I’ve been saving the above image in a stubbed-out blog post I’ve wanted to write since a conversation I’d had in Jerusalem last fall. The recent attention to high frequency trading and all of its attendant evils has reminded me that the topic is relevant and so I relate various thoughts at the risk of jumping on a cacophonous bandwagon of rumbling misinformation.
First of all, the conversation. It was with a talented guy who acted as the CFO for a variety of companies including a small startup hedge fund which traded US equities at a high frequency. Although he was a part-time cfo, he seemed pretty plugged-into their trading operations and noted that they use an agency-only brokerage service for automated traders I’m familiar with and that they were “looking at full data for many” hundred stocks concurrently. He remarked that their trading was going well but that their hit rate was something like 4% and dropping. By hit rate, he meant that they were placing limits frequently and generally pulling the orders if they didn’t get hit immediately. He didn’t specify, but I imagine that “immediately” might range from milliseconds out to a second or twenty. If the market is composed of makers and takers, then these guys were definitely makers of liquidity in the strict sense that they were placing limits and making markets.
At the time I thought it was interesting because it seemed that so many people were focused on the very, very short term trade that the frequency was becoming saturated. It looked like a reminder that trading frequencies populate a spectrum; in this case, this part of the spectrum was becoming so saturated that returns were becoming increasingly difficult to obtain as more players crowded into it. I’m not sure how this hedge fund has fared, but at the time I remember thinking that they were going to have a tough time competing if they were only geared for high-frequency trading as the space becomes increasingly expensive to play in as the inevitable talent and technology arms race marches on.
Lo and Khandani provide the below image illustrating this phenomenon happening to a class of contrarian strategies Lo & MacKinlay had described in 1990. The strategies stop working as people squeeze out the alpha.
My conversation in Jerusalem mostly made me think that we were seeing a similar phenomenon amongst HF strategies.
What does it mean for a strategy to be high-frequency? First of all, it’s a large class of strategies which probably shouldn’t be treated uniformly. What they have in common is an intention to trade in and out of positions on a frequent basis where frequent will range from sub-seconds out to perhaps several seconds or even minutes in particularly felicitous cases.
Aside from the fact that one can trade at various frequencies, one can mix them and one might even be only peripherally aware of doing so. A long-only, fundamentally-driven mutual fund (ie, not an algo or high-frequency trader) might call/fax/email/ftp/fix etc their trades into their brokers who might then execute the trades with their in-house or outsourced/white-labeled execution-quality algos. Those algos might use some very clever close-to-the-market analytics to provide great execution for the client. Or they might be traded profitably against. Or both.
In any case, to me it seems clear that there is nothing intrinsically wrong about high-frequency trading itself. People will always try to react to information as quickly as possible. Why wouldn’t or shouldn’t they? They also like to be clever. Again, why wouldn’t this be expected and good? I remember Lefevre recounting the use of personal teletypes by big speculators at the turn of the (prior) century. Not your everyday household item at the time. I also remember him recounting strategies for moving large positions which involved both buying and selling to hide one’s hand. Why wouldn’t algos do the same and more?
That the loudest critics have been old-style execution traders “talking their book” to me tells the story here.
One other thing that my conversation evinces is the kinds of biz models being employed by brokers. Like I said, this little hf hedge fund used an agency-only brokerage that caters to algo/hf traders. Why is it important to note that it’s “agency only”? Because, as the Goldman/Aleynikov story illustrates, strategies are organizationally porous in the sense that their value drips away as the human capital behind them moves from organization to organization and understanding of the strat’s internals become understood more broadly outside the organization. This is likely the dynamic that drove Lo’s example above – more and more traders were employing similar strategies as the knowledge of the strategy leaked further and further from its original source(s). Likewise, if I see all of your trading activity in sufficient detail, I might be able to reverse-engineer your strategy and work to steal your alpha.
Thus, traders are happy not to advertise their strategies’ behaviors. So an agency-only broker – a broker who doesn’t engage in prop trading themselves – should inspire trust in a potential client.
Great! What an honest business model! But there’s an irony here and it points to the real kinds of problems we should be bugging our regulators to be addressing. The specific agency-only broker I mention wasn’t self-clearing. That is, they were using another broker (Goldman in this case) to handle their backoffice duties. And guess what? Goldman is anything but agency only. So, clients who feel warm and fuzzy that they are dealing with an agency-only shop are actually exposing all of their activities with a particularly sophisticated and arguably predatorial prop trader. It’s like the Guiness ads.
It’s funny to me that while there sits a multi-trillion dollar hole in our fed’s balance sheet which such hippies as fox news and bloomberg (suing to find out) and our US congress (asking politely) can’t seem to tease an explanation for out of the relevant authorities, the blogosphere and regulators seem to focus their invective on short sellers, hedge funds and high-frequency traders.
secret meeting at 85 broad?
