Views on the integrity of global capital markets
02 June 2014

HFT Strategies: Why the Sudden Fuss over Speed Advantages?

Posted In: Market Structure

Given the controversies surrounding the Michael Lewis book Flash Boys, I decided that to have an opinion of the matter, I needed to read the book. Recently, on a long flight back from New York to Hong Kong, armed with my new Kindle Paperwhite e-reader, I did just that. In this blog post, I would like to comment on a statement found in chapter six: “three activities that led to a vast amount of grotesquely unfair trading.”

The first practice was called “electronic front-running.” This was explained as “seeing an investor trying to do something in one place and racing him to the next.”

In the early 1990s, I started my career as a trainee dealer with a local bank in Singapore. As a rookie, I was posted to the dealing room. There I spent some time on the foreign exchange trading desk. At that time, the wholesale market for foreign exchange was done through what is known as “broker boxes.” This consisted of telecommunication equipment that routed direct from the brokering house to the bank. Because there were about seven to 10 of these “shops” servicing approximately 50 to 70 banks, speed in “hitting” the market made all the difference for a scalper. By way of example, let’s say that US dollars/Japanese YEN was quoted by broker A at “60-70” and broker B at “63-70.” If “60” was hit for whatever reason (not having a link to broker B is the most obvious) and the “63” was not called “off” by the market maker, within a blink of the eyelid it would be hit, with the hitter placing a subsequent bid at “60” to try to earn the three basis points spread. There was some risk in doing this trade, but it generally was very low.

Over time, this speed advantage disappeared when electronic trading platforms were introduced in the market. As with the founding of IEX and the hammer-thumping speed bumps epitomized by “Thor,” progress will neutralize these advantages over time.

The second practice was called “rebate arbitrage.” This was explained as “using the new complexity to game the seizing of whatever kickbacks the exchange offered without actually providing the liquidity the kickbacks was presumably meant to entice.” My understanding of this is that exchanges were paying HFTs to trade with them, most commonly by providing liquidity through the market-making function, and sometimes quite perversely by soaking up liquidity by hitting the bid-offer prices.

I think that incentives of any kind by the exchanges are generally not beneficial to the investor. During the gun-slinging days in the forex markets, I noticed that certain brokers seemed to be getting a major chunk of the business. When I inquired “Why?” — especially when the prices they quoted were not the best in the market — the answer was, “You’ll know as you gain more experience.” I ultimately learned that it was because of the lavish entertainment given to the traders and special information access to trading flows by influential players in the market that led to this “rebate.”

In my experience, once incentives are provided, the individual’s needs and preferences overshadow that of the customer. In this case, the bank actually paid higher transaction costs for access to information of uncertain quality.

The third practice was called “slow market arbitrage.” This was explained as “traders able to see the price of a stock change on one exchange, and pick off orders sitting on other exchanges, before the exchanges were able to react.”

When I became the head of treasury for a foreign bank based in Singapore in the late 1990s, electronic-trading platforms were offered to me by many of the larger banks. As these banks made markets in both the spot and forward markets, because of the fragmented nature of the pricing mechanism there were many arbitrage opportunities. Either spot prices differed, or forward prices were inconsistent with the spot-plus-swap combination. Although the differences were small — at most three pips — it was “free” money for the taking.

In order to capitalize on this, I hired the “Nintendo Boys.” These were young individuals who grew up playing Nintendo games. They were hired not for their foresight in predicting where the currencies were going, but for their speed of execution based primarily on instincts that the markets were off. However, as more banks hired these types of dealers, the opportunities for arbitrage evaporated.

Although the time is different now and technology is playing a big part in enabling these opportunities to exist — at least in concept — the practices are not new. Over time, these inefficiencies will disappear, only to be replaced with newer forms.

One of the most innovative way of “front-running” that I’ve ever seen was on the floor of the Singapore International Monetary Exchange (SIMEX). This was at a time when futures trading occurred on an open outcry basis. I knew a local (an individual who trades for his own account) who was consistently ahead of trading before a big order from a large broker followed. He made millions for himself. When SIMEX closed and he retired, I asked him for his secret formula. He said, it was really very simple: “I learnt to read lips. So, as the broker was confirming the order over the phone with his customer, before he gave the hand signal to the floor trader to execute, I already knew what was going to happen.”

Was all the above wrong, or was it taking advantage of inefficiencies in an imperfect market? Let us know what you think.

Related post: High-Frequency Trading: How Should Regulations Develop in Response to Modern Trading Techniques?


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Photo credit: iStockphoto.com/TCmake_photo

About the Author(s)
Tony Tan, DBA, CFA

Tony Tan, DBA, CFA, is co-head of the CFA Institute Ethics, Standards, and Professional Conduct division. He is particularly responsible for ethics education offerings and the professional standards of CFA Institute. He is also a member of CFA Society Singapore.

6 thoughts on “HFT Strategies: Why the Sudden Fuss over Speed Advantages?”

  1. Paul Williamson says:

    The average investor does not have access to HFT tools therefore they perceive the market as rigged. Hence many retail investors, myself included, have stopped participating in the stock market. If you want retail volume to return end HFT, if not then allow the system to persist as is.

    That being said I think that every bid or ask must be a valid offer to buy or sell. Ghost quotes that are cancelled in fractions of a second are just silly.

  2. Tony Tan, DBA, CFA says:

    Dear Paul,

    Thank you for your insightful comments. I think the main issue in the US market is the fragmented nature of stock exchanges leading to multiple listings of the same stocks in different exchanges. This naturally provides arbitrage opportunities.

    On the positive side, transaction costs in the US are much lower now compared to, say, a decade ago and vis-à-vis other countries, and for the retail investor, unless you are a trader, the difference is quite small. To give you a comparison, in Singapore, where I come from, for a US$170,000 trade, I pay a commission of US$300. For that same size trade, it only costs me $5.99 using my online US trading account. On a pari passu basis, where I use limit orders for both my Singapore and US trades, the US comes out much cheaper.

    On ghosting, that may be an issue. I believe in other parts of the world this is being address by imposing a tax on orders withdrawn. As the markets evolve, regulators will address these issues, but unfortunately, at a much slower pace that what we would like to see!

  3. Randy says:

    Tony,

    Here is a better analogy for activity #1.

    Suppose you want to buy a million dollar flat on Orchard Road. You submit your offer to the builder. However, before the contract goes to the builder, I get to see it. I also get to see everybody else’s offer before it goes to the builder. Based on this vast knowledge, I can buy the flat before you can. I can also buy all the other flats that other people want to buy.

    Then since I know that you (and all the other people) want to buy into this project, I will then sell it to you $150,000 higher than the contract you wanted to put in. I can do this because I know that everybody wants to live in my building on Orchard Road. I know I can lay off the risk and make money by stealing from you (and others).

    Now how is that fair? If you think that HFT is fair from analogy #1, then I urge you to create a website. Please have everybody who wants to purchase a property at any prime location whether or not it is in Hong Kong, Singapore, London, or New York or anywhere else.

    Everybody who wants to purchase these flats will have to send their contract to the website. Let my investors see these prices for a brief period of time. We can choose to front run these natural real estate buyers if we like.

    If you believe that analogy #1 is totally fair, then this should be no problem. All of the governments, builders, and real estate agents should not complain about this.

    Of course, we know this is not fair.

    1. Tony Tan, DBA, CFA says:

      Dear Randy,

      Thank you for your interesting analogy. In my blog, I never said that this was fair or unfair. I tried to explain that because we are working in imperfect markets, these things do happen. In the case of my example for activity #1, information asymmetry was the cause, but it was made available because some banks have higher investments than others in procuring information. I hope this clarifies.

  4. Cornell says:

    Hi, I do believe this is an excellent blog. I stumbledupon it 😉 I will
    come back yet again since i have saved as a favorite it.
    Money and freedom is the greatest way to change, may you
    be rich and continue to guide others.

  5. Michael says:

    Tony-

    Check out Market Regulation Advisory Notice dated September 15, 2014 “Disruptive Practices Prohibited” Rule 575 recently released advisory notice to CME/CBOT traders in Chicago. I believe it will be an interesting read for you. CMEGroup.com Market Regulation Advisory Notices.

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