High Frequency Trading Not covered on final exam, Spring 2018

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1 High Frequency Trading Not covered on final exam, Spring 2018 Disclosure: I teach (for extra compensation) in the training program of a firm that does high frequency trading. Capturing the advantage: trading floors and electronic exchanges In (physical) floor markets Only a few people can directly participate. Floor traders have more information and more timely information. Electronic markets were envisioned as equal access. Bids and offers [will] compete instantly, equally and fairly regardless of their origin since, once entered into the system, they [will] be instantly reflected in the summary displays and capable of being executed. All brokers, dealers and investors [will] have equal, simultaneous access to all data. Morris Mendelson and Junius W. Peake (1979). "The ABCs of trading on a national market system." Financial Analysts Journal 35(5): and Joel Hasbrouck, All rights reserved 2 1

2 The reality Early electronic markets used visual displays and graphical user interfaces (GUIs) like the RIT client. Order entry and modification limited by human reaction times (around milliseconds) Later markets used application program interfaces (APIs). These allow electronic order entry, which is limited by computer speeds and communication latencies (delays). The delays are small, but important. Being first is more important than being fast Joel Hasbrouck, All rights reserved 3 Fast or first? If everyone else takes one minute to enter an order, I can be first in line if my delay is 59 seconds. If a few people cut their delay to 30 seconds, I have to speed up just to stay even. Forces of competition may lead to an arms race Large investments are made to reduce order entry speeds by a few microseconds. Next: the race between New York and Chicago 2018 Joel Hasbrouck, All rights reserved 4 2

3 Information Transmission Between Financial Markets in Chicago and New York Laughlin, Aguirre, and Grundfest. (2013) Using relativistically correct millisecond-resolution tick data, we document a 3-millisecond decrease in one-way communication time between the Chicago and New York areas that has occurred from April 27th, 2010 to August 17th, : new latency-optimized fiber optic connection : new line-of-sight microwave networks We estimate the total infrastructure and 5-year operations costs associated with these latency improvements to exceed $500 million Joel Hasbrouck, All rights reserved 5 And a historical note from The History of the Philadelphia Stock Exchange (1911) Prior to the introduction of telegraph wires in 1846 William C. Bridges maintained a unique private telegraph system between Philadelphia and New York. By the ingenious device of establishing stations on high points across New Jersey on which signals were given by semaphore [flags] in the daytime and by light flashes at night, information on lottery numbers, stock prices, etc., was conveyed in as short a time as ten minutes. Some of the mysterious movements in the stock markets were ascribed to this [system] Joel Hasbrouck, All rights reserved 6 3

4 The broad dimensions of speed competition Faster computers Trading systems don t use off-the-shelf components. They are usually tweaked to go faster. Colocation: traders move their computers to be physically close to the Exchanges computers. Exchanges data centers house blade servers. A trading firm can put its computer on a circuit board ( blade ) and rent a slot on a blade server Joel Hasbrouck, All rights reserved 7 Communication Replace standard commercial telecom facilities with dedicated microwave networks, fiber-optic links and so forth. The ultimate limit is the speed of light. NYC to Chicago is about 1,200 km meters meters/second = seconds = 4 milliseconds NYC to Shanghai is about 12,000 km (40 ms.) Where are the exchanges located? (from hudsonfiber.com) 2018 Joel Hasbrouck, All rights reserved 8 4

5 2018 Joel Hasbrouck, All rights reserved Joel Hasbrouck, All rights reserved 10 5

6 The current landscape Computerized algorithms ( algos ) are widely used by virtually all market participants. Many brokers make advanced algos available to their customers. A return to manual/floor markets is not likely. But the most advanced technology is used by high frequency traders (HFTs) operating as proprietary trading firms (PTFs) 2018 Joel Hasbrouck, All rights reserved 11 The HFT/PTFs have largely replaced traditional market makers NYSE specialists/dmms or NASDAQ market makers Like traditional market makers, the HFT/PTFs Post bids and offers, Trade many times each day, Keep positions close to zero, and end the day flat. Unlike traditional market makers They aren t obligated to post bids and asks. They can withdraw at any time. They can hit others bids and lift others offers. Recall: NYSE specialists couldn t trade in a destabilizing fashion Joel Hasbrouck, All rights reserved 12 6

7 The HFT debate in a nutshell Pro HFTs are just like traditional market makers (in a good way). Their profits are compensation for the risk they bear. They arbitrage across markets and increase efficiency. They stabilize markets. Trading costs have declined for retail investors. ModernMarketsInitiative.org (an HFT industry trade group) Con HFTs are just like traditional market makers (in a bad way). They exploit their access to take advantage of the customers. Their arbitrages are simply based on minor differences in latency, being one millisecond faster than everyone else. They make markets more volatile. Trading costs have increased for institutional investors. Themistrading.com (Sal Arnuk, Joseph Saluzzi); Nanex.net (Eric Scott Hunsader) 2018 Joel Hasbrouck, All rights reserved 13 Iextrading.com ( A fair, simple, transparent market. ) IEX started as a US agency broker unit of RBC (Royal Bank of Canada), run by Brad Katsuyama. An agency broker works on behalf of customers and does not trade against them. The early history is described in Flash Boys (Michel Lewis). IEX developed and implemented algorithmic strategies to help their clients avoid an HFT technique called latency arbitrage. Following the (favorable) publicity from Flash Boys, the group left RBC and attempted to set up an exchange Joel Hasbrouck, All rights reserved 14 7

8 IEX s first product: THOR (Tactical Hybrid Order Router) A pension fund wants to buy a large quantity. The fund sweeps multiple exchanges 2018 Joel Hasbrouck, All rights reserved 15 Suppose that transmission to A is fast, but transmission to B is slow 2018 Joel Hasbrouck, All rights reserved 16 8

9 Latency arbitrage With varying system latencies, different traders learn about current market conditions at different times. A fast (low latency) player can appear to predict the future from the perspective of a slow (high latency) player. Latency arbitrage refers to a class of strategies that exploit these differences Joel Hasbrouck, All rights reserved 17 The THOR solution: Mega delays the order sent to A so that it arrives at the same time as the order sent to B Joel Hasbrouck, All rights reserved 18 9

10 How do you delay a signal? The IEX Coil Add an extra length of fiberoptic cable to the transmission line. The spooled cable adds a 350 microsecond delay. That s seconds Joel Hasbrouck, All rights reserved 19 The IEX exchange proposal As an agency broker, IEX developed THOR to help customers get better executions. IEX believed that the principle of delaying orders and information was worth incorporating on a broader basis. IEX proposed an exchange in which delay was a central, structured feature. In June, 2016, the SEC approved the application. IEX is now operating as an exchange Joel Hasbrouck, All rights reserved 20 10

11 How should exchanges restrict speed advantages? Speed bumps (deliberate delays, the IEX solution) Give priority to limit orders that commit to minimum life. NASDAQ proposal. Take two identical limit orders, Buy 100 shares, limit $20. Normally, priority of execution would be decided by visible/hidden, and then by time of order entry. Suppose order A can be cancelled at any time, but order B can only be cancelled with a one-minute delay. Order B would have priority. Reward patience Joel Hasbrouck, All rights reserved 21 11