The Slow are Lunch After All
Is it just a case for open source software?
In the wake of their public face off in 2008 where during 6 hours and 45 minutes they were unable to consolidate any trades, the London Stock Exchange (LSE) announced that will upgrade it’s .NET TradeElect (Windows based) systems to the (MilleniumIT Linux) based platform. Following hereby the New York Sock Exchange that made this move in 2007.
By doing so the LSE, one of the few world-top stock exchanges, hopes to reduce their transaction speed to 0.4 milliseconds. This is more than 6 times better than the (in fact rarely observed) speed of 2.7 millisecond in their Windows based solution.
This should not surprise us: Linux gained a market share of 91% in the top-500 supercomputers (up from about 0% in 1998), it powers the top 15 without exception. It is just part of the success story of Free and Open Source Software (FOSS), where propriety systems lost the battle long ago in embeded systems, mobile devices (although the Redmond based company fights back with an OS and … of course legal claims)
I might not just have been speed that drove LSE to Linux, Linux is also a lot cheaper than Windows on such systems. Probably the most important argument is that now LSE is in the driving seat and that it is not held hostage by a network of monopolies.
According to the IBS Journal David Lester, Chief Information and Technology Officer at LSE, said that compared to the annual cost of $65 million for TradElect, MillenniumIT was a bargain at a purchase price of $30 million. Sure that is not the whole picture, but thehe LSE predicts that using Linux will give them an annual cost saving of at least £10 million (EUR 11.2 million). He adds: “The new technology is a lot lighter, nimbler and easier to install”.
But is that the whole story?
Or is there more? The May 6 Flash Crash
On the other hand we have fore example the May 6 Flash-Crash, this aberration in stock behaviour has cost some investors many millions, whereas for others it might have been the best day of the year. As a matter of fact, in my time zone it was about 8:30 pm and I was where I should be at such moments in front of my Bloomberg terminal ready to pull the trigger and make or loose a many many millions. Fortunately my blood was chilled enough and helped by the approach of my employer I avoided slipping our short (hedging) traders in the black hole created for a few seconds.
Even with hindsight one can only see that the markets on May 6th 2010 were very nervous about the possibility of Greece defaulting on its outstanding 210 billion euro debt, and over hours after closure in Europe markets declined a few percent, but then suddenly the debt dived 600 points in a matter of minutes. The stock exchanges followed that dive-boom scenario, with of course the U.S. Stock exchange being open the most visibly impacted. The dive erased about $862 billion from U.S. Equities alone! It was the largest intraday drop ever.
Regulators in the U.S. anounced weeks later that they wer investigating 6 possible areas, but it seems that HFTs have during the build up of the crash put thousands of trades per second in the stock exchange, only to cancel them within milliseconds.
Hedge Funds are So Passe
Hedge Funds and day trading are indeed so passe, it’s high frequency traders that are the new rebels of Wall Street. High Frequency traders are not interested in the fundamental value of a stock, but use mathematical algorithms to profit from other players’s actions. Some of them employ hundreds PhDs and use computers to generate thousands of trades per second, these trades are based on the trends of the last milliseconds and have a millisecond delay and are more often cancelled after a few microseconds than they are really executed.
There are basically two (known to me) ways of operating for high frequency traders. A first model is operating as market maker, such companies have permanently buy and sell trades in the market and take no directional bet. Another model is looking for local and temporally mis-pricings in stocks or … even inefficiencies in the systems of the stock exchange or between the different exchanges. But in all cases the High Frequency Trader is only interested in making a quick kill and moving on.
A simple expample would be a pairs-trade, where for example bad news pushes a whole sector down. HFTs will capture the first movers and then take positions of on the others in order to profit from those comming down also. Or a step further one could try to forecast a certain companies short term moves by monitoring a sector index, it’s raw materials, interest rates, etc. A second example is simply monitoring the bid and ask spreads and acting then they come too high and profit from conversion. But, do not try this at home! The active HFTs do not simply employ computers to look for patterns, basically they are doing what Keynes in in beauty contest parable stiplated. They employ computers to look for other computers that look for patterns.
Some researchers have found many cases of thousands of trades that were put into the stock exchange but were cancelled within milliseconds. This raises the suspicion of intentionally influencing the stock exchange’s systems. This is referred to as “quote stuffing"e; and is obviously on the limit of what is legally possible. Or is it just past that fine line? In any case regulators are investigating and considering what to do?
A simple model would be to watch for such large orders (eventually on an aggregated base) and when spotted take the same direction very fast and before the order is fully through the market reverse your position completely and therefore buying low and selling high in the case of one large buy order. But the true algorithms are known by only a handful company owners and CIOs (chief investment officers, not chief information officers!), most people will only know their part of the patchwork that is the web spun by their company around the stock exchanges.
If the asset managers who build up for you a retirement capital are the farmers raising livestock for you, then the High Frequency Traders are the hunters that lay in ambush to kill one of those cows when it comes too close to their trap (or at least take today’s milk).
But we should ask ourselves is that the stock exchange that we want for our children? Is that the stock exchange that will play its role as a catalyst for the economy and provide oxygen to growing companies that produce and create welfare?
Clearly there is an issue here and the U.S. Securities and Exchanges Commission (SEC) is considering if and what action to take. They consider for example imposing a minimum period of time that trades have to remain active (probably something in the order of 20 to 100 milliseconds). The SEC is further considering to monitor more closely firm that trade more than 2 million trades a day, and to force HFTs to stay in the markets when the going gets rough.
Do you Iceberg?
Institutional investors are already spotted the problems and try to put up an armour against what must feel like parasites. One technique is breaking up large orders in small pieces so that you show to the HFTs only the top of the iceberg. But as long as the regulator do not interfere it’s the same exhausing battle as between anti-virus software maintainers and Botnet Masters.
Institutional players such as investment funds cannot longer simply use block trades and they have to use the same techniques as the HFTs in order to defend themselves. Also hedge funds that work to find patterns and trade on them have to watch for HFTs to jump before them when taking action (triggered by themselves showing their intentions), and probably shorten their holding periods as market anomalies that a few years ago would have lasted for days now will disapear in minutes.
But as long as there are no regulations about the minimal lifetime of quotes or simply minimal processing windows (for example the exchange will only process and match trades every 100 milliseconds) then the stock exchanges, being private companies, will continue to compete with each other in price and speed "e; paving the way for their own problems. Just as banks did in the run up to the Global Meltdown in the lack of serious regulation! This is one of those examples where the regulators can and should play an important role and where they can do more than window dressing and finger pointing.
Regulators have to rethink their strategy of the last decade where since the introduction of the ECNs in 1998 and the decimalisation in 2000, and the best-and-fastest execution rule in 2007 (all USA) they have been striving in making markets more efficient on a micro level.
And You? Do you still believe that you need on-line information and daily newspapers to manage your broker account?