If you saw Sandra Bullock in The Blind Side or Brad Pitt in Moneyball, then you’re already familiar with Michael Lewis; he wrote the books those movies were based on. He’s a very engaging writer who finds a way to capture the perspectives of people who see the world differently. Lewis’ latest book, Flash Boys was just released and is already focusing attention on an aspect of the investing marketplace that deserves it, high-frequency trading, or HFT. In Flash Boys, Lewis tells an entertaining story of the evolution of equity market structure in the United States over the past decade. Trust me, it is entertaining.
Computerized trading has brought many benefits to the market, in terms of speed, reduced transaction costs, and a new level of choice in trading venues. It has also led to the evolution of HFT firms, or as Lewis’ subjects call them, “predators.” For me, as a trader with Principal Global Equities, the most interesting aspect of the book is in the description of one character’s battle against purported HFT-linked predatory behavior called “scalping.” This is where speed-addled HFT firms pay to see order flow data ahead of the market feed and profit by trading with that knowledge at lightning-fast speed (wouldn’t HFT firms love to be faster than lightning-fast). These ideas get right to the heart of trading strategy and what we, as an asset manager, can do to protect our order flow data and, ultimately, our clients.
What are some of the measures we take to protect our trading?
- We, like all other large investors, direct our clients’ order flow to “dark pools,” which sound mysterious, but are really just exchange-like venues where orders aren’t displayed. The benefit to institutions like us is that we’re able to place large orders that would otherwise send a clear signal to the market of our intent. To avoid being “picked off” in these pools, we protect ourselves by using minimum acceptable quantities (MAQs), where we stipulate trading in sizes too large to be attractive for an HFT firm’s risk horizon. When we trade in these venues, we employ the broker’s anti-gaming logic to avoid trading at an undesirable price, while retaining the ability to trade at the right price.
- Every trade creates a signal, and those signals can provide information to other market participants. We try to avoid sending obvious signals by employing trading strategies and techniques that can minimise how much of that information gets out. It’s this information leakage that would, in turn, increase the opportunity costs of our unfilled orders. One strategy we utilize is the extensive use of limits on our orders, again to avoid trading at an undesirable price.
- Predictable trading behaviour is something that HFT firms can pounce on and exploit. We avoid using predictable trading strategies that are easily detectable by predatory firms. This means randomising our trading activity and being opportunistic at desirable price points, employing aggressive and effective liquidity-seeking algorithms that are antithetic to risk-averse HFT-type participants.
The last thing that I’d say on this is that the media can tend to oversimplify and focus this topic in terms of big investors versus small investors, and I think that’s inaccurate. It’s more like short-term participants versus long-term investors. Our focus is on successful long-term outcomes, and to the extent that the industry can develop smarter, faster ways of identifying and eliminating abusive HFT practices, in the same way it currently does for slower miscreants, it will reinforce investor confidence and benefit all long-term investors.
If you’re interested in more info on the topic and some background on electronic trading, you can check out a paper I penned a couple years ago called “Rise of the Machines: On the Evolution of Electronic Trading.”
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