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algorithmic trading, automated trading system, Bernie Madoff, buttonwood tree, commoditize, computerized trading, corporate governance, cuban missile crisis, financial innovation, Flash crash, Gordon Gekko, High speed trading, latency arbitrage, locking in a profit, Mark Zuckerberg, market fragmentation, Ponzi scheme, price discovery process, price mechanism, price stability, Sergey Aleynikov, Sharpe ratio, short selling, Small Order Execution System, statistical arbitrage, transaction costs, two-sided market, zero-sum game
Dick highlights that investors are not allowed to use sub-penny prices to enter orders, such as $25.9999, yet brokerage and HFT firms can. The damage to investors is not only missed trading opportunities due to an uneven playing field, but harm to the integrity of public markets and quoting. What incentive is there for investors to display their quotes when those quotes can be used, in turn, to disadvantage them? How Latency Arbitrage in Dark Pools Hurts Investors Another way HFTs hurt investors in dark pools is through latency arbitrage. Latency arbitrage arises from the two speeds in the markets. On one hand, HFT firms, who colocate at the exchanges and buy their private data feeds, can construct the National Best Bid and Offer (NBBO) of any stock milliseconds before the investing public sees stock prices via the Securities Information Processor feed (SIP). On the other hand, most dark pools use the slower SIP to calculate reference prices (the prices that stocks will trade in their dark pool at any moment in time, such as the NBBO midpoint).
Gates has apparently tested the arbitrage numerous times, across a plethora of dark pools, with consistent results. Goldman Sachs, which operates Sigma X, one of the largest dark pools by volume, has recently undertaken the services of Redline Inc. and its InRush Ticker Plant product to speed up Sigma X’s NBBO calculation.11 To us, this is an acknowledgment of the harm latency arbitrage causes investors. In a white paper we published in December 2009, “Latency Arbitrage: The Real Power Behind Predatory High Frequency Trading,” we raised three serious questions about market integrity surrounding Latency Arbitrage:12 1. The primary response from HFTs or market centers is typically “a penny or two should not matter to long-term investors; this is much ado about nothing,” to paraphrase the CEO of a major ATS who was addressing a financial industry conference in New York City in early November.
Finance website, http://finance.yahoo.com/news/pf_article_109725.html. 11. A-Team Group, “Q&A: Redline’s Mark Skalabrin on Goldman, and Why Cell Is Better” (Sept. 25, 2011), Low-Latency website, http://low-latency.com/article/qa-redlines-mark-skalabrin-goldman-and-why-cell-better. 12. Sal Arnuk and Joseph Saluzzi, “Latency Arbitrage: The Real Power Behind Predatory High Frequency Trading” (Dec. 4, 2009), Themis Trading website, http://www.themistrading.com/article_files/0000/0519/THEMIS_TRADING_White_Paper_--_Latency_Arbitrage_--_December_4__2009.pdf. 13. Mary Schapiro, “Testimony on U.S. Equity Market Structure by the U.S. Securities and Exchange Commission” (Dec. 8, 2010), Securities and Exchange Commission website, http://www.sec.gov/news/testimony/2010/ts120810mls.htm. 9. Dude, Where’s My Order? It was summer 1999, and the NASDAQ was rocking.
algorithmic trading, automated trading system, banking crisis, bash_history, Bernie Madoff, butterfly effect, buttonwood tree, Chuck Templeton: OpenTable, cloud computing, collapse of Lehman Brothers, computerized trading, creative destruction, Donald Trump, fixed income, Flash crash, Francisco Pizarro, Gordon Gekko, Hibernia Atlantic: Project Express, High speed trading, Joseph Schumpeter, latency arbitrage, Long Term Capital Management, Mark Zuckerberg, market design, market microstructure, pattern recognition, pets.com, Ponzi scheme, popular electronics, prediction markets, quantitative hedge fund, Ray Kurzweil, Renaissance Technologies, Sergey Aleynikov, Small Order Execution System, South China Sea, Spread Networks laid a new fibre optics cable between New York and Chicago, stealth mode startup, stochastic process, transaction costs, Watson beat the top human players on Jeopardy!, zero-sum game
CUMMINGS had more tricks up his sleeve. Around 2004, he began to develop a strategy to make money trading in dark pools, a rising force in the early 2000s. While institutional traders were running from the lit markets such as Nasdaq into dark pools, in order to get away from the new breed of high-speed traders, like Tradebot, the speed traders devised methods to swim in the dark as well. Known as “latency arbitrage,” the strategy involved gaming the difference between the price of a stock in a dark pool and its price in the lit markets. Tradebot was effectively exploiting the “latency” of the system, a measurement of the time it takes for information to move from place to place in a closed system, such as a market. Behind the difference: dark pools that priced stocks based on an electronic feed called the Securities Information Processor, or SIP.
While the firm was named after a delicate flower—a trillium is a lily with three leaves—it stayed faithful to its hard-charging push-the-envelope legacy. LEVINE wasn’t quite ready to stop trying to save Wall Street from itself, however. An inventor at heart, he was still determined to change the world through technology. His next project concerned the computer system that disseminated trade data around the market, the Securities Information Processor, or SIP (the same SIP that high-speed firms such as Tradebot exploited for their latency arbitrage strategies). In the early 2000s, the SIP feed was notoriously slow—giving quick-draw firms opportunities to arbitrage a stock trading at slightly different prices on different pools. Levine submitted a proposal to build what he called the Big J SIP to a committee of market experts that was considering remaking the feed in 2002. Levine proposed to do the work for $1. The next lowest bid was on the order of tens of millions.
Flash Boys: A Wall Street Revolt by Michael Lewis
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The activity peaked roughly 350 microseconds after an investor’s order triggered the feeding frenzy, or the time it took for HFT to send its orders from the stock exchange on which the investor had touched down to all of the others. “Your eye will never pick up what is really happening,” said Brad. “You don’t see shit. Even if you’re a fucking cyborg you don’t see it. But if there was no value to reacting, why would anyone react at all?” The arrival of the prey awakened the predator, who deployed his strategies—rebate arbitrage, latency arbitrage, slow market arbitrage. Brad didn’t need to dwell on these; he’d already walked each of the investors through his earlier discoveries. It was his new findings that he wanted them to focus on.†† On IEX’s opening day—when it had traded just half a million shares—the flow of orders through its computers had been too rapid for the human eye to make sense of it. Brad had spent the first week or so glued to his terminal, trying to see whatever he could see.