One of the topics most often discussed on Zero Hedge before the wholesale takeover of capital markets by central planners was finally accepted by everyone, was the domination of market structure (first in equities, and now in commodities, FX and even credit) by new technologies such as High Frequency Trading as a result of a shift in the market to a technological platform domination, away from the specialist model, and one where the entire concept of discounting, the primary role of the market in the Old Normal, has been made redundant courtesy of a race to be the first to react to events (i.e., backward looking, and direct contravention with the primary function of markets) courtesy of milli- and nanosecond, collocated servers which collect pennies in front of steamroller and generate profits purely by “virtue” of being the first to trade.
This new “technology paradigm” developed in the aftermath of the regulator complicit adoption of Reg NMS (and to a smaller extend Reg ATS) which unleashed a veritable cornucopia of “SkyNet”-controlled algorithmic traders, even as regulators did not and still do not, to this day understand all the evils that rapid technologization of the stock market has brought, most vividly captured in the May 2010 flash crash, and daily subsequent mini flash crashes, which have achieved one thing only: the total collapse of faith in the stock market by ordinary investors, who now see it for what it is (and always has been but to a far lesser extent) – a gamed casino, in which not only the house always wins and the regulators are either corrupt or clueless, or both.
And while more and more “dumb money” Joe Sixpacks awake every day to the farce that is the stock market, one entity that continues to ignore it, whether due to its own incompetence, due to conflicts of interest, due to corruption, due to co-option, or for whatever other reason, are the regulators, in this case the Securities and Exchange Commission: arguably the most incapable entity to handle the topological nightmare that the current market landscape has become. Which is to be expected: after all only an idiot would expect that when the SEC invites a GETCO, or a DE Shaw to explain and observe the fragmentation of the market, and the evils brought upon by HFT, either in a closed session or before congress, that they would voluntarily expose their business for the parasitic fallout of what once was known as capital formation. After all, it is their bread and butter: to expect them to commit professional suicide by truly showcasing the ugliness beneath it all is beyond stupid. And the flip side are various fringe blogs, which must be relegated to the tinfoil crackpot ranks of conspiracy theorist (even as conspiracy theory after conspiracy theory becomes conspiracy fact after conspiracy fact).
So instead of uttering one more word in a long, seemingly endless tirade that stretches all the way to April 2009, we will this time let such dignified members of the credible, veritable status quo as Credit Suisse, who have released a two part primer on everything HFT related, with an emphasis on the broken market left in the wake of the “high freaks“, which is so simple even a member of congress will understand (we would say a member of the SEC, but even at this level of simplicity its comprehension by the rank and file of the SEC is arguable). As Credit Suisse conveniently points out “market manipulation is already banned”, but that doesn’t mean that there are numerous loophole that HFT can manifest themselves in negative strategies that have virtually the same impact on a two-tiered market (those that have access to HFT and those that do not) as manipulation. Among such strategies are:
- Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
- Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
- Order Book Fade: lightning-fast reactions to news and order book pressure lead to disappearing liquidity
- Momentum ignition: an HFT trader detects a large order targeting a percentage of volume, and front-runs it.
So to all those who still foolish believe in a fair and efficient market: read on, because that concept died long ago, and every day you keep money in the market is one more in which the deck is stacked entirely in the house’s favor, and on a long enough timeline, a total loss of capital is virtually assured.
And for all the regulators, who are somehow still uncorrupted, unconflicted and uncoopted – those very, very few of you – and who still harbor a hope that one day retail investors may regain their faith in the stock market (a critical milestone needed to enable Bernanke’s plan of rekindling the “animal spirits”), read on so you too can now what should be the focus of both regulation and enforcement in a world in which government supervision is several decades behind the curve.
Part 1: High Frequency Trading – The Good, The Bad, and The Regulation
Part 2: High Frequency Trading – Measurement, Detection and Response