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.