The Inoculated Investor http://inoculatedinvestor.blogspot.

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An Outsider’s Perspective on High Frequency Trading

I think it would be an understatement to say that there is a lot of confusion in the mainstream press and in
the blogosphere regarding high frequency trading (HFT). For many of us, it is only in the last few weeks
that we have started to add the words “co-location,” “flash trading,” and “predatory algorithms” into our
lexicon. Fortunately for HFT novices like myself, blogosphere luminaries such as Karl Denninger of The
Market Ticker and Tyler Durden of Zero Hedge have been vigilant in trying to educate us regarding the
potential for market manipulation that apparently surrounds HFT. Furthermore, I think that people such as
Joe Saluzzi from Themis Trading have done a great job in explaining what HFT is in a way that people who
have never worked on a trading desk or never created an advanced trading algorithm can understand. As a
result, I am not going to try to explore the nuances and potential pitfalls of HFT. I will let those who have
far more experience than I tackle that. My concern only surrounds the illegal uses of certain HFT strategies.

Having said that though, I happen to think this entire developing story is fascinating. Starting with the
details of the stolen Goldman algorithm and the US prosecutor’s admission that anyone (including GS)
could use it to manipulate the markets, you have a very compelling beginning to a new Russell Crowe
movie about corporate espionage and government conspiracies. And now that we find out that some of
these HFT programs could be used to front run trades and provide phantom liquidity, I wouldn’t be
surprised if Jerry Bruckheimer is currently taking diligent notes. Where is a Law and Order “ripped from
the headlines” episode when you need one?

All joking aside, I think the people who espouse the virtues of HFT could use some advice on how to sound
more credible. If types of HFT are not actually as nefarious as some people seem to believe they are, then
the proponents are doing a terrible a job of defending them. So far, I have seen a couple of arguments that
don’t help their cause in the slightest. Both were articulated by Irene Aldridge of Able Alpha Trading who
is about to publish a book entitled “High-Frequency Trading: A Practical Guide to Algorithmic Strategies
and Trading Systems.” If you haven’t watched her showdown with Joe Saluzzi from last week I highly
recommend it. Not that all of it is comprehensible due to the fact that the CNBC moderators always allow
people to talk at the same time. But, her reactions to the criticisms are very curious and seem somewhat
indicative of person who doesn’t spend much time out of the office or read the newspaper. Here are a
couple quotes from Ms. Aldridge:

Ms. Aldridge: “First of all there is nothing new about high frequency trading…”
Ms. Aldridge: “Everyone knows that front running is illegal, especially in equities, and it is strictly
monitored…”

CNBC’s Steve Liesman: “Are some people able to see the data of other people’s orders ahead of
time and able to trade in front of it using supercomputers?”
Ms. Aldridge: “It’s illegal.”

Huh? Is there some connection between something being illegal and actually being a deterrent? Let me list
a few other things that are illegal: $50B Ponzi schemes, smoking marijuana, jaywalking in New York City
and insider trading. All of these things happen (or happened) often despite the fact that they are illegal.
Obviously, Madoff’s crime is a little more serious than jaywalking, but that just illustrates the point that the
magnitude of illegality does not preclude people from partaking in certain activities. In other words, just
because it would be a huge scandal that would likely land people in jail if HFT firms were actually front
running does not necessarily mean that it isn’t happening. Our recent corporate history is littered with
examples of somewhat brazen attempts to flaunt the law.

Furthermore, the suggestion that we can trust that HFT programs are not front running because trading is
“strictly monitored” by the regulators seems very naïve. Here are some examples of recent regulatory
failures to protect consumers and investors:

1. Fed: Mortgage fraud and predatory lending throughout the housing bubble
2. SEC: Madoff’s Ponzi scheme
The Inoculated Investor http://inoculatedinvestor.blogspot.com

3. SEC: Insider trading- just look back at the spike in the option activity on Schering-Plough (SGP) a
few days before the Merck (MRK) deal was announced and tell me people weren’t trading based
on knowledge of the deal
4. FDIC: Continuing to allow regional banks to carry loans on their books at levels that do not reflect
the actual magnitude of impairment
5. SEC & Others: Allowing the rating agencies to deem anything and everything AAA without any
scrutiny of their models or assumptions

These are just a few examples off the top of my head. I’m sure there are dozens more. Oh yeah, the
regulators have a fantastic track record of spotting and putting a stop to illegal or intentionally misleading
practices. Accordingly, for anyone who wants to defend HFT, my suggestion is to not use the fact that the
regulators are on the beat and that front running is illegal to bolster your case. Instead, say that your firm
does not engage in front running and that any group that does should be prosecuted to the full extent of the
law. Or explain how HFT is like a weapon of mass destruction in that it can be abused or misused by less
honest individuals. But, in the hands of people who believe they have a responsibility to make markets
more efficient and fair, HFT can be a very useful tool.

Additionally, there was another argument that Ms. Aldridge used that I have seen multiple times but does
not necessarily help the case of HFT supporters. This is the contention that HFT is not a new thing so we
should assume no one is misusing their advantages. In a Bloomberg article on the same subject, Frank
Troise of Barclays plc candidly stated:

“This has been going on for quite awhile, and it’s now at a fever pitch…There’s always been an
advantage to executing with speed.”

Are we supposed to conclude from this statement that firms aren’t using their enduring speed advantage to
swindle institutional and retail investors? As we learned with Madoff, just because something has been
going on for a long time does not mean anything about its legitimacy. It is entirely possible that traders
using supercomputers have been able to front run for many years now. Does the length of time that HFT
has been a force in the market really have anything to do with whether or not specific programs are acting
properly? Also, the idea that if front running were going on then it would have already been detected seems
a bit foolish, considering the regulatory failures listed above. Therefore, HFT advocates should continue to
highlight the benefits in terms of providing actual liquidity to the markets instead of asking us to put our
heads in the sand and assume that the regulatory infrastructure is sufficient to protect us from bad actors.

Finally, I would like to conclude with a word of caution. I have no insight into whether or not firms are
using predatory algorithms to front run. I hope it is not happening but at this point nothing would surprise
me. And that is the problem. We have all become so jaded by the actions of too many of our fellow
Americans during this crisis that we don’t even blink anymore when we learn that someone was fleecing or
robbing one of his neighbors. We also are now so used the words billions and trillions that any infraction
that falls short of those amounts doesn’t seem so serious. But, in the case of proven front running through
HFT, let’s not allow our collection outrage be shaped by previously being inundated with scandals or the
magnitude of the crime. I don’t care if the entire scheme only netted $1M illegally. The fact that someone
was willing to ignore the laws and manipulate our markets so brazenly should be enough to spur on
widespread anger, despite the inherent complexity of the crime. If illegality and the presence of regulators
are not strong enough deterrents, maybe in the future public shame will be a more effective method of
preventing abuses.

(Picture of Joe Saluzzi courtesy of sramanamitra.com)