Sunday, August 23, 2009

High speed trading: an $8 billion per year tax?

Because there is money to be made at this game (estimated in the article to be in excess of $8 billion per year), it is attracting both financial and human capital. The human capital might be doing more productive things elsewhere. Let's suppose that the social utility provided by the market is efficient resource allocation via price signals. I see no benefit to society from making these price signals "efficient" over time scales as small as a tenth of a second (i.e., much smaller than the time scales over which physical resources can be allocated, or humans can make executive decisions). Imposing a 1-100 second random delay on any order placed at an exchange would not (as far as I can see) have any negative impact on the actual economy, but would eliminate an expensive arms race that transfers money from small or long-term investors to brainy hedge funds.

These activities are particularly appealing to banks and hedge funds in the current environment because a trader can book a real profit or loss at the end of each day (or even every few seconds!) -- very different from the illiquid positions that led to the credit crisis. In the long run, even complex derivatives like CDO and CDS contracts have the potential of providing some social good -- the ability to diversify risks, etc. I see no comparable redeeming value in high speed trading.

A couple years ago I listened to a talk by a former high energy physicist about how his firm was using FPGAs to execute their trading algorithms in hardware. Sound like a good use of brainpower and resources to you?

Regarding the Aleynikov case reported on below, 32 MB of proprietary source code is not a small amount of code. It could be the core of Goldman's algorithms. I would think a court-appointed expert could easily determine the value of the code Aleynikov downloaded. If he merely grabbed it by mistake while downloading some open source directories (his claim), it would be unlikely to contain the key algorithms.

Related posts here (Aleynikov vs. Goldman) and here (Volfbeyn and Belopolsky vs. Renaissance).

NYTimes: ... the charges, along with civil cases in Chicago and New York involving other Wall Street firms, offer a glimpse into the turbulent world of ultrafast computerized stock trading.

Little understood outside the securities industry, the business has suddenly become one of the most competitive and controversial on Wall Street. At its heart are computer programs that take years to develop and are treated as closely guarded secrets.

Mr. Aleynikov, who is free on $750,000 bond, is suspected of having taken pieces of Goldman software that enables the buying and selling of shares in milliseconds. Banks and hedge funds use such programs to profit from tiny price discrepancies among markets and in some instances leap in front of bigger orders.

Defenders of the programs say they make trading more efficient. Critics say they are little more than a tax on long-term investors and can even worsen market swings.

But no one disputes that high-frequency trading is highly profitable. The Tabb Group, a financial markets research firm, estimates that the programs will make $8 billion this year for Wall Street firms. Bernard S. Donefer, a distinguished lecturer at Baruch College and the former head of markets systems at Fidelity Investments, says profits are even higher.

“It is certainly growing,” said Larry Tabb, founder of the Tabb Group. “There’s more talent around, and the technology is getting cheaper.”

The profits have led to a gold rush, with hedge funds and investment banks dangling million-dollar salaries at software engineers. In one lawsuit, the Citadel Investment Group, a $12 billion hedge fund, revealed that it had paid tens of millions to two top programmers in the last seven years.

“A geek who writes code — those guys are now the valuable guys,” Mr. Donefer said.

The spate of lawsuits reflects the highly competitive nature of ultrafast trading, which is evolving quickly, largely because of broader changes in stock trading, securities industry experts say.

Until the late 1990s, big investors bought and sold large blocks of shares through securities firms like Morgan Stanley. But in the last decade, the profits from making big trades have vanished, so investment banks have become reluctant to take such risks.

Today, big investors divide large orders into smaller trades and parcel them to many exchanges, where traders compete to make a penny or two a share on each order. Ultrafast trading is an outgrowth of that strategy.

As Mr. Aleynikov and other programmers have discovered, investment banks do not take kindly to their leaving, especially if the banks believe that the programmers are taking code — the engine that drives trading — on their way out.

Mr. Aleynikov immigrated to the United States from Russia in 1991. In 1998, he joined IDT, a telecommunications company, where he wrote software to route calls and data more efficiently. In 2007, Goldman hired him as a vice president, paying him $400,000 a year, according to the federal complaint against him.

He lived in the central New Jersey suburbs with his wife and three young daughters. This year, the family moved to a $1.14 million mansion in North Caldwell, best known as Tony Soprano’s hometown. ...

This spring, Mr. Aleynikov quit Goldman to join Teza Technologies, a new trading firm, tripling his salary to about $1.2 million, according to the complaint. He left Goldman on June 5. In the days before he left, he transferred code to a server in Germany that offers free data hosting.

At Mr. Aleynikov’s bail hearing, Joseph Facciponti, the assistant United States attorney prosecuting the case, said that Goldman discovered the transfer in late June. On July 1, the company told the government about the suspected theft. Two days later, agents arrested Mr. Aleynikov at Newark.

After his arrest, Mr. Aleynikov was taken for interrogation to F.B.I. offices in Manhattan. Mr. Aleynikov waived his rights against self-incrimination, and agreed to allow agents to search his house.

He said that he had inadvertently downloaded a portion of Goldman’s proprietary code while trying to take files of open source software — programs that are not proprietary and can be used freely by anyone. He said he had not used the Goldman code at his new job or distributed it to anyone else, and the criminal complaint offers no evidence that he has.

Why he downloaded the open source software from Goldman, rather than getting it elsewhere, and how he could at the same time have inadvertently downloaded some of the firm’s most confidential software, is not yet clear.

At Mr. Aleynikov’s bail hearing, Mr. Facciponti said that simply by sending the code to the German server, he had badly damaged Goldman.

“The bank itself stands to lose its entire investment in creating this software to begin with, which is millions upon millions of dollars,” Mr. Facciponti said.

Sabrina Shroff, a public defender who represents Mr. Aleynikov, responded that he had transferred less than 32 megabytes of Goldman proprietary code, a small fraction of the overall program, which is at least 1,224 megabytes. Kevin N. Fox, the magistrate judge, ordered Mr. Aleynikov released on bond.

Clarification in response to comments: I guess I should make my claims more precise. It seems to me that imposing a random delay of average length T would

1) remove the possibility of gaming the system on timescales much less than T (thereby sending lots of smart people back to productive activities)

2) not affect market liquidity on timescales much larger than T. I claim that for T of order a minute (or even longer) there is no social value from liquidity on much smaller time scales.

I am not highly confident of my statements because market making is a dynamical system, with interacting agents, etc. Doyne Farmer and Sante Fe researchers did some modeling for NASDAQ in anticipation of their 2001 decimalization (see here); the details are complicated. Yes, the price of decimalization and liquidity on very short time scales is the current arms race, but I have yet to see an argument for why those things are good for society.

For a defense of high frequency trading, see discussion at Scott Locklin's blog here and here.


Siddharth Sharma said...

hi steve, have you read scott locklin's blog @

he defends HF as not being a tax on long term investors due to the resulting lower impact costs (compared to older market making systems) and rather eating into profits of both other kinds of market makers as well as noise traders.

Ian Smith said...

"Let's suppose that the social utility provided by the market is efficient resource allocation via price signals"

That's one factor. Another one I can think of is the management of the managers via stock and corporate bond price. Most of secondary stock issues are for employees.

The HF guys can claim they are providing a market making function. With the end of fixed commissions there is more trading and more opportunity for HF, and trading substitutes for commissions.

Here is Bernie Madoff explaining his legitimate business.

Derivatives sepculation is just gambling though.

Dave Bacon said...

Why would a 1-100 second random delay mess things up? I would think there would still be a race to act the fastest after the order is placed?

Steve Hsu said...

Sorry, I should have written that the random delay should be on both bids and asks, but then you have to go into details of how transactions are actually determined (matched), etc.

Unknown said...

I haven't actually seen evidence of gaming. The fact that a market intermediary is making a profit is not evidence that something unfair is happening. There are some interesting comments on the Cassandra blog here .

knappador said...

Millisecond trading is about performing aggressive, sophisticated market-making that induces stable feedback systems, like warm water feeding a hurricane, that will continue to propagate to the advantage of the millisecond trader.

Sure, the trades are completely legitimate when cast as market maker style trades designed to take advantage of small gaps in market depth etc, but by making every small trade accomplish two purposes - the accumulation/distribution of positions and or building stable feedback - big trading firms use the legitimacy of the first technique to obfuscate the esoteric nature of the second.

The whole fact that it's called millisecond trading underscores the difficulty in identifying how the practice works or what it's designed to accomplish. "Millisecond trading" makes it sound like the computer's advantage comes from speed, something well within our sensibilities for what computers are known to be useful for. If it were called "induced market feedback trade interception" or something, it wouldn't go over very well.

This is about like the "I'm an administrative assistant" line. People use semantics to cover up their nature whenever its unflattering. In this case, "millisecond trading system" already sounds so sophisticated and space-age, it will be years before anyone gets to the heart of the systems and finds out why they're profitable.

Here's my cranktastic blog Still pretty sloppy. Have fun until I start redrafting.

LondonYoung said...

Introducing random delays in order execution would result in vast and ongoing transfer of wealth from people who try to trade fundamentals (e.g. news) to people who trade mathematical algorithms or technicals. The main cause of the damage would trace mainly to forcing market makers to ask for larger bid/offer spreads.

The problem is that orders are asymmetric. Some orders are "buy 100 shares", other are "I bid to buy 100 shares at 66.60 and I offer to sell 100 shares at 66.70". Still others are "buy me 100 shares ASAP but I will pay no more than 66.65". Yet another problem for the public, about whom regulators care most, is that most of the public pay commission fees which are directly impacted by the market structure.

If a market maker is offering to sell IBM at 66.70 when news breaks that IBM has invented a new and fanstastic type of memory, then it will be a free lottery ticket to put in an order to buy, but paying no more than 66.70 as a limit, in hopes of getting filled before the random delay allows the market maker to cancel his 66.70 offer. I am happy to engage further, but at this point I will assert that attempts to work around these problems will only create worse problems. The best market for the public is the one with the shortest delays and the most consistency of execution.

You also bring up those words "good for society". Has these blog previously given a summary of what you mean when you say "good for society"? Is it good for society to make cigarettes illegal, or is it good for society to allow people to make their own health/pleasure trade-off decisions? However, I can still answer in general - a passive buy and hold portfolio of equities is probably all that ma and pa should ever be exposed to, and "buy and holder's" are very minimally affected by any of this stuff. So how all this effects them depends on what they are trying to accomplish when they over-trade their investment portfolio - are they trying to beat the market? If so, anything which teaches them not to try is probably a social good since - for the public in aggregate - it can't be done.

Ian Smith said...

Why random delays and not higher taxes on short term gains?

LondonYoung said...

Hedge fund operating companies, and most of their investors, participate in U.S. markets but do not pay U.S. taxes.

Ian Smith said...

Can it be agreed that in most markets speculation is overdone and long-term investing should be encouraged, that is coerced by government.

It takes time and energy and intelligence to speculate. Gambling requires the same yet accomplishes nothing.

What does neo-classical economic ideology say about speculation that is actually true.

Nicolas said...

Well said mr LondonYoung.
"good for society" is a very vague notion. And even in free market theory, only an incidental property..

The big elephant in the room problems are:
- credit market. That's the one which should be adressed

- economic imbalances (huge national debt deferring effort to future generations) and misguided frenetic consumption.

Their recent failure of credit market is leading to the public inspection of every little corner of the vast financial world, where for sure one will find borderline case, as in milisecond trading etc... but they will be secondary and not worth much reflexion.

LondonYoung said...

Nicolas - you know how to get me going.
The credit crisis is the wages of Americans (and to some extent the British) consuming beyond their productivity. Because ma and pa don't want to admit that they should have never owned two SUV's and a 5000 sq ft home, it is time to find somebody else to blame.

My big fear is that this financial side-show it taking focus off the consequences of Washington's attempt to replace the consumption that ma and pa couldn't afford with consumption that Washington cannot afford. The can has been kicked down the road in the form of an on-going structural $1 trio deficit ...

Anonymous said...

Hey Steve, thanks for the link. I'd like to take issue with a couple of things.
First, derivatives trading is very much a productive activity. If you think insurance is socially useful, derivatives can be thought of as a form of insurance. Trading the things is a way of spreading out risk across lots of people who are interested in taking on risk. This is a lot more humane than just taxing an entire society as a risk hedge. Only the people who want to gamble have to gamble. Think of derivatives trading as health insurance for smokers. They want to take the risk of lung cancer, so let 'em. It doesn't effect the rest of us. Or at least it shouldn't.
I also very much do see providing liquidity as a productive activity. Much, much more so than doing physics; in particular very speculative unproductive physics, such as QCD. Liquidity providers provide a real service to humanity that people are willing to pay for. Theoretical physicists for the last 50 years have mostly been counting the angels that can fit on the head of one of Ed Witten's pin. What is more, liquidity providers have a bag of tricks which are a lot more generally useful to humanity (viz, software and statistics) than, say, noodle theory, or even something as practical as semiconductor physics. Oh sure, I often hear the justification from physicists that breakthrough physics can be of enormous benefit to humanity, but how many people end up doing that kind of physics? I don't know *any* of our generation. Now, who are the real gamblers here? Physicists or quant traders? Quant traders provide a service which people gladly pay for. Physicists are gambling on a once in a generation payoff. So, be nice to us small stakes gambling men: you're gambling too, you just don't see it that way.

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