Wednesday, 30 April 2014

Virtu Reality

The appearance yesterday of the U.S. Securities and Exchange Commission Chair Mary Jo White before a House of Representatives panel reminded me that a few weeks ago, the eloquent and well educated GAIN Capital trader Matthew Trenhaile challenged me to write a post highlighting the benefits of HFT (High Frequency Trading) and of its cousin in the sports investing world of CST (Court-Sider Trading). 

It’s a tough task, up there with trying to justify a belief in one specific god or in support of creationism. The evidence just doesn’t support the claims for any of these, and with trolls already only too willing to quote me out of context, the best I can do is highlight the claimed benefits of HST and then shoot them down.

Incidentally, there is definitely a god, and it’s the one true god that my parents told me about and everyone around me supports the same god and it says so in the Bible so it must be true. The other 3,000 or so gods of recorded history are just made up and silly and if you don't believe me, you are all going to hell. 

A convincing argument? No, me neither. I feel the same way about the arguments in favour of HST and CST which usually boil down to “added liquidity” and “narrower spreads”.

HST - “It's really a tool that has benefited the investment community”, says Peter Nabicht of Modern Markets Initiative. Nabicht is a senior advisor at MMI, a firm "focused on demonstrating the benefits of algorithmic or quantitative trading" and claims that HFT has lowered costs, tightened spreads and added liquidity to the markets, adding that "not all high-frequency trading is predatory."

HFT in itself is not a problem. The more people or companies trading a market, the more liquidity there is, and the tighter the spreads. However, the issue highlighted in Michael Lewis' book "Flash Boys: A Wall Street Revolt", is that of front-running, “in which the firms are able to quickly identify an investor's desire to buy stock, rush to buy it first and then sell it back at a higher price.” Lewis says:
"the market moves at two speeds: one speed for people who pay for access to the exchanges, who put their trading machines right next to the black boxes … and everybody else. And we are everybody else, everybody else being investors in the stock market."
In other words some traders are able to “have an early sneak-peak at data” which is quite different to having the ability to “react more quickly to publicly available data”.

The similarities with court-siding here are clear. Mary Jo White says that it “is not unlawful insider-trading” and that may be technically true, and court-siding is not breaking any rules either, but as the FBI, the U.S. Attorney General, New York state prosecutors and the SEC have all confirmed, they are investigating the practices of high-speed firms, and for a reason, which is to ensure that the markets are not seen as ‘rigged’.
"the staff, at Chair (Mary Jo) White's direction, is conducting a comprehensive data-driven analysis of a range of market-structure issues, including high-frequency trading practices and their impact on the fairness, efficiency and integrity of our markets."
When a company loses money on one day out of 1,238, as Virtu Financial reported in their accounts, it is clear to any reasonable person that they have an advantage, and by definition others in the zero-sum market are thus at a disadvantage. It would be irrational for someone at a disadvantage to continue trading under such circumstances, and while not everyone is rational, the result of losing money consistently will ultimately remove all but the most stupid, stubborn and deep-pocketed from the markets. New entrants will come and go of course, but are unlikely to remain for too long once they realise they are at a disadvantage, so it is reasonable to say that in an unfair trading environment, liquidity will ultimately decrease.

Active in the financial markets are there are those who are there to invest and those who are there to trade. It’s probably true to say that the impact of HFT to the small investor is minimal.

Sports markets are a little different, but if you think of the pre-in-play punter as an investor rather than a trader, the parallels continue. The punter enters the market before the shenanigans of the in-play take place, and either wins or loses.

When the market goes in-play, the court-sider has an immediate and persistent advantage. They may not be able to match Virtu Financial’s 1,237 profitable days out of 1,238, but in the long run their advantage will be profitable at the expense of others. Air fares, accommodation and expenses for a trip to Australia do not come cheap.

When Mr. Nabicht says “I think there's a confusion here. I don't think high-frequency traders, professional traders, are competing with the general public. They compete with each other but not with the general public” he has a valid point.

In sports markets though, the majority of participants are not professionals. There are a few full-timers out there, and as the Australian Open revealed, at least one enterprise willing to pay for “an early sneak-peak at data” the rewards from which clearly justify the expense involved.

As with the financial markets, once it becomes clear that they are trading at a disadvantage, and it should be clear from the price movements just how much of a disadvantage they are at, any rational person would step away, and liquidity will decline. The market may not be ‘rigged’ but it is not a fair one. 

Unfortunately, the inherent nature of betting means that most bettors do not act rationally. That markets with court-siders active in them are as liquid as they are is testament to that. Again, some new blood will always be coming in, but ultimately the liquidity will fall perhaps leaving a situation where court-siders are competing with themselves.

As for the argument that spreads are tightened, this is certainly not true in the sports markets. The presence of court-siders means that they are, or should be, the only ones willing to front-run the markets, and they don’t look to back at 1.71 and lay at 1.7. The spread is more like 1.8 / 1.6. Should the non-court-sider wish to back at 1.6, he is either getting poor value (but may of course still win on occasion) or he will not get matched because the court-sider has had a sneak-peak and adjusted his prices.

The investigation into the financial markets continues, while Betfair and the Gambling Commission continue to drag their feet, allowing a few individuals, including former employees, to clean up as they slowly suck the in-play markets dry. After all: who would want to play in a casino so explicitly rigged?

1 comment:

Matthew Trenhaile said...

Dear Zio Cassini,

Thank you kindly for entertaining my suggestion for a blog post. I find the topic both in the financial and sporting arenas fascinating and I love to hear other educated opinions on the matter. What interests me is the consolidation that has been going on amongst HFT firms as the big beasts swallow up the smaller ones. I like the idea of a competitive arms race when it comes to any technological pursuit and an oligopoly would do no one any good. I would like to see more competition among smart market makers on the betting exchanges with them all competing on latency and strength of pricing model and with no 10 second delay. Some people will say that last sentence puts me in the same category as hardened war criminals but there you have it.

Also interesting to see that you have done your due diligence on me (LinkedIn?) and have gratifyingly provided a link to my current employers. That is what happens when one posts under one's own name. I am sure the many anons that post on your blog are now putting me in the stupid war criminal category.


Matthew Trenhaile.

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