THE SPEED TRADERS
AN INSIDER'S LOOK AT THE NEW HIGH-FREQUENCY PHENOMENON THAT IS TRANSFORMING THE INVESTING WORLD
By Edgar PerezThe McGraw-Hill Companies, Inc.
Copyright © 2011 The McGraw-Hill Companies, Inc.
All rights reserved.
ISBN: 978-0-07-176828-3
Contents
AcknowledgmentsIntroduction1 The Emergence of High-Frequency Trading2 Meet the Speed Traders: John Netto3 The Path to Growth4 Meet the Speed Traders: Aaron Lebovitz5 High-Frequency Trading Goes Mainstream6 Meet the Speed Traders: Peter van Kleef7 The Technology Race in High-Frequency Trading8 Meet the Speed Traders: Adam Afshar9 The Real Story Behind the "Flash Crash"10 Meet the Speed Traders: Stuart Theakston11 Life After the "Flash Crash"12 Meet the Speed Traders: Manoj Narang13 The Future of High-Frequency TradingConclusionNotesIndex
Excerpt
CHAPTER 1
The Emergence of High-Frequency Trading
While high-frequency trading has gained relevance with the general public onlyrecently, the practice of using computerized trading has been active fordecades, going as far back as 1971, when Nasdaq started as the world's firstelectronic market.
In the Beginning, 1969–1976
Traditionally, financial markets were physical locations where brokers withbuying and selling orders met and matched them appropriately. The technologicalevolution and, consequentially, the exponential growth of computing powerbrought a revolution to the financial markets, making it unnecessary for brokersto meet physically and enabling traders from remote locations to participate.The now Nomura-owned Instinet led the charge more than three decades ago.
February 24, 1969
On this day, Institutional Networks Corp. filed a patent application for its"Instinet Communication System for Effectuating the Sale or Exchange of FungibleProperties Between Subscribers." The company, founded two years before, aimed tocompete with the New York Stock Exchange by means of computer links betweenbanks, mutual funds, and insurance companies, with no delays or interveningspecialists. Through this Instinet system, which would start operating by 1970,the company would provide computer services and a communications network for theautomated buying and selling of equity securities on an anonymous, confidentialbasis. It also acted as a securities information processor, supplyingprofessional-level market data systems containing last sale, quote, and sizeinformation. Institutional Networks received income from commissions on thetrades and from the rental of the Instinet terminals located in the offices ofits clients. Institutional Networks was renamed Instinet in 1985.
February 8, 1971
This was the first trading day at the Nasdaq, an electronic alternative to over-the-counterstock exchanges. Nasdaq opened electronically with 2,500 over-the-counterstocks. It was not until the 1990s that the Nasdaq became a competitorof the New York Stock Exchange (NYSE); Nasdaq merged with the American StockExchange (AMEX) in 1998.
May 1, 1975
On this date, the Securities and Exchange Commission (SEC) banned fixed minimumcommission rates, a cornerstone of the U.S. securities markets and all otherorganized exchanges throughout the world. "Until then, the NYSE fixed theminimum commission of stock trading; these extraordinary high costs had hinderedquantitative traders from entering the equity markets," according to author LarsKestner.
March 1, 1976
The fully automated Designated Order Turnaround (DOT) system was introduced onthis day by the NYSE to route smaller orders electronically. The orders attendedby a stock exchange agency would be sent electronically to the computers insidethe market, allowing the stock exchange agencies to confirm the execution ofsome operations while still having the client on the telephone line, significantprogress for the time.
The DOT system involved the use of computer technology to relay orders. With anetwork interface, it was possible for investors to submit orders that wereimmediately logged in the servers for the exchange. The orders could be executedand confirmation of the execution relayed to the investor in what was thenconsidered real time. This type of real-time investment capability made itpossible for investors to benefit by having an order executed immediately ratherthan 10 minutes or an hour later. The DOT system was able to handle suchtransactions as limit orders, basket trades, and several other types of marketorders.
The Lead-up to Black Monday, 1982–1987
There were many voices eventually blaming the market collapse on electronictrading. The "flash crash" of 2010? No, Black Monday in 1987. That'sright—even back then, startups and banks, which were just getting startedin the electronic trading race, were pointed as the culprits of the dramaticdecline in the financial markets. The story would repeat itself 23 years later.
July 5, 1984
On this date, the NYSE approved the use of a version of the Super-DOT system foroptions trading. Super-DOT was an improvement over the DOT system and guaranteedthat any market order of less than 2,100 shares of a stock would be executedwithin three minutes at the prevailing bid price (for a market sell order) orasked price (for a market buy order) at the time the order was entered or atbetter prices, if possible. The DOT-for-Options system provided the NYSE optionsfloor with an electronic order-routing system not available on any other optionsexchange. The Super-DOT system, which included the NYSE's DOT, Opening AutomatedReport Service (OARS), and Limit Order (LMT), had been used to provide automatedtrading support to the NYSE equities trading floor since 1976.
October 19, 1987
After five days of intensifying stock market declines, selling pressure hit apeak on this day, Black Monday. The Dow Jones Industrial Average (DJIA) fell arecord 22 percent, with many stocks halted during the day because orderimbalances prevented true price discovery. The lead-up to October 1987 had seenthe DJIA more than triple in five years, and price/earnings (P/E) multiples onstocks had reached above 20, implying very bullish sentiment. And while thecrash began as a U.S. phenomenon, it quickly affected stock markets around theglobe; 19 of the 20 largest markets in the world saw stock market declines of 20percent or more.
Floor traders, working by telephone, dominated the action, andcomputer-generated trading still was in its infancy; certainly, dark pools andhigh-frequency trading were the stuff of science fiction, said the WallStreet Journal. Nevertheless, that didn't stop people from speculating onthe exact causes of the crash (which was rare in that the market made up most ofits losses rather quickly rather than falling into a protracted economicrecession) and pointing to automatic trading programs in place at the time aspossible culprit. An important parallel, though, was how a number of tradersabandoned the market; in 1987, some human market makers on the floor of theexchange stopped providing bids for certain stocks; more than two decades later,in a market dominated by technology, high-speed traders, who often provideliquidity for the market, just switched off their computers for very importantreasons that will be detailed in Chapter 9.
Technology Improves, 1994–2001
Upstarts and established players jockeyed for positions at the end of the 1990sto advance their standing as the SEC readied itself to approve Regulation ATS,the regulation of alternative trading systems, an area now dominated by BATS(Better Alternative Trading System) and Direct Edge.
August 1, 1994
On this date, Banque Nationale de Paris (BNP) announced that it would purchasemost of the operations of Cooper Neff, a Philadelphia-based options trading firmwith a reported $400 million in capital, to provide a broader array of financialproducts to its corporate and institutional clients worldwide. The acquisitionwould include all of Cooper Neff's technology and research capabilities, as wellas most of its trading operations.
Richard Cooper, founding partner of Cooper Neff, expected the buyout would pushhis firm "into the direct OTC [over-the-counter] customer market" using BNP'sclients in Europe and Asia. Before, Cooper Neff's 100-plus traders made marketsin exchange-traded options only and traded for the firm's own account. Later inthe decade, Cooper Neff would become the largest program-trading firm in theUnited States.
Cooper Neff was characterized in 1998 as another example of wizardry thatworked. In an enlightening article in BusinessWeek, BNP/Cooper Neff wasreferred to as the firm focused on the arbitrage between stocks that had becomeovervalued or undervalued because of such things as money flows in and out ofmarkets. The company was scrupulously neutral on the attractiveness of growthstocks versus cyclic stocks or large-cap stocks versus small-cap stocks.Although the firm's assets under management weren't huge, about $10 billion, itwas estimated that it accounted for about 4 percent of the daily trading volumeon the NYSE and 6 to 10 percent of the volume on the principal exchanges ofFrance, Germany, Spain, and Italy. BNP/Cooper Neff, which was so far not open tooutside investors, needed enormous volumes of trades because its average profitmargin per trade was so small. Its research staff included about a dozen physicsPh.D.s. Contrary to what most funds would have claimed, chairman and cofounderRichard W. Cooper had said that August was the company's best month in history,pointing out that in markets that become irrational, you can find greatermispricing opportunities.
December 4, 1994
On this date, William Christie and Paul Schultz, in a paper entitled, "Why DoNasdaq Market Makers Avoid Odd-Eighth Quotes?" published by the Journal ofFinance, pointed out that odd-eighths spreads were rare on Nasdaq becausedealers rarely quoted prices ending in 1/8, 3/8, 5/8, and 7/8; therefore, theinside spread always was at least ¼. Just the day after the study wasreported in news, spreads suddenly narrowed, which was interpreted by theauthors as evidence of tacit collusion. Ultimately, a federal class-actionlawsuit against the Nasdaq won $1.03 billion in 1998.
November 28, 1997
Xetra, an all-electronic trading system operated by Deutsche Börse, based inFrankfurt, Germany, was launched on this date. The Xetra platform offeredincreased flexibility for seeing order depth within the markets and trading instocks, funds, bonds, warrants, and commodities contracts. The Xetra system wascreated originally for use on the Frankfurt Stock Exchange but has expanded tobe used by various stock exchanges throughout Europe. As a result of its plansto acquire NYSE Euronext, Deutsche Börse is now planning to merge Xetra cashequity market with the Euronext platform to form a pan-European share-tradingmarket.
April 4, 1998
On this date, James and Marilyn Simons hosted a party at their Setauket home onLong Island for fellow mathematicians attending the "Connections in ModernMathematics and Physics" meeting, a special geometry festival in honor of Simonson the occasion of his sixtieth birthday. It was interesting to see that JamesSimons, founder of Renaissance Technologies, famous for shunning the limelightand rarely giving interviews to the press, opened his house for the occasion.Once, citing Benjamin the donkey in Animal Farm, he tried to explain hisbehavior: "God gave me a tail to keep off the flies, but I'd rather have had notail and no flies."
April 21, 1999
Regulation ATS, the regulation of alternative trading systems (ATSs), becameeffective on this day. The term ATSs was to encompass systems that theSEC previously had called proprietary trading systems, broker-dealer tradingsystems, and electronic communications networks (ECNs). In additionto a variety of reporting and operating requirements, there were three mainelements to the new framework. First, the SEC adopted a new interpretation ofkey terms in the statutory definition of exchange to include ATSs performingmarket functions. Second, authority provided by Congress to exempt systems fromexchange registration was invoked to give ATSs the option of registering asexchanges or as broker-dealers and complying with various requirements. Finally,the Securities Exchange Act of 1934 was interpreted to accommodate theregistration of for-profit entities as exchanges.
July 12, 1999
On this date, Goldman Sachs announced that it would buy Hull Group, Inc., aleading electronic trading company, for $531 million, making it one of theworld's largest electronic market makers for derivatives, especially stock andindex options. Goldman's purchase of Hull, its first major acquisition sincebecoming a public company two months before, was a calculated bet that peopleand institutions increasingly would buy and sell securities electronicallyrather than in private deals or on traditional exchange floors. Hull, which isbased in Chicago and would operate as a subsidiary of Goldman, was one of thelargest electronic traders and specialized in derivatives trading. Hull derivedmore than half its revenue from Europe, where electronic trading of securitieswas a step ahead of that in the United States, said M. Blair Hull, Hull'sfounder and chief executive. It had a substantial presence on stock exchanges inBritain, Germany, and France.
Like other large securities firms, Goldman had invested in new electronicsecurities exchanges, known as electronic communications networks(ECNs), that match buyers and sellers of stocks outside traditional exchangessuch as the New York Stock Exchange and the Nasdaq. Such exchanges helped tofill buy and sell orders for less money and at all hours. They had alreadysucceeded in taking some business away from the established exchanges.
January 11, 2001
On this date, the SEC approved the Nasdaq stock market's SuperMontage plan tocentralize display of its best stock quotes, overriding opposition fromautomated trading networks that compete with it. In granting Nasdaq thepreliminary approval of the new system in January 2001, the SEC ordered it tocreate an alternative automated system for electronic trading networks that donot want to use it. Known as the Alternative Display Facility (ADF), the othersystem posted stock prices but didn't permit its users to execute trades.
Nasdaq screens would display only the single best buy and sell orders, soinvestors looking for the next-best quotes must search the ECNs. The ECNs, whichautomatically match buy and sell orders, accounted for about a third of Nasdaq'svolume. ECNs, like Instinet from the Reuters Group, had expressed concern thatthey would lose business under the SuperMontage plan.
Regulating the Market, 2001–2008
If there was a clear turning point for electronic trading, it arguably would bethe decision by the SEC to require all U.S. exchanges to convert to decimals.Thereafter, it would just be a matter of time for ECNs and ATSs to experienceexplosive volume growth.
April 9, 2001
This was the deadline established by the SEC, the federal agency that overseesthe U.S. stock markets, for all U.S. stock markets to convert to decimals. Thedecimal system brought several benefits to investors, according to NYSE chairmanand CEO Richard A. Grasso. In June 2000, he had told a congressional committeethat decimals would generate stockholder savings. Studies had shown thatinvestors could save $1 billion or more a year. Stockholders would save oncommissions paid to stockbrokers. Commissions often were based on the price of ashare. Previously, stock prices had been measured in sixteenths of a dollar, or6.25 cents. Now, price increases could be measured to the penny, making smallerfluctuations in price and smaller commissions possible. Since most other stockexchanges already used decimals, the United States would be more compatible withthe rest of the world. Grasso also told the committee that the NYSE had upgradedits technology to handle twice as many transactions.
June 10, 2002
On this date, Instinet announced plans to acquire competitor Island ECN. Themove came just under two months before Nasdaq rolled out its beefed-up order andexecution system known as SuperMontage, which had been engineered to provide thebest liquidity for market makers big and small. While Instinet served 40 marketsaround the world, Nasdaq trades were the lion's share of its business. Islandrecently had made a name for itself as a marketplace for increasingly popularexchange-traded funds (ETFs).
Instinet and privately held Island were both ECNs that had garnered favor in the1990s with institutional and professional traders looking for fast, cheap, andanonymous trade execution, a platform in which Nasdaq itself had fallen behind.Worth nearly $3.5 billion at the initial public offering (IPO), Instinet hadwatched its market share and market value shrink as lower trading volumes anddecimalization made stock trading a less lucrative business.
Over the past year, Nasdaq had been slowing moving toward going public itself.Although it hadn't officially filed an IPO registration, the company had filedall other documents required for a public company with the SEC. The Nasdaqplanned to use an IPO to increase its global scope, which included ventures inJapan and Europe, attempting to head off ECNs before their international marketshare swelled.
August 28, 2002
On this date, the SEC approved Nasdaq's use of its new ATS, which cost thecompany more than $100 million to develop and had been stymied repeatedly by thelobbying efforts of its rapidly growing competitors; the system would letinvestors view orders placed through a variety of marketplaces that were thenseparate from one another. SEC officials said that they had sought to balanceconcerns raised by rivals about anticompetitive aspects of the system againstthe promise that it actually may lead to important advantages for investors.
The architects of the system said that by posting stock prices and orders fromall market participants and rivals, the new system, known as SuperMontage, wouldenable stock traders to pick from a variety of sources for the lowest buy andhighest sell prices.
October 9, 2002
On this date, Tradebot Systems, Inc., for the first time traded 100 millionshares in a single day, most of them stocks listed on the Nasdaq. The kind oftrading practiced by Tradebot, founded by David Cummings, was a particularlyfast form of algorithmic or black-box trading, in which computerprograms decided when to buy and sell securities.
(Continues...)
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