The three stooges of the high frequency apocalypse
What happens when you buy something? Well, someone sells it to you. If you want it for cheap, you sit around and look at different markets (ebay, amazon, craigslist) until someone displays a price you find acceptable. If you want that “something” right now, you drive to a store and buy it. You’ll almost certainly pay a little more at the store, because they need to make enough money to pay employees to prevent barbarians from stealing everything, and to keep the lights on and other such things for your convenience. You can also generally return what you bought to the store much easier than to ebay or amazon. You’re paying for the immediacy (buy it now!) and liquidity (buy as many as you want!) provided by the store. This is a service which costs money. Joe Saluzzi wants all stores to follow the same shag-carpet era rules his little Two Guys operation does. Paul Wilmott apparently wants to make stores illegal, because stores might “distort the economy.” Chuck Schumer is peeved those guys with a shop in his state didn’t fork over the correct amount of campaign contributions.
The stooges diagnose what is wrong with Wall Street: obviously it’s the Quants fault somehow!
I’m not really talking about buying tchotchkes on the internets versus Target or Costco. What I’m talking about is the latest brewing financial moral panic against “high frequency” traders. High frequency traders are people who sell liquidity and immediacy. If you want to buy or sell at a given moment, you will often do business with these guys. Otherwise, you can place a limit order, or wait around for a price you find more acceptable later. High frequency guys provide the service of buying and selling when you want to buy and sell, and they take a risk that the market will move against their book. You pay them to take this risk. In the dark ages before decimalization, this was a pretty simple business to be in, and as far as I know, nobody complained about it. The spread between bid and ask would be at least a “piece of eight,” aka an eighth of a dollar (or a sixteenth later on). Now a days, the spread can be as small as a penny. As such, the people who provide liquidity to the markets have to be a lot more nimble and clever to earn their penny. All that this “high frequency” business really does, is make decimalization possible. Back when the market was measured in 1/8ths, people displayed more depth on the order books, because they had a smaller risk in displaying the prices. Now, people display smaller amounts on the order book at any given instant, because there is money to be made and lost in small price moves. So, you can either buy in cents, and deal with some form of high frequency guy/liquidity provider trying to make money on pennies, or you can go back to 1/8ths of a dollar and pay bigger spreads.
There are a lot of ways in which liquidity can be provided to a customer. It can be direct, as with the example of market specialists above. Liquidity providers may be arbitraging across markets. Liquidity providers may be taking advantage of “statistical arbitrage” -a term which no longer really means anything, but which I’ll borrow to mean “people who earn a mean reverting spread over some reasonable period of time.” For all I know, there are liquidity providers who earn the spread by sticking pins into Timothy Geithner voodoo dolls. “High frequency” is taking a big publicity hit right now, because these guys are making money. Well, of course they’re making money. They’re getting paid to take liquidity risks at a time when there is much less liquidity across all markets. Generally, if I have a large warehouse full of something, and my competitors warehouses burn down, and demand remains more or less the same, I am going to make more money.
I’m pretty sure all this news buzz around the evils of “High Frequency” started with Joe Saluzzi, who appears to be a sort of liquidity provider himself. His fund, Themis, apparently manually gets the best price for his customers. At least, that’s what it looks like on their website. A noble profession, though very likely a dying one. It seems the “high frequency” guys are picking his pocket, because computers are better at finding liquidity than human beings are. Joe blathers on about a lot of things, and I don’t feel like picking apart all the points in his various white papers on the subject. Joe appears to have a lot of time to go on television and indignantly blather about the evils of “high frequency” trading, despite the fact that his company appears to do exactly what “high frequency” traders do. The only difference between Joe and his tormentors seems to be that firm does it manually and in slow motion. I can’t let his nonsense about “false trading signals” pass uncommented though. Since when is anyone entitled to “true trading signals?” Gee, Joe, I’m sorry your crappy old signals don’t work any more; maybe you should invest in developing some new ones? Joe would probably be better off staying home, learning C++ and figuring out how to deal with these high frequency fannullones on a mano de mano basis, you know, sort of like all the other shops like his are doing. It probably won’t get him the attentions of pretty girls as much as being on TV does, but it’s going to be more productive in the long run. I can’t help but like Joe Saluzzi; he seems like a regular guy; un tipo forte, and he appears to be mostly looking after his own self interest. Joe just wants to continue providing liquidity with stone knives and bearskins. I have no doubt that buggy whip manufacturers in the time of the model-T were big advocates of speed limits as well, for the “public good.”
Moe, the coolest stooge, conveniently looks a bit like Joe
Paul Wilmott is someone who should know better than his latest New York Times drivel. I can understand why Paul is sore about the high frequency guys. Presently, high frequency guys are making money and hiring people. Wilmott’s line of business is selling educational and recruiting services for quants. Unfortunately, Paul doesn’t know anything about high frequency or any form of algorithmic trading, can’t sell educational services catering to this type of trading desk, and probably doesn’t place many people with algorithmic trading desks of any trade frequency. Paul’s business is providing education and recruiting services for structurers and hedgers. As such, he probably feels left out of the high frequency party. He shouldn’t be upset; he had a pretty good run when everyone in the world was hiring structurers to hedge risk with those complicated derivative securities which were the last moral Wall Street panic.. Wilmott has a decent book on the subject, and by all accounts, a good operation for placing his students. No doubt, if he is patient, he will be in the money again. Whatever Paul’s issues with the continued profitability of liquidity providers, he has no excuse for making statements like this:
“Leaving aside the question of whether or not liquidity is necessarily a great idea (perhaps not being able to get out of a trade might make people think twice before entering it), or whether there is such a thing as a price that must be discovered (just watch the price of unpopular goods fall in your local supermarket — that’s plenty fast enough for me), l want to address the question of whether high-frequency algorithm trading will distort the underlying markets and perhaps the economy.”
Wilmott, like Curly is the most likable of the lot. Perhaps he also eats hallucinogenic millipedes?
While I am not a famous cavolo like Paul Wilmott, I happen to think liquidity and price discovery is a good idea. The reason these are a good idea, is without liquidity and price discovery, you get people cornering markets and making off with real value at the expense of everyone else, like Jay Gould did in the panic of 1869. Sure, we could go back to call markets and market makers running off with their 1/8ths or whatever Paul sees as more desirable than the present state of affairs. Why would we want to do that? Just to deprive the high frequency guys of a living? Someone will profit from going back to a call system, and lots will make bank on fat spreads. Because Wilmott understands them better? I bet he doesn’t understand call markets any better than the present state of affairs. As for high frequency trading “distorting underlying markets” -the fact of the matter is, high frequency trading is a small business. The scariest numbers I have heard are about 10 billion a year. This is a tiny drop in the bucket compared to the tens of trillions that change hands on the markets these guys provide liquidity for. I bet the guys who provide lunch for Wall Street make more money than the liquidity providers do. Sure, there are pathological ways a bunch of algorithmic liquidity peddlers could go wrong. If they magically turned from mean reversion traders to trend followers, they could have a very negative effect on things. But then, they wouldn’t be liquidity peddlers, and they wouldn’t be high frequency traders either! You know what this would look like? This would look like a whole bunch of testa di cazzos borrowing cheap money and bidding up the market. This is a dynamic that everyone should be well familiar with by now from looking at .com bubbles, oil bubbles and housing bubbles, and it has nothing to do with transactions that last a few milliseconds. Wilmott should know better than to say something this dumb, but I guess being published in the NYT means you have to say something -even if you’re saying something stupid.
Joe, Paul and Chuckie fixing the markets: they’re here to help!
Wilmott then goes on to tell the story of 1987′s Black Monday. He tells the story of how the portfolio insurance guys software got into a feedback situation which caused the market to crash. The first thing you need to know about the portfolio insurance strategy is, even though it was often run by computers, it is not a high frequency strategy. It is the opposite of a high frequency strategy. It is taking a short position on market futures, and keeping that position open as a hedge against your portfolio falling. If you were to take a short position, then sell it the way a high frequency trader does by definition -the feedback effect is impossible. Sure, if every high frequency trader gunned the market at exactly the same time in exactly the same way, with all their cash reserves, it could cause the market to move. Then everyone else would pile in on the position and buy the over sold market, it would mean revert, and the high frequency dudes would lose an enormous amount of money. The second thing you need to know about Wilmott’s fairy tale, is the 1987 crash was arguably not due to program trading. The fact of the matter is, the crash originated in Hong Kong at a time and in a place when people were still calculating greeks on abacuses. Proximate causes were all news-related: America was shelling Iran: duh. I’ll split the difference with Wilmott and say program trading made the crash worse, but program trading no more caused the crash than 9/17/01′s crash was caused by program trading.
As for Chuck Schumer, -he’s such a dirtbag I can’t even bring myself to attempt to comment objectively. If GETCO or Citadel had him on the payroll, no doubt he would be less protective of the “consumer” who Chuckie just saddled with a couple trillion dollars in debt. As Bob Dole once put it, “the most dangerous place in Washington to be is between Chuck Schumer and a microphone.” I suppose after Chuckie’s hatchet job on Indymac (yo, remember that? back in the halcyon days of summer 2008?) and you know, his general scumbaggery -I guess he wanted to go for the hat trick and destroy one of the few businesses still functioning properly in America. Thanks a lot Chuckie.
The resemblance is uncanny, and nobody likes Larry either.
So, people, lest you be spooked into “fare i gattini” by opportunistic bastardos attempting to get you to pick up the pitchforks and torches and go burn down GETCO or Ken Griffin’s art collection, try to think about what these politicians and commentator cretinos are really selling you. Making money is not always a sign of moral turpitude; some people actually earn their dough by providing things that other people want. There are plenty of looting scumbags in our society who richly deserve vilification. High frequency guys? Innocent until someone comes up with a good reason why they’re guilty of anything but selling people stuff they want. It’s too bad there is no great champion of high frequency traders out there to stand up and say, “non mi scazzare i coglioni,” but in the meanwhile, leave my high frequency paisanos alone. They got a job to do.
With apologies to the Italian language: once you start cussin’ in Italian, it’s difficult to stop.