April 6, 2014
Weekly Market Outlook
By Keith Schneider
Considering all the hupala about Michael Lewis’s new book , Flash Boys, I would like to weigh in on the subject matter. Having been an independent floor trader on all the NY Commodities exchanges and having develped several high end computerized trading systems, I am quite familiar with the subject matter of High Frequency Trading (HFT). The first thing is that no matter how much things change, it’s remarkable about how much they stay the same.
Back in the day when dinosaurs roamed the earth , the only way to buy a stock or a futures contract was to place an order with your upstairs broker who then sent the order to the floor of an exchange. All orders ultimately ended in a floor brokers hand and through an open outcry system( screaming at each other in the trading pit), they executed the order. This was the primary way to transact business which I always considered as the last bastion of pure capitalism. The highest bidder and the lowest offer had to be recogonized first, and the playing field was level. Your talent to trade determined the outcome.
Well, most of the time. There were three types of exchange members, Independent Floor Traders ( like myself) who only traded for their own accounts, ate what they killed for dinner and only made money if they were good enough to figure out which way the market was going to move next. The other type of exchange member was the Floor Broker, and they only executed trades for others and earned a brokerage comission. The third type was one who did both.
Many of the independent floor traders primarily scalped the market (quick trades lasting seconds or minutes), took risk and provided liquidity to the markets which allowed the larger orders to get done with minimum price impact. Independent floor traders made their money by reading the market or tape and had to master knowing when big institutional buying was coming into the market, how strong or perisitent it might be and then trade accordingly. We actually took on risk and performed a crucial function.
Therefore, It was critical that new institutional buying was revealed to all the brokers in the trading pit at the same time. This allowed for best execution for the big buyer and a level playing field for the independent traders. If the specifics of large orders were revealed to certain other brokers in the pit in secret, it gave an unfair advantage to those players in the “know” as they could buy ahead of everyone else, trip the big orders off, step in front of those orders, and then sell at much higher prices, leaving all the other players at a big disadvantage. Some independent floor traders operated in kahoots with floor brokers, tipping off their friends and and costing the bigger players and other independent traders fortunes. Those brokers that colluded often settled their scores with a round of golf and cash under the table. Ultimately, some of those floor traders were caught, indicted, and others simply got away with it. When the World Trade Center went down on 9/11, the Commodities Futures Exchange Comission(CFTC) lost its offices as well and some traders under investigation for front-running got off as the paperwork vanished along with the towers.
So fast forward to today where HFT algo’s dominate the market. Just like what happpened on the floor years ago, some HFT performs a useful market making function adding liquidity, while many HFT shops just game the system. Don’t be fooled by low comission costs, as many brokerage firms tout their low fees, but don’t tell you that they are selling you out to HFT shops that get to look at your orders before they hit the exchanges computers. Some brokerage firms are simply victims as well. The collusion between some brokerage firms, the exchanges and HFT shops is not any different than what occurred years ago between exchange members. Now they just do it with computers and fibre optic cables which operate at lightspeed. Revealing orders to HFT shops is frontrunning and is illegal, however legitimate market making and high speed speculation is needed to maintain orderly markets. Certain order types, specifically Flash Trades which is equivelent to jamming the markets with orders that are specifically designed to facilliate frontruning real orders, are the worst culprits. The exchanges and brokerage firms should be banned from selling order flow to HFT shops that are not providing liquidity. That’s our take, and if inclined, let us know what you think. You can e-mail me at firstname.lastname@example.org.
Meanwhile, the US stock market is looking very heavy and had a key reversal pattern on Friday, while Brazil and some of the countries we mentioned in last weeks video did quite well. Commodities such as sugar, corn, and coffee also firmed in the wake of Fridays sell-off. The crises in the Ukraine is heating up as Putin raised the price of natural gas to it wayard neighbor by 80% this week. Like a jilted lover, he is using all his powers to convince her to return.
To see how things are setting up at this critical juncture, check out this weeks video.