High-frequency traders were "eating the lunch" of its business

[Cees Binkhorst]

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Groet / Cees

"High-frequency trading, fundamentally, when you look at what their
algorithms are finding, they're almost a structured way of trying to
front-run. That just seems to me ultimately as doing it at the expense
of other investors"
McCaughan (CEO Principal Financial Group, $215 billion assets) said he
had no proof of wrongdoing, yet he suspected it is quite likely the
leaking of information may have happened. "If it has, it would at best
be unfair to other investors and perhaps criminal," he said.
--------------
Being nimble is key to success. Narang said he and his partners at
Tradeworx realized a couple of years ago that high-frequency traders
were "eating the lunch" of its hedge fund business. In response, Narang
moved into fast trading and incorporated those techniques in the hedge
fund.
--------------
Institutional investors mostly complain about alleged unfair advantages
and that their trades are being "gamed."
A high cancellation rate for orders has sparked suggestions that the
algorithms are deployed to glean information from pending order flows,
and then based on that knowledge, race ahead to scoop up trades.
--------------
Detractors also question the amount of money the high-speed traders
make, especially after holding a stock for only a few seconds. They
wonder what purpose such quick turnover serves.
--------------
If in a good mood, I say Wall Street is nothing but a vast promotion
machine. If not, it's a den of thieves. So there is always the
possibility of front running, insider trading, market manipulation.
--------------
Most of our clients really don't spend a lot of energy worrying about
the last penny on a trade, or the last two pennies
--------------

http://www.reuters.com/article/wtUSInvestingNews/idUSN173583920091202
By Jonathan Spicer and Herbert Lash

NEW YORK (Reuters) - Inside the offices of Tradeworx, an emerging player
in the secretive and controversial world of high-frequency trading, it's
dead quiet as staffers pore over the "tape," financial industry speak
for the record of the day's transactions.

Many of the firm's 30 employees are not yet 25. They were hired straight
from college to ensure their thinking and work habits are untainted. Now
they're making Wall Street's latest fortune, a fraction of a penny at a
time.

The only clue that Tradeworx, a six-year-old hedge fund based in Red
Bank, New Jersey, is a financial outfit at all are two giant screens
that break up the monotony of white walls and grayish carpets. The
physics and computer science graduates are crafting complex computer
codes to exploit trading patterns revealed by the tape.

Tradeworx and other firms like it use such algorithms in the
lightning-quick trading approach that is altering the landscape of U.S.
markets, driving broker-dealers out of business and changing how money
managers invest.

High-frequency trading now accounts for 60 percent of total U.S. equity
volume, and is spreading overseas and into other markets. These traders
stand ready to buy and sell shares at all times, providing the liquidity
that keeps markets moving. As a result, trading is now cheaper and
easier than ever.

Yet critics worry fast trading may undermine the integrity of the U.S.
equity market, a bastion of capitalism and corporate America, and could
even spark another financial crisis.

They also complain about the money high-frequency firms are making --
and how they are making it. During last year's plunge, when volatility
rose, many high-frequency traders earned 10 times their usual profits,
executives at several of the proprietary firms told Reuters.

For their part, the fast traders don't see what all the fuss is about.

"We live in a capitalist society," said Tradeworx Chief Executive Manoj
Narang, 40, wearing jeans, runners and a Yankees baseball cap.

"People should expect and be willing to pay a price for the liquidity
that they get. No one should expect that a provider of liquidity is just
going to stand there while you bulldoze them into submission," Narang
said.

Tradeworx started high-frequency trading in January and now accounts for
about 3 percent of overall volume in the exchange-traded fund SPDR
Trust, which tracks the Standard & Poor's 500 Index and is one of the
most heavily traded securities.

High-frequency traders point to last year's steep sell-off as proof of
their value in helping the market run smoothly. While over-the-counter
and other markets seized up, exacerbating the worst financial crisis
since the Great Depression, fast traders continued to buy and sell
shares.

Proponents also laud computerized trading for eliminating the shady
transactions that often occurred in the past when people were directly
involved in trading.

TAPE HOLDS ANSWERS TO DEBATE

Trading today seems less intimate, less human, married as it is to
computer code. The revolution has caught some people off guard, and has
led to deep concerns.

Many institutional money managers are uneasy about how the fast traders
anticipate their transactions, and worry that there might be information
leakage about their trading intentions -- a critical issue for asset
managers.

"High-frequency trading, fundamentally, when you look at what their
algorithms are finding, they're almost a structured way of trying to
front-run," said Jim McCaughan, chief executive of the asset management
arm of Principal Financial Group, where he oversees about $215 billion
in assets.

"That just seems to me ultimately as doing it at the expense of other
investors," he said.

McCaughan said he had no proof of wrongdoing, yet he suspected it is
quite likely the leaking of information may have happened. "If it has,
it would at best be unfair to other investors and perhaps criminal," he
said.

A furor over the extent of computerized trading erupted this summer when
news of the enormous profits being garnered rankled a public already
apprehensive about a crisis rooted in Wall Street -- whose bailout the
taxpayer is footing.

Critics fear an errant computer code, similar to the program trading
behind the Black Monday crash of 1987, could engender another deep
market plunge.

The U.S. Securities and Exchange Commission is taking months to
investigate all this. With high-frequency trading spreading quickly from
its U.S. equity base, the regulator's response will be crucial for
capital markets around the world.

Key to any discussion of high-frequency trading is the tape, which
records the price, time, size and order of trades. It's the day's
financial narrative, and its availability is held up as a major reason
why the U.S. equity markets are trusted for their transparency and
fairness.

The tape is also highly prized by traders, who base their computer
instructions, called algorithms, on this data. The Nasdaq Stock Market
produces about 50 gigabytes of information every day, which is measured
in nanoseconds -- or a billionth of a second.

Lotus Capital Management LP of New York earlier this year realized that
a competitor was beating it to a trade it had programed by exactly 3
microseconds, day after day. The loss meant Lotus was forfeiting about
$1,000 in daily revenue on that particular trading strategy.

Lotus, a quantitative trading firm that uses high-frequency strategies,
invested and tinkered, eventually shaving five microseconds from the
router and two microseconds from the execution server.

"By just reading the tape you can see a lot of what the other guys are
doing. You can see who is successful. So eventually everyone is
operating more or less the same strategy," said Louis Liu, the
37-year-old founder of Lotus.

BROKER-DEALER MODEL UNDER FIRE

Operators like Lotus have changed the nature of the business. Small
start-ups can launch with less than $1 million, and are creating
enormous cost pressures on established broker-dealers and others that
can't keep up, Liu said.

"That's where a lot of the complaints are coming from. We're driving the
spreads down and squeezing the profit margins," he said. Legacy
operators know what needs to be done, "but they're not willing to
cannibalize their existing business," he added.

Being nimble is key to success. Narang said he and his partners at
Tradeworx realized a couple of years ago that high-frequency traders
were "eating the lunch" of its hedge fund business. In response, Narang
moved into fast trading and incorporated those techniques in the hedge
fund.

The firm began targeting math whizzes very selectively. Last year, just
six of 1,500 resumes led to jobs at Tradeworx, one of several firms
setting up shop in up-and-coming Red Bank, a former manufacturing hub.

Others agree with Liu that the recent cries of foul play and other
criticisms of electronic trading are coming from those who have been
displaced in the lucrative brokerage business.

"The broker-dealer business model is dying, and you have massive
over-capacity," said Harold Bradley, chief investment officer at the
Ewing Marion Kauffman Foundation in Kansas City, where he oversees $1.7
billion in assets.

"You don't need a dealer to put you and me together through three other
brokers in a Nasdaq stock. There should be fewer people in the
business."

Several incidents this summer underscored the secrecy and money to be
made from high-frequency trading. The FBI in July arrested a former
Goldman Sachs Group Inc (GS.N) computer programer for allegedly stealing
trade secrets. The bank later reported blowout second-quarter earnings,
bolstered by $10.78 billion in trading income.

When TABB Group estimated $21.8 billion was earned annually in
high-frequency trading, the media pounced on the issue. Yet few critics
asked how the size of profit compared to the past. Rosenblatt Securities
pointed out that as far back as 1997, overall trading on the Nasdaq
alone may have generated $20 billion in annual brokerage revenue,
suggesting that profits were already substantial more than a decade ago.

REGULATOR'S REPORT LOOMS

Proprietary trading powerhouses Getco and Tradebot, hedge fund Citadel
Investment Group and trading desks at Goldman Sachs and Citigroup Inc
(C.N) are some of the industry's prominent names.

Tradebot and Getco, seen as trailblazers in rapid trading, regularly
account for a combined 20 percent of the overall U.S. stock market.
Market sources suggest the firms each trade more than 1 billion shares a
day. Tradeworx trades some 80 million shares per day.

With worries over systemic risk growing, the SEC has jumped into the
fray. It has proposed a ban on so-called flash orders and wants to crack
down on the scores of anonymous trading venues known as dark pools.

The regulator plans to issue a report early next year that officials
said would focus on whether markets reliant on high-frequency trading
are more or less efficient for long-term investors, including those
trading small- and mid-cap stocks.

Most fears of a blow-up surround what is known as naked sponsored
access, in which brokers allow traders use of their identification to
directly trade on exchanges, saving the traders valuable time.

Critics also say the fast traders are less willing to take the other
side of trades outside of large-cap stocks, reducing the amount of
liquidity in smaller companies.

Politicians also are stirring the pot. Senator Ted Kaufman has warned
high-frequency trading could lead to market chaos and systemic risk.

In October, SEC Chairman Mary Schapiro told Reuters the regulator "will
not hesitate to propose regulatory approaches" if concerns are
"significant.

The SEC recently hired Richard Bookstaber, a well-known former risk
manager at Morgan Stanley (MS.N), Salomon Brothers and hedge fund Moore
Capital Management, to work in a newly created division designed to
identify risks in financial markets.

Bookstaber indicated on his blog in August that he is not particularly
worried that high-frequency trading or the use of algorithms will lead
to a blow-up. "I don't think the risk is as big as many are making it
out to be," he wrote.

Institutional investors mostly complain about alleged unfair advantages
and that their trades are being "gamed."

A high cancellation rate for orders has sparked suggestions that the
algorithms are deployed to glean information from pending order flows,
and then based on that knowledge, race ahead to scoop up trades.

More than 90 percent of orders submitted to the New York Stock Exchange
by high-frequency firms are canceled, according to an NYSE Euronext
(NYX.N) official. Overall, the average daily trade volume of NYSE-listed
stocks has more than tripled in five years as of 2008.

The head trader of a European money manager with more than $100 billion
in assets said high-frequency traders profit through pattern recognition
software to anticipate a trade.

"It's a certain knowledge of what's coming. It's not like they're
guessing what's going to happen, they're not speculating," said the
trader, who spoke on the condition of anonymity. And he added
emphatically: "They know."

Detractors also question the amount of money the high-speed traders
make, especially after holding a stock for only a few seconds. They
wonder what purpose such quick turnover serves.

The market "is not trading on fundamentals anymore. It makes no sense,
it's very frustrating for traders," said Alan Valdes, director of floor
trading at NYSE member Kabrik Trading. "It's all programs."

'NO BARRIER TO ENTRY'

The criticism has frustrated high-frequency traders, who are
increasingly going public to defend their business. Several said they
expect little impact from any new regulation, and expressed confidence
that their role in the marketplace would be preserved.

Fast traders are proud they make their money through a battle of wits,
believe in the work ethic and do not rely on chummy business ties. There
is talk of forming an association, presumably to quell complaints and
educate the public about their business.

"If you were on Wall Street in the 1990s ... you would need to take guys
out to dinner and build relationships, otherwise you couldn't get at the
order flow. And now, if you're good ... there's no barrier to entry,"
said Cameron Smith, general counsel at Houston-based technology and
trading firm Quantlab Financial LLC, which does high-frequency trading.

"That is a really incredible improvement to the Wall Street
environment," he said. "That's how we want markets to work."

A sign of the critical role the fast traders have assumed came to the
fore last year after the SEC briefly banned the short-selling of
financial securities. Spreads widened and trading volume declined as
high-frequency traders cut back on their presence to adjust algorithms.

After the ban was lifted, the high-frequency players came back. Spreads
started collapsing and volume picked up, said Todd Mackedanz, head
trader at Fisher Investments, the firm founded by billionaire investor
Ken Fisher based in Woodside, California.

"With that said, they do in a sense play a fairly important role in the
marketplace," Mackedanz said.

Fisher Investments, like other institutional investors, has set tight
price limits and is careful about whom it trades with to try to ensure
it gets the best execution possible.

Many investors fear that high-frequency trading may fall prey to bad
habits. In 1994, for instance, an academic study found that a large
number of Nasdaq stocks were traded with spreads that were double the
minimum, raising the question of whether dealers colluded to maintain
wide spreads.

Jean-Marie Eveillard, a legendary investor on Wall Street, said that
high-frequency trading strikes him as suspect. But Eveillard said in an
e-mail message that he had no particular insight other than this: "If in
a good mood, I say Wall Street is nothing but a vast promotion machine.
If not, it's a den of thieves. So there is always the possibility of
front running, insider trading, market manipulation."

HIGH FREQUENCY TRADING STRATEGIES

Any big market move creates ripples on which high-frequency traders
feast.

Correlation strategies -- like selling the S&P 500 index exchange traded
fund when a blue-chip company misses earnings expectations -- are left
to high-frequency players with the most horsepower. Others are relegated
to more complicated techniques, poring over historic trading records in
various regions and asset classes.

Market making is the dominant technique, with the top-tier "ultra
high-frequency" firms -- those trading more than 1 billion shares per
day and holding positions for seconds -- relying heavily on gathering
the rebates exchanges pay them for posting orders.

If a trader's bid of $15.80 for Bank of America (BAC.N) shares is
matched, that person might immediately post an offer for the same price,
hoping to capture two rebates while breaking even on the spread.

The result, according to several independent proprietary firms, is a
flooding of the 50 some U.S. trading venues with orders, and
near-immediate execution for investors -- even if the high-frequency
trader on the other side of the trade walks away with one-tenth of a
penny per share, on average.

A misunderstood dynamic of high-frequency trading is that it thrives off
volatility, thereby reducing it. The clear winners in the revolution are
small investors, who have seen their trading costs fall remarkably and
markets price shares far more efficiently.

"Most of our clients really don't spend a lot of energy worrying about
the last penny on a trade, or the last two pennies," Charles Schwab,
founder of Charles Schwab Corp (SCHW.O), the largest U.S. discount
brokerage, said last month during a Web cast business update.

"We think the liquidity components are perfectly satisfactory."

SECRECY AND SUCCESS

The 2000 decision to price quotes in decimals of a dollar was probably
the most important in a series of U.S. rule changes in the last dozen
years that sowed the seeds of high-frequency trading.

A spread of 25 cents for a Nasdaq stock was not uncommon 15 years ago,
when market makers and floor specialists had fixed commissions and wooed
clients to win business.

The late 1990s introduction of alternative trading venues was another
regulatory turning point, as well as a 2005 "trade-through" rule that
ensured investors get the best U.S. bid or offer, no matter where it
was.

Transactions are dramatically faster, and the duration of time long-term
investors own securities has been shortened. Eighteen months is now
considered very long, compared with two or three years about half a
decade ago.

Another complaint that haunts high-frequency trading is secrecy -- not
just around their firms' strategies but even who they are. A number of
firms declined to be interviewed by Reuters.

"People think that high-frequency trading firms ... are secretive
because they're doing something untoward," Narang said. "Really the
reason they're secretive is because as soon as they spill the beans
other people can compete with what they're doing."

All Wall Street firms want to stay under the radar screen, said Robert
Olman, president of Alpha Search Advisory Partners, an executive search
firm for hedge funds and prop shops.

"Once you're successful, once you have a system that's making money, you
become very secretive because it's very easy for one of your guys to
leave and replicate it," he said. That's the reason behind Coca-Cola
Co's closely guarded formula for making Coke, he said.

"What are the exact ingredients and proportions of Coca-Cola? Is there
something wrong going on at Coca-Cola?" he said. "That's the point. It's
replication, ease of replication. The barriers to entry, to competing,
are not too high."

(Reporting by Herbert Lash and Jonathan Spicer, editing by Jim Impoco)

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