Friday, September 3, 2010

Agent Smith Arbitrage

Today's FT has a fantastic story unearthing a few more details of the high frequency trading world.  I love reading about this stuff because it makes it completely clear that 58% of US equities by volume and 38% of EU equities by value are now, officially, a casino.  But what a casino!   This is the greatest poker game in the world.  I can't believe there's no reality TV  show about HFT.  You could have great interludes where 20 year old Russian hackers score millions and go out partying all night with the Jersey shore girls, only to wake up next week and discover that their botnet was caught in a "Bandsaw II" pattern (pictured below) by some clever Serbian helping the Mexican drug lords go completely legit before they shut down Vegas ... er ... I mean, Oaxaca.

Anyhow, all joking aside I can imagine a new business model where somebody proposes an exchange that actually has rules.  This is kinda like the fancy backroom of a casino where everybody is rich and agrees to play like a gentleman.  The big pensions funds, endowments, insurance companies, etc ... could simply give up some of the decrease in trading costs they've seen over the last 20 years, in exchange for a less volatile market.  Wouldn't an investor owned exchange be a viable model if you could get it off the ground?  Why are we always stuck getting screwed by Wall Street -- let's go around them already.  If Calpers, Vanguard, and a few others said that they were going to start a new exchange that only traded, say, once a second, and that they were not going to buy shares in any company that did not list on this exchange, wouldn't others follow along, and subsequently wouldn't issuers be forced to move venues as well.  Not that you'd have to twist their arm.  I mean, I'm pretty sure P&G got nothing useful out of the twelve second in which the company was worth $0.50.  In fact, nobody is getting anything useful out of this except the algo guys themselves.  They are an invasive species in our capitalist garden of Eden.

But I digress.  There's a million problems with that idea, and in the meantime there's money to be made.  I doubt that "latency arbitrage" is "making markets more efficient by providing liquidity", but I can certainly image it being possible and profitable:

Mr Cronin is not alone in suspecting that certain kinds of algorithms are actually predatory. Analysts at Nanex, a Chicago market data company, say high-frequency traders may be using algorithms to send unusually heavy traffic to exchanges and other platforms in a deliberate attempt to slow down their data systems.

Knowing that a certain exchange’s system is about to run more slowly gives a trader an opportunity to set up a buy or sell order in advance. The process is called “quote stuffing” and is used in a strategy known as “latency arbitrage” – latency referring to the speed at which message traffic moves through a system.

There's one thing the online version of the article leaves out, so I snapped a picture of a box that appears in the print version.  

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