Friday, August 28, 2009

WSJ: Meet Getco, High Frequency Trade King

I guess "High Frequency Trading" is the official term for what I've called HAL9000 for the past few years... the Wall Street Journal has a nice story on Getco, one of the major players. It would best to familiarize yourselves with the actions of these few firms who now (depending on where you ask) are controlling 30-70% of every day's trades. Being in the market quite actively since the mid 90s I have said countless times in the blog that the market "acts" and "feels" different than even 3-4 years ago. Part of it is the algorithms and part of it is the dominance of ETFs which now move hundreds of stocks inside of them without regard for individual prospects. Now as we see what is going on behind the surface we see why that is.

The human leverage in a firm like this is amazing - less than 250 people, in 1 firm, account for 10 to 20% of the daily trading volume in many US stocks. Think about that for a moment... how concentrated the power is; and this company is only 10 years old. Throw Citadel, Goldman, Getco, and Renaissance Tech together and at that point I don't know why the rest of us bother to show up. I am sure I am missing one or two other firms since I am not "inside baseball" but if you give each 5-6 firms 10-15% of the daily trading volume, you see what is left for the other 99.85% of investors. We're a freak sideshow.
  • One of the biggest players in the hot area of high-frequency trading is one of the least known. Getco LLC, a private company with fewer than 250 employees, often accounts for 10% to 20% of the daily trading volume of many U.S. stocks, the company has said, including highly traded names such as General Electric Co., Oracle Corp. and Google Inc.
  • High-frequency trading, in which traders use powerful computers and algorithms to trade at lightning-fast speeds, has grabbed attention after it produced stellar results during the financial crisis and amid estimates that it now accounts for more than half of U.S. daily stock trading.
  • Since its founding a decade ago, the firm has risen to become one of the five biggest traders measured by volume in stocks and other instruments that trade electronically on exchanges, such as Treasury bonds and currency futures, according to firm executives, who spoke with the Journal this week, and other people in the industry.
  • "They are probably the biggest market maker in the U.S. stock market," said Justin Schack, a vice president at Rosenblatt Securities Inc. who closely tracks high-frequency trading. A market maker is a firm that always stands ready to buy or sell a stock.
  • Critics say high-frequency traders can trade ahead of less fleet-footed investors and squeeze pennies out of their pockets. Defenders say high-frequency shops help markets operate more efficiently by constantly stepping in to trade securities when investors wish to buy and sell. That, in turn, makes trading cheaper for individual investors.
  • Getco has increased its contact with the SEC and others as it seeks to influence policy decisions on matters such as rules governing options markets.
How is it done?
  • At Getco, traders stare at enormous high-definition screens stacked to the ceiling that display trades in virtually every financial instrument traded electronically on exchanges. Large white boards, thick with scribbled formulas and intricate diagrams, line the walls of its expansive trading hub on the second floor of the office tower that houses the Chicago Board of Trade.
  • Getco depends on the success of its proprietary complex algorithms to help it make money on the transactions more often than not. It also can pick up tiny rebates that some exchanges offer to firms willing to take the other side of trading orders.
  • Unlike traditional Wall Street firms, the company holds relatively few securities by the time markets close for the day. Nor does it use much leverage, or borrowed money, to amplify the effects of its trades.
  • During the trading day, it can lose money if it accumulates large positions and the market suddenly moves against it, a risk it works to minimize by trading quickly in and out of markets.
When I read this it does help to explain the post 3:30 PM action - not so much it going "up" so often, but why we have huge spikes in volume at the close of each day especially in the last 5 to 10 minutes. Since anywhere from "30 to 70%" of the volume each day is not held overnight, all these HFT traders need to get back to cash by 4 PM. Rinse. Wash. Repeat the next day. And that's your current "investment" landscape; the vast majority of trades executing not meant to be held for over 6.5 hours - just as Benjamin Graham envisioned. Ahem.
  • The boom in ETFs in recent years has also boosted high-frequency trading, as moves in and out of the funds can mean hundreds of trades in the underlying stocks. More recently, exchanges have been ramping up their technology platforms, making high-frequency trading easier and more profitable.

We can also assume they have been dominating in the Fannie, Freddie, AIG, Citi, Bank of America trade the past few weeks
  • It favors shares that are the most heavily traded.
  • For example, if Microsoft shares are trading in range of $24.09 and $24.12, an investor may place an order to sell Microsoft for no less than $24.10. On the other side of that trade could be Getco with an order to buy at $24.10. Getco likely also will have an offer to sell Microsoft for $24.11.
  • If the trade works, Getco will make money on that tiny spread. Sometimes they don't; the challenge then is to get out as quickly as possible. In this case, if it accumulates a large amount of Microsoft stock at $24.10, however, it will stop buying and offer to buy and sell at lower prices.
Who are the players?
  • The company focuses on hiring top computer programmers and technicians, as well as traders.

I actually don't have an issue with the concept from a 40,000 foot point of view - I just think the advantages of colocating right within the exchange offers advantages to a tiny fraction of financiers that the normal investor will never have. But that's basically how markets are set to be, and no one wants to change it - so it is what it is. Obviously technology will advance and now we seem to be in a window where it seems to have surpassed the framework supposed to contain it. I will ask, would it really be so wrong to require "investors" to own a stock more than 10 seconds and how apparently a game changer that "unfair" request would be nowadays.

I will repeat what I said last year - this might keep working for a year, 2 years, 5 - even 10. But eventually this will turn on itself and cause a another Black Swan. Just as humans are apt to do, although I expect the speed of this Black Swan event caused by HAL9000s to be extraordinary. I could see October 19, 1987 literally happening within a 10 minute time frame especially if we continue down this path and even more money goes into these strategies. But until that day, certainly incredible wealth will be created by a small subset of firms while the rest of the investing class just looks like a 1910 Model T trying to buy stocks on... fundamentals (chortle). As we now know everything in financial America is about exploiting narrow windows, even if it breeds massive instability down the road - and then have the taxpayer clean up the mess. So we're on track here.

As to the claim to fame for skimming (which is basically what the HFT trader does) is "providing liquidity" - we saw in August 2007 and various times in 2008 that their liquidity disappeared once things started going really haywire. So it's not a true claim - a true liquidity provider would be (hate to say it) like the Fed, throwing money in every direction at the darkest moments; not running away. The bigger picture is - we are going overkill on using liquidity as a justification for everything JUST as we did with credit. The parallels identical. Maybe if stocks did not have supreme liquidity and there was a .04 spread instead of 0.0012 people might think about why they are buying the stock and hold it for more than 4/300th of a second. It's really the same as asking if every college student with a heartbeat should be offered a $4000 VISA and a free Tshirt - we do overkill on everything and when the eventual excess explodes, I'll be paying for it.

But don't worry about - I'm sure it will all work out in the end. It always does.

*note: I know from emails some of my readers are in the HFT game and this is not a criticism of you - this is the regulatory framework, and if this is what we've chosen to have as a stock market, the free market will come in and exploit the nooks and crannies - fair enough. My questions are more along the lines of - what is the stock market here for... investing in vehicles for appreciation over 1 day appears to not to be it anymore.

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