7, 2010, CBSNews.com, retrieved on November 18th, 2011. http://www.cbsnews.com/8301-505124_162-43340481/stock-markets-robo-panicis-sign-of-things-to-come/?tag=mncol;lst;3 20. Steve Kroft, Tom Anderson, Coleman Cowen, Wall Street: The speed traders, June 5, 2011, Webvideo, 60 Minutes, CBSNews.com, http://www.cbsnews.com/video/watch/? id=7368460n&tag=cbsnewsMainColumnArea.12 21. Alexis Madrigal, Market Data Firm Spots the Tracks of Bizarre Robot Traders, The Atlantic Monthly Group, Aug 4 2010, retrieved on November 17th, 2011, http://www.theatlantic.com/technology/archive/2010/08/market-data-firm-spotsthe-tracks-of-bizarre-robot-traders/60829/ 22. Jaksa Cvitanic & Andrei A. Kirilenko, High Frequency Traders and Asset Prices, March 11, 2010, retrieved from Google Scholar on November 15th, 2011 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1569075 23. Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on emerging regulatory issues, FINDINGS REGARDING THE MARKET EVENTS OF MAY 6, 2010, September 30, 2010. Retrieved on November 20th, 2011 http://www.sec.gov/news/studies/2010/marketevents-report.pdf

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