Locklin on science

Michael Lewis: shilling for the buyside

Posted in finance journalism, microstructure by Scott Locklin on April 4, 2014

Journalism, in the ideal world, is supposed to inform the citizenry of facts important to their well being. Modern journalism seems to involve issuing press releases from the oligarchical reptiles who are destroying Western Civilization. Maybe I am a naive fool, and it was always thus. Either way, Michael Lewis’s latest book lends credence to the view that he is a very modern journalist.


lookin a bit scaly, bub

Lewis’s book purports to be about high frequency trading. He manages to write several hundred pages of gobbledeygook without actually speaking to a High Frequency Trader (unless you count his incongruous encounter with poor Sergey Aleynikov ). The story Lewis actually tells is one of incompetent sell side traders who started an exchange which serves the interests of wealthy buy siders and shady brokers.

Brad Katsuyama is the hero of the book. Lewis’s recent books use the dreary trope: the band of clever and plucky outsider misfits who take on the establishment. Katsuyama’s misfittery is he’s an Asian who is good at sports, bad at math and computers; and even though he worked for a Wall Street bank, he went to a crappy Canadian school instead of Yale-vard. Among his misfit sidekicks are a potato-wog who is good at network ops, but who could never get a break on the street (I can relate). Also, a fat grouch from Brooklyn, a computer genius, a puzzle wizard and a few other guys who fade into the woodwork. They worked for RBC: a Canook bank which is supposedly the least Wall Streety place on the Street.

The plucky outsiders in this story are not portrayed in a particularly flattering way. In fact, they come off as  dimwitted incompetents. Katsuyama was an old school block shopping sell side trader. If you remember my previous pieces on  HFT nay sayers: Joe Saluzzi was also a sell side block shopper. Old fashioned sell side guys have obsolete jobs. Their jobs are to find liquidity for “buy side” customers buying into or liquidating a large position. Katsuyama’s anger at the idea that “the market is rigged” seems the simple rage of a man who has been assigned a task he is not qualified for. There are tales of he and his team wasting hundreds of thousands in RBC money executing bad trades to see what happens. They seemed shocked, shocked, that the market would move away from their ham-fisted dumpings of huge blocks of shares to someone else’s routing system.


Lewis keeps going on about how “nobody understood” any of this back in 2009, except for his plucky outsider heroes. If “nobody” understood it, how was I was able to write about it on my blog in 2009? Over 100,000 people read my various blogs on HFT that year.  If you were not among the elite group of more than 100,000 insiders who read blogs, any punter could have purchased the Larry Harris book “Trading and Exchanges” available on Amazon.com for $71.58 + tax. This is how I originally clued myself in (thanks FDAX-H). Larry’s book was published in 2002.  In early 2010 Barry Johnson published the book, “Algorithmic Trading and DMA” which explains the profession dedicated to getting a good fill on the modern electronic trading landscape. So, in 2010, there was not only a  job description, “algorithmic trader,” for getting a good buy-side fill, there was also a “how to” book on the subject.  Such people perform the function that used to be done by sell side people like Katsuyama and Joe Saluzzi. Lewis repeatedly states that this was a mysterious topic and nobody was talking. Actually, it is an extremely well understood topic;  library shelves groan with volumes dedicated to the subject.

No books were really needed; history and experience should suffice. Back in the days of pit traders, if you threw a huge order at the pit, you might get a fill on a couple of round lots. The rest of the pit is going to change their prices, because they figure anyone swinging 10,000 or 100,000 share orders around must be informed traders. If they’re informed traders, they need to pay for their immediacy. Informed traders may be criminal insider-trader creeps,  they may be people with really good trading strategies; it doesn’t matter -they’re informed somehow: they know stuff. If the market maker doesn’t adjust their prices in front of an informed trader, the market maker will go bankrupt. That’s market economics 101. As I previously described it in 2009 in the Three Stooges of the High Frequency Apocalypse;

What happens when you buy something? …  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.

Immediacy costs money. Markets have always moved prices away from large orders. Market participants  have always been able to cancel or move a limit order. That’s one of the features of the limit order. If  Katsuyama didn’t understand these simple facts, he had no business collecting a $2 million a year paycheck shopping blocks for his customers, because he didn’t understand the basics of his profession. It’s  possible that Lewis simply misunderstood something Katsuyama explained to him. It’s also  possible that Katsuyama is a shark who told Lewis a lot of bullshit to get good press for IEX.  This leaves only two possibilities: either Lewis is a credulous idiot who is not competent as a journalist, or Katsuyama is an idiot who was not competent as a trader. Take your pick.



They made their money trading flow as well

Where it gets interesting is where Lewis claims bigshot buysider crybabies like Loeb and Einhorn  never heard of any of this. They made it sound as if, back in the day when Loeb and Einhorn were paying 1/8 of a dollar spreads to knuckle-dragging pit orcs, no rock-ribbed he-man trader with 10lbs of undigested beef in his lower intestine would would dare move his price away from where Loeb and Einhorn wanted it. Why, moving the price away from a big order: that’s un-American!

So … these “plucky underdogs” helped Katsuyama form a new stock exchange, IEX. They claim that no sort of nefarious activity is possible on IEX, because, well, “trust us!”  Liquidnet’s average cross is 45,000 shares; over 100 times the vaunted liquidity figures provided by IEX.  If I traded stocks, why should I trust IEX over Liquidnet? Because Michael Lewis says they’re honest guys? If I believe the tales of Michael Lewis, the founders of  IEX are a collection of “traders” who do not know how to trade, and the market itself is owned by … buy side traders. He seems to give IEX sloppy wet kisses for honesty, yet sees nothing wrong with the fact that they’re owned by a bunch of buy side guys. They’re also owned by some unknown buy side guys, which does not inspire confidence. Buy side guys, if they’re good at their jobs are informed traders.  Nobody wants to trade against informed traders. Everyone wants to trade against noise traders.


IEX  has simple order types; limit, midpoint, fill or kill and market: I  approve of this. On the other hand:

“IEX follows a price-priority model first, then by displayed order second. Then comes broker priority, which means a broker will always trade with itself first, which Katsuyama described as “free internalization.” He explained that brokers do not pay IEX to trade should an order be matched against another order from that same broker. This, he added, offers brokers incentive to trade in IEX.”

Hey now, wait a minute. Internalization and broker priority is pretty much the same thing as dark crossing, which Lewis was trying to tell us was bad. Now it’s supposed to be OK when Goldman does it?  Later, Lewis actually quotes Katsuyama saying there were only a few brokers acting in their customer’s interests:

“Ten,” Katsuyama said. (IEX had dealings with 94.) The 10 included RBC, Bernstein and a bunch of even smaller outfits that seemed to be acting in the best interests of their investors. “Three are meaningful,” he added: Morgan Stanley, J. P. Morgan and Goldman Sachs.

I think this is the crux of this story: according to Michael Lewis and Katsuyama, we’re supposed to trust people like Einhorn who have been convicted of insider trading, people who are suspected of insider trading (buy side is by definition rife with this; particularly firms that do merger arb and special events), J.P. Morgan, Goldman and Morgan Stanley: we’re supposed to trust these guys more than we’re supposed to trust a bunch of tiny little market making firms who had been inconveniencing them by taking away some of their flow. Lewis tries to make this seem like a battle between the underdog “good guys” and the evil establishment. To believe this, you’d have to believe that Goldman Sachs and people like Einhorn are underdogs, rather than the actual establishment. To believe this, you’d have to believe the tiny industry of HFT traders actually rules the world and buys off congressmen and the SEC more than … J.P. Morgan and Goldman.

To give you a sense of scale: the largest HFT firm I know of, KCG, has operating cash flows of $140 million a year and a  modest market cap of $1.4 billion (betcha didn’t know it was a publicly traded company: Lewis certainly doesn’t mention it). JPM has operating cash flows of  $100 billion a year, almost a trillion on the balance sheets, and a quarter trillion or so in market cap. David Einhorn is personally worth $1.25 billion dollars. KCG’s entire market cap is only slightly more than that, and it employs 1200 people. Yet, somehow the HFT firms are the evil establishment, and JPM and Einhorn are … the plucky underdogs standing up for truth, justice and market makers not changing their quotes when some reptilian oligarch dumps 200,000 shares of YoyoDyne on the market.

Yeah, I might believe that. I might believe that if I were a dribbling retard.


Put down Lewis’s book; read one by Bernays

Doing a bit of investigation into who owns IEX: we have the $13.2 billion  activist shareholder fund Pershing Square, owned by Bill Ackman, another “underdog” worth $1.2 billion. We have the $6.7 billion Senator Investment Group. Scoggin Capital is only worth $1.8 billion; they do distressed debt and mergers, and have managed to only have one down year in 25. Another investor is venture capitalist  Jim Clark, net worth $1.4 billion. He is particularly noteworthy as being a pal of Michael Lewis, and almost certainly the guy who made the introductions to the “flash boys” at IEX. Brandes Investment Partners is an old $29 billion AUM politically influential money management firm doing value investments, and is run by another billionaire. Third point, a hedge fund with $15 billion, also working in special situations aka “distressed debt and mergers,” run by  Danny Loeb (who also miraculously has only one down year). Another investor in IEX is a little place called  Capital Group Companies, one of the biggest buy side investors in the world, with $1.15 trillion AUM. Capital Group has been more or less scientifically proven to be one of the most powerful and influential corporations in the world.

You get the idea: IEX is not owned by plucky underdogs. It is owned by very rich and powerful “buy side” people. People who find the present system of liquidity provision inconvenient.  Buy side has always found liquidity providers inconvenient; they had to pay old school “sell side” traders like Katusyama to work the trades for them at the very least. There wasn’t much they could do about it until now. Now that they own  almost everything, they can open their own damn stock exchange and buy some cheap brokerage flow. That and unleash Michael Lewis, the FBI and New York Attourney General on the peasants who make them pay for liquidity.


IEX … little investor… blah blah blah

I  don’t think IEX and their investors represent the interests of “the little guy” at all. The actual little guy (aka people like me) does pretty well making small orders with the present system. If you  believe Lewis’s book, the thing we’re supposed to be worried about is telegraphing a big buy or sell by routing  your order to several different exchanges. The thing is, “the little guy” doesn’t make large buy or sell orders, and unless he does, what Lewis describes is impossible. The people IEX benefits are exclusively preposterously wealthy buy side people. That and the brokerages who get to trade against the pieces of their flow that they want. Pardon me if I notice that such people aren’t exactly tribunes of the people. What’s actually going on here is the brokers are, as usual, taking the flow. They’re giving up some of the leftovers to the buy side guys, who also pocket the exchange fees. If you’re worried about flow or think the present system of liquidity provision is somehow predatory: this is a buzzard and a hyena sharing a carcass.

I have no dog in this race: I’m not a HFT, I have never taken a dime from any exchange, and I haven’t so much as executed a stock trade in 4 years.  Everything I’ve read, and all the traders (buy side and otherwise) I’ve spoken with seem to think that HFT market makers have improved things from the pre-decimalization bad old days of pit traders who got their jobs because they went to the right New York City high schools.  I know for a fact that HFT market making as a business is nowhere near as profitable as it was even a few years ago. This is exactly what you would expect when you have lots of smart people competing in a not-so profitable business. I don’t think the use of computers makes markets any more inherently dangerous, any more than the use of computers in automobiles makes them  more inherently dangerous. If you asked me what I thought the worst thing about the present system was, it would be the profusion of weird order types. Something that IEX, to their credit, gets right.  There are actual frauds in HFT, just like there are in any other business involving money, from the Avon lady on up the food chain. The worst HFT tort I can think of is the practice of “quote stuffing.”  Lewis (of course) never mentions this, and I have read nothing which indicates IEX is ready for it.

I know a few HFT type people. One of ’em might be even be as rich as Michael Lewis.  So far, all the ones I have met are clever and decent people, and I figure whatever they’ve managed to earn by the sweat of their brows, they deserve it. I’m not real pleased with the idea of a small group of decently paid, politically helpless nerds being the fall guys for a bunch of crooked oligarchs who don’t want to pay for their liquidity.

Speaking of which: FREE SERGEY



despite the awesomeness of his pantaloons, this man’s legal problems are a bad sign for America


Edit Add:
This review by a trader lists 15 more technical inaccuracies in the book. He also noticed that broker priority is shady business if we’re talking about helping “the little guy” here.

Edit Add2:

This trader gives a really great review.

The compass rose pattern: microstructure on daily time scales

Posted in chaos, econophysics, microstructure by Scott Locklin on August 12, 2010

One of the first things I did when I fired up my Frankenstein’s monster was plot a recurrence map between equity returns and their lagged value. This is something every dynamical systems monkey will do. I did. In physics, we call it, “looking at the phase space.” If you can find an embedding dimension (in this case, a lag which creates some kind of regularity), you can tell a lot about the dynamical system under consideration. I figured plotting returns against their lags would be too simple to be interesting, but I was dead wrong. I saw this:

A high quality compass rose can be seen on Berkshire Hathaway preferred stock

I convinced myself that nothing this simple could be important (and that it went away with decimalization), and moved on to more productive activities, like trying to get indexing working on my time series class, or figuring out how to make some dude’s kd-tree library do what I wanted it to. I realized just today, this was a mistake, as other people have also seen the pattern, and think it’s cool enough to publish papers on. None other than Timothy Falcon Crack, bane of wannabe quants (and their employers) everywhere, was a coauthor of the first paper to overtly notice this phenomenon.

A slightly later epoch pre-decimalization

You can sort of see why this pattern would fade out with decimalization. If you’re trading in “pieces of 8” (aka 1/8ths of a dollar), returns which don’t neatly divide into 1/8ths will not be possible. In other words, there are only 7 prices between $20 and $21, as opposed to 100 like there are now. Therefore you’d expect to see some gaps in the lagged returns, which are just price ratios. Roughly speaking, if the average variance is small compared to the size of the tick, you’ll be able to see the pattern. At least that’s what most people seem to think. Weird that Berkshire Hathaway should be effected by this, but as it turns out, it had an effective tick size which was fairly large compared to daily motion, because the people trading it were lazy apes who wouldn’t quote a price at market defined tick size (which, even at 1/8ths was very small compared to Berkshire Hathaway’s share price of several tens of thousands of dollars).

Here you can still see some evidence of Compass Rose in the early decimalization era

One of the interesting implications of all this: if ticks are important enough to show up in a simple plot like this, what happens when you apply models which assume real numbers (aka virtually all models) to data which are actually integers? This is something I’ve wondered about since I got into this business. Anyone who notices his model returning something which has many decimal points at the end …. when the thing you’re measuring should be measured in integers should notice this. I don’t think this sort of issue has ever been resolved to anyone’s satisfaction; people just assume the generating process uses real numbers underneath, and average up to the nearest integer; sort of like trusting the floating point processor in your computer to do the right thing. The compass rose points out dramatically that you can’t really do that. It also demonstrates that, in a very real way, the models are wrong: they can’t reproduce this pattern. For example, what do you do when you’re testing for a random walk on something like this? Can it possibly be a random walk if the returns are probabilistically “loitering” at these critical angles? Does this bias models we use? Smart people think it does. Traders don’t seem to worry about it.

Finally, the compass rose is completely gone in the more recent epoch of decimalization for Berkshire Hathaway series A

Some other guys have attempted to tease some dynamics out of the pattern. Not sure I buy the arguments, since I don’t understand their denoising techniques. Others (Koppl and Nardone) have speculated that “big players” like central banks cause this sort of effect by creating confusion, though I can’t for the life of me see why central bank interventions would cause these patterns in equities. Their argument seems sound statistically. It was done on the Rouble market during periods of credit money versus gold backed. Unfortunately, they never bother relating the pattern in the different regimes to central bank interventions, other than to notice they coincidentally seem to happen at the same times. That doesn’t make any sense to me. It’s a regression on two numbers.

My own guess, developed over a half day of thinking about this and fiddling with plots in R, is that these patterns arise from dealer liquidity issues and market dislocations. How?

  1. Human beings like round numbers. Machines don’t care. Lots of the market in ye olden pre-decimalization days was organized by actual human beings, like my pal Moe. Thus, even if there was no reason to pin a share at a round number, people often would anyway, because $22.00 is more satisfying than $22.13. Since liquidity peddling is now done by machines, most of which assume random walk, I’d expect compass rose patterns to go away in cases where it persisted for a long time, like with $100k Berkshire Hathaway preferred shares, which are all that is pictured above. Voila, I am right. At least in my one stock guess, though the effect can be seen elsewhere also.
  2. The plethora of machine-run strategies has made the market much more tightly coupled than it used to be. What does this mean? For example: at the end of the day, something like an ETF has to be marked to its individual components. One of the things which causes a burst in end of the day trading is the battle between the ETF traders trying to track an index, and arbs trying to make a dollar off of them. Similarly with the volatility of the index. With all this going on, there isn’t much “inertia” pinning the closing price to a nice, human round value. It was observed early on that indexes don’t follow the compass rose pattern, and it’s very easy to understand why if you think of it from the behavioral point of view; add together a lot of numbers, even if they’re mostly round numbers, and chances are high you will not get a round number as a result (especially if you weight the numbers, like in most indexes). You could look at the dissolution of this pattern over time as increasing the entropy of stock prices. High frequency traders make the market “hotter.” As such, the lovely crystaline compass rose pattern “melts” at higher temperatures, just like an ice cube in a glass of rum. With the Berkshire Hathaway preferred shares patterns above, you can see the pattern fading out as the machines take over: while some compass rose remains post-decimalization, it’s completely gone after 2006. You might see it at shorter time scales, however.

Relating it back to the Rouble analysis of Koppl and Nardone, I’d say they saw the compass rose in times of credit money simply because the market moved a lot slower than it did when it was based on gold. When it was credit money, there were effectively fewer people in the trade, and so, monkey preferences prevailed. When it was gold, there were lots of people in the trade, and the “end of day” for trading the Rouble was less meaningful, since gold was traded around the world.

One of the things that bothered me about the original paper is the insistence that one couldn’t possibly make money off of this pattern. I say, people probably were making money off the pattern: mostly market makers. What is more, I posit that, where the pattern exists (on whatever time scale), one could make money probabilistically. What you’re doing here is bidding on ebay. Everyone on ebay knows that it’s a win to not bid on round numbers, because the other apes will bid there. If you bid off the round number, you are more likely to win the auction. Similarly, if you’re a market maker, you might win the trade by bidding off the round number, and giving the customer a slightly better price. Duh. My four hours worth of hypothesis would predict thinly traded stocks which aren’t obviously important components in any index would continue to show this end of day pattern, since they won’t be as subject to electronic market making. And, in fact, that’s what I saw in the first one I saw, WVVI, which appears to be a small winery of some kind. Even in the most recent era, it has a decent compass rose evident. Second one I looked at, ATRO (a small aerospace company) similarly showed the compass rose during the 2001-2006 regime. I’m pretty sure there are simple ways to data mine for this pattern in the universe of stocks using KNN, though I don’t feel like writing the code to do it for a dumb blog post; someone’s grad student can look into it.

All of this is pure speculation after too much coffee, but it’s a very simple and evocative feature of markets which is deeper than I first thought. Maybe with some research one could actually use such a thing to look for trading opportunities (probably it’s just a bad proxy for “low volume”). Or maybe the excess coffee is making me crazy, and these patterns are actually just meaningless. None the less, in this silly little exercise, we can see effects of the integer nature of money, behavioral economics, visible market microstructure on a daily time scale, and very deep issues into the dynamics of financial instruments.

Da plunge

Posted in finance journalism, microstructure, systematic trading by Scott Locklin on May 14, 2010

So, I don’t claim to know what’s going on here any more than anyone else does. Thus far, we have the Fat Finger theory. The fat finger theory at least makes a little bit of sense. When people dump enormous blocks of stock … things happen. Microstructure 101. I was going to try to work through the microstructure of how this could happen using a little of Hasbrauck’s book, but unfortunately, the SEC says it didn’t happen that way.

The usual band of numskulls is out blaming HFT in their typically nebulous manner. Nobody seems to want to go out on a limb and show us how such a thing could happen, other than, “things we don’t understand are the source of all evil!” It boggles my mind that people who don’t know a limit order from a fill or kill feel free to weigh in on this subject. Hey man, I know about iphones; it must be computers!

Other seemingly less likely possibilities include “cyber attack” or market manipulations. My favorite unlikely speculation is that Taleb did it. Probably the real answer is complicated.

Rather than pointing fingers around like a bunch of hysterics, or attempting to clean the Augean stables of figuring out exactly, precisely what happened, why don’t people think about what market rules would have prevented this? I mean, that’s what everyone seems to be agitating for: changing the rules. Rather than changing the rules to please self interested parties who want trading to go back to the days of ticker tape and the horse buggy whip, why not change the exchange rules to prevent this sort of thing and make everybody happy?

Right now, people are talking about circuit breakers, stop price logic and so on… The standard circuit breaker in the NYSE never engaged, as it was never hit (it’s linked to the DJIA). Stop price logic seems to be circuit breakers for individual instruments: stop trading for a few seconds, then go back to normal. This is apparently implemented in US futures exchanges. Since the futures did a little better than equities, we’re supposed to believe this would have solved the problem. Well, maybe, but maybe not. According to the WSJ, one of the proximate causes of the plunge was … well, an effective halt in trading in PG&E.

Assuming this is true, can someone explain to me why halting the trade for a few more seconds would be anything remotely resembling a good thing? As far as I can tell, that would be a silly thing which wouldn’t help anyone. While I can’t claim this is an original idea: it seems like doing what happens during other market dislocations would make more sense. You know, like when you start trading at the beginning and end of the day. Dudes with market orders would be fucked, but they were fucked anyway, and at least you’d restore some semblance of order.

Maybe dropping to a call auction model when something goes pear shaped is what they’re actually proposing, but it doesn’t look like that reading the funny papers. The Europeans do it this way. The Asians do it this way. Why not do it this way? You need liquidity? Drop to a call auction. I’m not really optimistic that anybody is thinking of this; a google on NYSE and vol interruption auctions yields the following link …which rather indicates the NYSE never heard of the idea.

Seems like the right thing to do to me. Beats stockbrokers jumping out the window.

Edit add:
Apparently this is how it works in the NYSE.
Don’t look like an auction to me.
CME debug:

And … the mystery seller is … Waddell & Reed! Who? Some financial advisor who got the world’s worst execution from Barclays. Who dumps 4 billion of anything on the market?

There you have it: as usual, the biggest fuck ups come from the “respectable” bozos in the investment business, rather than the eeeevil high frequency traders. I, for one, eagerly await the apologies from the numskulls who blamed HFT.