Follow up on high frequency trading

My last blog post on high frequency trading got a surprisingly wide reception – and was reprinted for several different audiences. The comments at Talking Points Memo were muted and did not touch the general angst about this issue. That is not surprising – that is a politics driven audience. The commentary at Business Insider was outright hostile with the general consensus being that I am an idiot. The reception on my own blog was balanced – with several people pointing out mistakes I made (and I made a few) and with most talking about the argument on its merits.

Still – one lesson – if you write an article that is not outright critical of Wall Street practice then you should expect to be called an idiot. I got endless emails asserting my stupidity.

All I wanted to really understand what the risks Goldman is taking to make all those trading profits. Sure I know most of them are fixed income – but the balance sheet is still in the trillion dollar range and this crisis has proved that ultimately these balance sheets get socialised. If taxpayers are ultimately on the hook then it is incumbent on taxpayers (at a minimum) to understand and manage the risks that they are taking through their regulatory agencies.

Anyway back to the hot-button issue which is electronic and high frequency trading.

First – let’s discuss front running.

I gave an example of a stock that was bid $129.50, sell $131.50. I bid $129.55 and immediately a computer bid $129.60 over me. I called this front running.

I stand corrected – if someone (even proprietary traders associated with my own broker) bids $129.60 over my bid of $129.55 they are not committing the crime of “front running” – but using the public information in my bid to make a different bid.

It would only be front running if they (a) worked for my broker and (b) organised to have their bid filled preferentially at $129.55.

Of course from my perspective it makes not a rats difference whether they got in front of me at $129.55 or $129.56. That difference is less than 0.01 percent and if you are in my business (strict fundamental investing for medium and long term) it makes no sense to be worried about that sort of percentage. Front running as a crime might have mattered when notional spreads were wide and we did not have 1c pricing. But now the issue is just pricing over me and my clients - not whether those orders are legal or otherwise.

The issue is not front-running per-se (except maybe using my broader – non-criminal use of the term). The issue is that more often than not, as a smallish institution, we are forced to go to the middle of the spread or often cross the spread to get filled. Traders – whether they be bots or the old fashioned screen addicted traders of yore make a good proportion of their profits simply by consistently earning spreads. One old Sydney Futures Exchange trader (open outcry) admitted that (unsurprisingly) was how he made his living. Traders make profits on their short term positions (and sometimes make surprisingly good returns on equity). Those profits come out of somewhere – and I am not averse to the notion that Bronte and its clients pay a small share of them. I am not averse to the notion that clever algorithmic traders effectively “tax” other market participants (and I am not particularly scared of that loaded word “tax”).

Nonetheless the tax is small and the issue is not and should not be a target for major reform. The attention played in the blogosphere – driven in part by Zero Hedge – is simply not warranted.

To quantify: these days the spreads are often 1c on $15 shares (say 0.07 percent) and I can easily get brokerage at a tenth of a percent. I can often buy more than enough stock at the high end of spreads. Even if I lose to the algorithmic traders every time (and I accept that I do a fair bit) then – hey – I am paying 0.15 percent for trading. That is a lot better than it was in the old days when brokerage fees were fixed, large and non-negotiable.

Moreover as a fundamental driven investor the turnover in my portfolio is low. Ideally we will turn over less than once per three years – but as market volatility is high we seem to be getting more opportunities for good switches than that. I can’t imagine how the switching costs for Bronte Capital’s portfolio are higher than they were before brokerage reform even with the “tax” that high frequency traders impose on the rest of the market. [Likewise we trade currency with spreads of 1 point (ie down to the hundredth of a US cent). Only a few years ago we traded with 5 points of spread.]

This issue is – as I suggested – a distraction. There are plenty of real issues for financial reform – and one of the most important in my view being the large and seemingly wholesale funded balance sheets of investment banks. Nobody really understands these balance sheets but ultimately we (though the tax base) are guaranteeing them. That is what the slogan “no more Lehmans” means.

Can we focus where it matters? HFT remains a distraction.

John

PS. Thomas Peterffy pointed out in the comments to my last post that fairly good algorithmic trading is available to small institutions like Bronte at very low fees. (He should know – he is probably the single most important driving force behind electronic trading globally. However he is selling his own service.) If anything these programs reduce the “tax” paid by ordinary institutions such as Bronte even further. Peterffy thinks his algorithm tends to beat the electronic traders. We have not experimented enough to back that conclusion.

PPS. A reasonable summary is that old-fashioned traders earnt big spreads with quite a deal of sweat and only a modest degree of certainty. New fangled high frequency traders earn small spreads with high frequency and ruthless efficiency. But they are still smaller spreads.

PPS. Quantifications of this as a $20 billion issue are insane. Felix Salmon once took umbrage at my assertion that the pre-tax pre-provision profits of the financial sector in the US were at least $300 billion. That looks like an underestimate. He however swallows this insane number without too much question.