Locklin on science

The arguments against HFT

Posted in finance journalism, systematic trading by Scott Locklin on March 1, 2011

People are still whining about HFT. I’m still annoyed at whiners and doom sayers. This has been going on long enough, and enough hot hair has been expelled on this subject, a taxonomy of the contra-arguments is called for.

  1. It’s not faaaaaiiiiir because I can’t do it. This is the Chuck Schumer/Themis argument. The fact of the matter is: nothing about finance is fair, because not everyone can do everything in finance. Why can’t I borrow at the repo rate, and where’s my goddamned bailout money, Chuckie? No fair, yo! If people knew the enormous list of things which the individual investor couldn’t do, well, they’d be peeved about a lot of things. Why can’t I underwrite insurance? Why can’t I have access to Goldman’s data on dark liquidity pools? Why don’t I have 20 awesome Ph.D.’s of the capabilities of Lenny Baum working for me, like Jim Simons used to at Rentech? Why can’t I have all the data sources that a fund has, so I can do stuff like trade on SEC data? The answer is: that’s life. Some people has, some people has not. Amusingly, the individual investor can do things like trade on inside information and can generally get away with it better than SEC monitored funds do; nobody ever complains about that.
  2. Technology: it’s scaaaaaaary. HFT may turn into skynet and take over the world! This argument probably dates back to some australopithecus who was worried fire might cause cancer in rats. Sure, we could regulate trading such that some arbitrary time scale makes up a tick. Who makes that choice? Large market participants seem to like the idea of regulation. You know why? Because they’re the ones who are going to write the regulations. Don’t believe me? Go read something written by a government bureaucrat. What, did you actually think they work for the little guy? They don’t: not any more than Chuckie Schumer is a modern day Cincinnatus.
  3. I am a communist revolutionary, and I don’t want to pay for liquidity. Liquidity should be provided by government functionaries, appointed by proletarian revolutionaries. Also, trade should be banned, as well as money. Our modern economy will be denoted in locally-grown carbon-neutral seashells. Quite a lot of the arguments fit into this category. If you don’t believe in trade, well, I guess I don’t have a good come back. Have fun eating gruel.
  4. I am someone who will benefit from wider spreads caused by knocking out the legions of small HFT players. This is never the stated reason, but it’s almost always the actual reason. This is the actual reason most regulatory laws are passed in the modern age: because someone who bribed a congressman wanted ’em passed. See the link in #2 for more insights.
  5. They’re stealing from the small investor! No, they’re actually providing a cheap service to the small investor. Hundreds of HFT’s are competing for your liquidity dollar, making spreads lower than at any point in human history. You know who really steals from the small investor? Brokers, incompetent money managers, the government who taxes everyone to penury and prints worthless dollars, incompetent and self-serving boards of directors and management, and media crooks who dispense lousy hype, either through incompetence or corruption. Of course, unlike HFT firms, these sorts of rip-off artists have well paid media flunkies and Washington lobbyists, so nobody ever notices. Blaming HFT firms for whatever financial problems we presently experience is like blaming Apple computer for the problems with Alar because they use the word “apple.”

I tire of this artificial “controversy.” No, I don’t have skin in this game, other than being someone who benefits from the cheap spreads provided by hundreds of little HFT’s. I don’t work in this space, and have no immediate plans to do so. This “controversy” is a distraction; a sort of sleight of hand applied to mass media misinformation about a poorly understood subject. Of all the myriad of subjects people could get bent out of shape about our financial system, of all the potential dangers presently faced by America and the world financial system, this is the least worrisome. Why not agitate for the breakup of firms which are “too big to fail?” Why don’t people worry about the preposterous pyramid scheme we call the US government and Federal Reserve system? Why don’t people complain when their jobs are outsourced? Why aren’t shareholders agitating for more board accountability? Why is nobody noticing the fact that nothing has appreciably changed since 2007? No, no, we must punish one of the few honest and competent areas of the financial system: after all, they’re making money.


This “controversy” is offensively dumb. Yet, so few people understand anything about it beyond “they make money,” I figure I’m going to have to hear about it for years to come. Get back to me when someone comes up with a better argument against HFT which isn’t one of the above 5; until then, you’re a moron and I’m not listening to you.

28 Responses

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  1. Rod Carvalho said, on March 1, 2011 at 2:00 am

    I am trying to understand such hysteria. Aren’t trading systems algorithmic? If so, then such systems are, essentially, “black boxes” that map available information to actions, a bit like control systems in engineering, right? One should keep in mind that there’s a difference between automated decision-makers and decision-support systems, though. To me it looks like HFT changes two things:

    1) the speed / rate at which the decision-making is performed

    2) the information available to the decision-maker.

    Personally, I don’t see most human thought as something non-algorithmic.

    • Scott Locklin said, on March 1, 2011 at 2:08 am

      Doing away with HFT is sort of like going back to the days when the “internet” was a bunch of pneumatic tubes.

  2. Matthew Gerring said, on March 1, 2011 at 3:38 am

    Here’s a different argument- finance, and money in general, is supposed to be symbolic of the real economy, allowing people to raise capital to actually do something useful and create a return on said investment.

    High-frequency trading entirely divorces finance from reality, creating more money without actually creating anything of real utility, and more importantly, it sucks up brain power that could be better applied to something other than making the rich marginally richer.

    Go ahead and tell me all that money will go back into the “real” economy and then rainbows and dandelions will shoot out of everyone’s asses, then go back and look at how trillions in imaginary wealth evaporated in the financial crisis, fucking over absolutely everybody.

    You’re only calling this a non-controversy because nothing bad has happened yet. Rest assured, it will.

    • Scott Locklin said, on March 1, 2011 at 5:17 am

      You didn’t read a thing I wrote, you just reacted, displaying about as much nervous system activity as my knee when the doctor hits it with his little hammer. HFT is a tiny, miniscule part of the economy, comparable in size to the NYC lunchtime restaurant business. Unlike the NYC lunch business which could be replaced by the brown paper bag business, it provides a service essential to the economy: liquidity.

      It doesn’t make the rich richer; it pays a group of smart people a decent salary. I suppose you’d rather they worked for facebook. Fair enough.

    • Rod Carvalho said, on March 1, 2011 at 8:05 am

      “…it sucks up brain power that could be better applied to something other than making the rich marginally richer.”

      Charlie Munger once said something like that. But… since when does the U.S. have a planned economy? And finance is sucking up brain power from what sectors?

      • Scott Locklin said, on March 1, 2011 at 9:16 am

        To be fair, there is plenty of engineering of the economy by the government. For example: making mortgages tax deductible to prop up the building/auto/real estate businesses and encourage home ownership, and the various laws and regulations which discourage manufacturing.
        I don’t know why it’s supposed to be awesome to work for a utility company like Google or for gawdsake, Facebook, but evil and immoral to work for GETCO. Probably it is some kind of SWPL thing I’ll never understand short of a frontal lobe cerebrovascular accident.

        • Rod Carvalho said, on March 1, 2011 at 7:26 pm

          “To be fair, there is plenty of engineering of the economy by the government.”

          Sure, but it’s still very far from Soviet-style allocation of human resources. There’s no point in whining that there’s too much brainpower being wasted in XYZ unless one is part of the North Korean ruling elite.

          The status quo merely reflects the incentives.

          • Scott Locklin said, on March 1, 2011 at 7:51 pm

            No arguments here; just 3am kvetching about things that are broken about the financial system that everyone takes for granted as being normal.

  3. tr8dr said, on March 1, 2011 at 1:25 pm

    Forget about HFT, the real dangers in the financial system IMO are still the huge leverage that banks and other financial institutions still wield.

    The other aspect is that the risk takers still have a “free option”, a call on any profits and no responsibility for losses. Traders and salespersons at banks can fail repeatedly with little consequence, usually jump to another institution once the going gets rough with their trading.

    [disclosure I am a HF prop quant / trader in a small fund]

  4. Aaron Smyth said, on March 1, 2011 at 1:44 pm

    “The truth is the high-frequency traders create volatility and create liquidity,” said John Damgard, president of the Futures Industry Association.
    What he apparently meant to say was that they reduce volatility, not create it. And this was just a slip of the tongue. As Sigmund Freud observed, such slips can reveal the reality.

    I am concerned about High-frequency Trading (HFT) for two main reasons: Reduction of the relationship between value and price; Potential for positive feedback.

    Markets exist to enable businesses to raise money, to expand, to thereby employ people, and so on, for the benefit of society. This only works if the market does a decent job of revealing the true value of a company via its share price. Otherwise the market is no different from a casino, a share price may as well be given by the spin of a roulette wheel. Fundamental analysis is supposed to do a similar job. You analyze a company, study its customers, research the management, etc., and come to a conclusion. But fundamental analysis is hard work.

    Much easier is to run a data feed into a black box containing some algorithm, then optimize that algorithm. Your HFT black box doesn’t care a hoot about the true value of a company, it only cares about what happens to the price over the next few seconds. You may spend a few months setting up this black box the first time, but thereafter you can apply it to a wide variety of markets with relatively little effort. Just re-optimize for that market. (And we know from how market players are compensated that the question of whether or not the result is long-term profitable is of second-order importance.) Not so with fundamental analysis, each market is different, each requiring the same weeks of hard work.

    The above wouldn’t matter if the HFT boys didn’t dominate the market. Is it now 70% of trades on some exchanges are HFT trades?

    Whenever you have a bandwagon, such as HFT now is, then you have the potential for systemic risk and feedback. Remember the last bandwagon…the credit products. How did that one turn out for the world economy?

    To get feedback you need a quantity of traders following similar strategies.

    “They all have different strategies,” you say. Perhaps true for a while, but nor for long. Traders copy each other mercilessly, and since people in finance change jobs every two years it doesn’t take long for ideas to diffuse widely.

    But feedback can be positive or negative.

    Negative feedback is when an up move in a stock leads to a sell signal, and thus a fall in the price, and a down leads to a buy, and thus a rise in the price. This dampens volatility.

    Positive feedback is when an up begets a buy, which causes the stock to rise again, causing another buy, etc. etc. And when a fall begets a sell, causing another fall, and further selling, and…

    So which is it? Does HFT result in a reduction of volatility via negative feedback or an increase via positive feedback? This is an easy one. If you are a hedge fund manager which of the following would you prefer? A or B?

    A. Low volatility. Shares go up or go down fairly predictably. No skill is required to make money, even by the man on the street. Hedge funds can’t charge large fees.

    B. High volatility. Very difficult markets, experts needed and can charge large fees. If a fund does well they make a killing because of the enormous profit they have made for their clients. But they are just as likely to lose all their clients’ money, in which case…nothing bad happens to the fund manager.

    Yes, we are in that familiar territory of moral hazard. Of course the funds want to increase volatility and they have found themselves in exactly the place they want to be to make this happen.

    (BTW If you want the mathematics of feedback see PWOQF2 or read the paper The feedback effect of hedging in illiquid markets, (P.Schoenbucher and P.Wilmott.) SIAM J. Appl. Math. 61 232-272 (2000). It’s all about the gamma of a strategy.)

    How did we find ourselves in this place? Because the HFT boys cleverly played the “liquidity card” at the right time. The argument goes along these lines: “When Mom and Pop want to sell off some of their portfolio to fund their retirement then they’ll get a better price if there’s more liquidity. So liquidity is good.” True! For the shares they’ve held onto for 20 years they will indeed get an extra cent. Whoohoo! Break out the champagne! So you mustn’t argue with the liquidity card. The more the merrier, right? Well, no. The fact that during those 20 years their shares have lost 50% of their value thanks to the Great HFT Crash doesn’t ever get mentioned. One extra cent versus a 50% fall? Hmmm.

    Everything in moderation. The more liquidity there is, the more you rely on its providers, and the worse the collapse when that liquidity dries up. And who is in the position to both cause this drying up, and to benefit from it? Why, it’s the HFT boys again!

    Paul Willmot.

  5. sportgamma said, on March 1, 2011 at 1:59 pm

    I attended a lecture were an economics professor claimed that the HFT-field had considerable edge but as other participants recognized how lucrative this market was and entered the field, naturally the market became crowded and profits modest.

    So, as you point out in nr. 5, the benefits get past on to the “consumer”.

  6. tr8dr said, on March 1, 2011 at 2:04 pm

    “Fundamental analysis is supposed to do a similar job. You analyze a company, study its customers, research the management, etc., and come to a conclusion. But fundamental analysis is hard work.”

    Would you say that the stock price intra-day should represent fundamentals? On what information? Fundamentals are a medium-long term convergence target for a stock price. Theoretically should see a more or less smooth curve towards those expectations. However:

    Even before HFT, what factors dominated the prices across the trading day? I would say supply and demand, motivated by sentiment and buying and selling patterns more than anything else. Momentum and MR are byproducts of feedback in the market.

    Is it possible that HFT magnifies the amplitude of these swings? Quite possibly. Depends on what one is doing. That said, many of the HF traders I know are essentially doing prop market making. It is very expensive to aggress the market, so for the most part HF orders are passive and therefore providing liquidity.

    In times of momentum, HF trading will often take an aggressive stance. As one of the participants in the feedback that momentum represents, is surely helping the price move further from its long-run mean.

    An algorithm that does this blindly (such as may have happened in the flash crash) is a poorly written algorithm.

  7. sharpend said, on March 1, 2011 at 2:58 pm

    nice bit of sophistry there.
    true value of a company? 70% HFT? Does that mean anything?

    Forget all that.
    “Shares go up or go down fairly predictably. No skill is required to make money”
    Is one frightening statement.
    You know what you get with low volatility?
    And that begets systemic risk and instability.
    HFT no so much. A little volatility would serve as a reminder of the fallibility of market.

    I don’t disagree that liquidity is somewhat overplayed.

  8. William O. B'Livion said, on March 2, 2011 at 11:48 am

    Narrow minded fuckwits have always whined about middlemen.

    Had a twit I worked with down in Palo Alto whine about the cost (rate) of his mortgage–six percent he was bitching about.

    Fuck, when my folks bought their second house (1974) they would have killed for a six percent mortgage (and knowing my father that might be literally true). At some point they refinanced it because the rate had fallen to somewhere around 9 percent.

    This is the same shit.

    To the first nincompoop who responded–No one “makes” money. People add *value* (well, some do. Some are net-negative. We call them middle managment) HFT types add value by making things convenient for people, They buy and sell not when they want, but when there is an opportunity.

    To put in terms you might understand, they’re like your neighbourhood dope dealer. Not the guy who hangs around the highschool trading crack for blowjobs, but the old dude who lives in that crappy house, the one with teh long hair and hte old volvo. The one who never has a LOT to sell, but he’s always got a dime somewhere when you need it. He doesn’t come to your house, he doesn’t bother anyone, and if you come into a little extra and are short of cash, he’ll buy it off you cause he knows this dude who’s looking.

    Now, of course the HFT types don’t drive volvos, and most of them don’t hang round highschools looking for oral pleasure (Not even colleges these days, except for maybe in the bars near bigger MBA factories where there are buxom young lasses working on their MRS degrees).

    Look, the “ruling elite” fucked up.


    And again the News Media is trying to cover for their buddies and dump on the folks they don’t like.

    And again the half educated nitwits are sucking it because it fits in with their asinine and simple minded world view.

    In the Nuclear Reactor game there are some people working on reactor types that use physics to prevent bad shit from happening. They don’t take reality into account when designing a nifty reactor, they use reality–physics, materials science, whatever you want to call it, as a BASIS for designing the system. This doesn’t wind up with a system that is failproof, but it does wind up with a system that fails more elegantly, more safely.

    When “designing” your economic system you need to do the same thing. The western canon from the Greeks forward keep repeating the same sorts of lessons about people. We haven’t changed much since the first Neolithic whore gave it up for a leg of mastadon.

    Any time you build a system that begs to be gamed, it will be.

    Quants and HFTs didn’t cause this economic disaster. It was caused by politicians, community organizers, poverty pimps, lobbiests and government agencies.

    Oh, and ignorant motherfuckers who couldn’t do math. No fucking way you can afford a 150k house on 30k a year AND have a late model F150 AND a Camry AND a bass boat AND a 45 inch home theater system and and and.

    • Scott Locklin said, on March 3, 2011 at 3:38 am

      Let me know when you run for office: you got my vote.

    • Chris said, on March 11, 2011 at 3:46 am

      Community organizers? You take what seems like an intelligent response to a subject and add a little political stupidity and make yourself seem like those nitwits who think Fox is fair and balanced.

    • Chris said, on March 11, 2011 at 5:48 am

      Oh, and the disaster wasn’t at all , in any way, caused by mortgages being given by dimwits to people who couldn’t afford them, and then packaging them together to hide the true risk associated with them and then trying to sell them to unsuspecting dupes who trusted the ratings firms to do their jobs?

      • Scott Locklin said, on March 11, 2011 at 5:59 am

        What difference do ratings firms make when the loans are backed by the government? Ratings firms say T-bills are AAA: nobody believes that either.

        • Chris said, on March 12, 2011 at 5:20 pm

          Yeah, you’re right… No one really thinks t-bills are safe. The whole thing really is the fault of those organizers. You know, the people who get communities together to have neighborhood watches and clean up parks and protest when the police do a shitty job. it’s their fault.

          Ever get the feeling you try too hard sometimes, Scott?

          • Scott Locklin said, on March 19, 2011 at 7:13 am

            Only when I’m working on shitty projects. Why do you ask?

  9. HFT 3 | FMTrading Blog said, on March 3, 2011 at 2:51 am

    […] But this guy puts it better than me. Have a read of this article, The arguments against HFT https://scottlocklin.wordpress.com/2011/03/01/the-arguments-against-hft/ […]

  10. fmtrading said, on March 3, 2011 at 3:05 am

    Nice taxonomy, nails it.

    Could you also have a look at those wanting HFT to be required to provide liquidity in times of extreme volatility? I have no idea of the basis of the argument that HFT should be required to make a market when no-one else will, it is not as if HFT is a specialist with sole access to the order book and all the financial benefits that brings.

    • Scott Locklin said, on March 3, 2011 at 3:36 am

      I don’t understand their argument. Themis types stop trading when it’s not profitable. Why shouldn’t ones who know C++ do the same thing? The day of the market specialist is over. More event driven traders and other volatility harvesters would help in times like that. If the dipshits who run the exchanges would stop busting high volatility trades, I’d be happy to risk my personal capital making this better.

  11. […] PhD physicist I regularly follow the blog of explaining some criticisms of HFT in 2009, and again in 2011. Famous investor Dennis Gartman gets behind HFT as well. My views probably mirror Gartman’s […]

  12. isomorphismes said, on March 27, 2015 at 10:15 pm

    Well, slightly different under #1 is the Haim Bodek story. Which is that only certain people were close enough to the exchange to know all order types. The other side is that Bodek didn’t read the fine print, but this is a different argument than your 5.

    Additionally afaics #1 as you stated it is extra wrong because your father doesn’t need to have a seat at the exchange to get into market making anymore.

    And one more, anyone who thinks HFT is free money needs to look at the Knight Capital / Getco merger. No way to argue that one mistake having the ability to cost you ¼ of your firm’s value in a morning isn’t taking on risk. Look up a couple other names like Allston and RGM and check the news feeds about those specific firms, you’ll get a second perspective than NPR’s “Oh Dear, Numbers!”.

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