
High Frequency Trading and Finance's Race to Irrelevance - hype7
http://blogs.hbr.org/2014/06/high-frequency-trading-and-finances-race-to-irrelevance/
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kiyoto
I want to shed some light on this topic. As a former HFT quant, I find the
general "Main Street" sentiment toward the profession to be misguided.

1\. HFT does NOT take anything from most investors most of the time. Most
investors trade on a much longer investment horizon than any HFT firm. If you
are a normal investor, you can lump up most of HFTs into the same bucket as
the exchange itself. Most of them engage in some combinations of (i) pure
arbitrage (ii) very short-termed statistical arbitrage (iii) market-making
based on (i) and (ii). None of this is really that relevant to most investors.
The only time HFTs can screw over a lot of investors is when their software
goes awry. But this is a risk that any computerized system has, high frequency
or not. If there is a major bug in Chicago Mercantile Exchange's matching
engines, that would be a total disaster.

2\. HFT firms do have huge execution risks: if you are making a two-sided
market, there is a chance you can get "swept", meaning when the value of the
underlying moves faster than you can react, you get filled on one side of the
order without a realistic chance of hedging for a profit. HFT firms do a ton
of research into estimating their execution risks. (edit: This point is often
glossed over, making HFTs look like this evil superpower group of nerds
exploiting other investors. That's not the case)

3\. Finally, most HFT traders don't go into the profession solely for the
money, just like most people do not apply for YC solely for their passion.
Most of my former coworkers weren't that greedy and led pretty modest lives
despite making hundreds of thousands of dollars. For them, high frequency
trading had a locally optimal balance of tackling intellectually challenging
problems while getting paid handsomely.

I won't say HFT is the most valuable thing that its practitioners can be
doing. I think the (trading) world would operate just fine without all these
micro-second level transactions. But they are NOT the next subprime mortgage,
and I just hope folks stop commenting on stuff they have no clue about.

~~~
rdrdss23
If you step back for a second. You say: " HFT does NOT take anything from most
investors most of the time."

Yet the HFT people are making tons of money. Where is it ultimately coming
from?

~~~
kasey_junk
"tons of money" is also relative. HFT firms make way less money than the
ibanks that act as middle men to most investors and the exchanges.

Most of the money in HFT actually comes from those previously more rapacious
middlemen's bonus.

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minikites
> What Lewis’s book demonstrated to me isn’t just how “bad” HFTs are per se,
> but rather, what happens when finance keeps walking down the path it seems
> to be set on — a path that involves abstracting itself from the creation of
> real-world value. The final destination? It will enter a world entirely of
> its own — a world in which it is fighting to capture value that is
> completely independent of whether any is created in the first place.

I'd say the financial markets have been there for 6-8 years already.

~~~
rsync
Nothing will change, since it's turtles all the way down.

The first person to discount a bill at the very first bank was "abstracting
itself from the creation of real-world value".

Later, I'm sure someone said the _exact same sentence_ that you just did when
the first exchange traded fund (ETF) was created. I know for a fact it was
said throughout the 90s in relation to derivatives, etc.

In the future, HFT as it exists today will be a quaint feature of a bygone era
that will be referenced to illustrate the problems with whatever new practice
has superseded it.

What _does_ matter is where you are on the spectrum and how fragile that makes
you, but there is no natural law limiting how abstracted you can be and how
fragile you can be. By some relative measures we're impossibly abstracted and
fragile, but by other relative measures (as yet unknown) we're adorably
simple.

~~~
jeremyjh
I thought EFTs were only possible due to HFT, which seemed like one of the
greatest benefits to retail investors. A little bit of arbitrage tax is no
where near as bad as sales loads and management fees.

~~~
dragontamer
The only problem is that arbitrage tax is hard to measure, while sales loads
and management fees are predictable values. But I agree with your point
overall.

Getting pennies skimmed off of my trades is not nearly as big a deal as a 0.1%
yearly recurring fee on say... a $100,000 retirement account. (ie: $100 /
year). Those tiny percentages add up to a huge amount of money in the long
run.

I've heard of reports of 1.5% or even higher management fees (or ~$1,500+ /
year in this example)

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goodgoblin
HFT provides liquidity, and extracts a price for providing that value.

HFT seems like stealing only because they are using advanced technology
methods to make money, whereas in the 1980s and before market makers routinely
manipulated the spread and pocketed likely a similar percent of trading
profits.

At least the online brokerages and pioneers of HFT broke down the antiquated
1/8 stock price ticks and lowered the spread and per share transaction costs.

~~~
001sky
Ugh. The memes. HFT is not "liquidity". The purpose of the "speed" is to
elicit information.

~~~
tptacek
This comment isn't even wrong.

~~~
001sky
Thanks for the clarification. /S

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lmg643
I started reading the Cringley book on IBM. It's a captivating and maddening
read. By this story IBM management, trying to satisfy the desires of
shareholders looking for earnings growth, is destroying the company.

HBS is graduating lots of portfolio managers and analysts who contribute to
this phenomenon. Not so many HBS grads in HFT, based on the folks I know in
the industry.

HFTs certainly aren't driving major global corporations into the ground by
pushing for stupid forms of management like share buybacks, "outsourcing" core
competencies, and the like.

I give this guy credit for referencing these impacts. I don't think HFT is
really part of that trend at all. HFT is actually pretty benign when you dig
into the details. Sure, they scalp pennies here and there, and it adds up. But
the competitive pressures on technology force efficiencies to a point, which
is good for the market.

~~~
wehadfun
I agree . I am far from an expert but I did not understand the connection
between HFT and companies making bad long term decisions for short term. He
said himeself that HFT firms don't care about the actual companies anyway.

------
herge
> it allowed the high frequency traders to peek at the ballots others were
> sending in to the newspaper before they arrived, in turn giving them the
> ability to cast their votes using information not yet available to the rest
> of the market.

From what I gathered from Lewis's book, the crux of the problem is that people
were doing their trades in multiple exchanges and that HFTs were simply noting
trades in the fastest exchanges to reach (like BATS) and using that
information in exchanges that were farther away.

To take his analogy, it would be like using the results published in another
newspaper the day before to determine your ballot choice.

------
bayesianhorse
There is a very deep misunderstanding of the purpose of stock trading. Somehow
almost everybody assumes that the very purpose of stock investment is to time
the market. But no, timing the market is only a mechanism of the market. Those
who successfully time the market are more a part of the market mechanism
rather than the customers/end users of the market.

The only real purpose of financial markets is risk management. Any human
society (and non-human societies also) has to risk some capital to gain more
capital/value. The purpose of stocks and financial markets in general is to
diversify the risk, while still funding oportunities and it's the only proven
mechanism by which a large portion of the population can participate in this
wealth creation.

The value of risk management is hard to fathom. But if you are a programmer,
you might want to try and simulate "gambler's ruin" and see what happens with
high risk or low risk strategies. In this simple game, computing the right
risk management is the difference between stagnation and exponential growth.
In a complex economy, this seems also to be true.

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dsjoerg
Summary: investors who focus too much on short-term results are bad for the
long-term success of the companies they buy and sell.

High-frequency traders are somewhat similar, in that they don't care enough
about the long-term health of the companies they buy and sell. Therefore they
are bad.

~~~
bunderbunder
I'll agree with the first premise. But I don't think the 2nd bit follows.

The reason speculation based on short-term results is problematic is that it
creates perverse incentive structures that discourage a company's management
from thinking too much about the long-term success of the company. But that's
only possible because speculators are able to create market demands that
punish and reward specific kinds of behavior. But HFT doesn't really create
demand; it only responds to it. So the analogy fits in every spot except the
only one that matters for the sake of the argument.

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dodders
Treating HFT as a proxy for 'Finance' is a flawed premise.

Without 'Finance', you would not have: \- Cheap mortgage rates - mainly due to
securitization. \- Cheap loan rates - yes, car leasers, I'm looking at you....
\- Rational commodity markets. Think Starbucks, every car/computer made today.
\- You get the idea.

Certainly, some aspects of modern markets appear to add little value, but the
bulk of 'finance' benefits not only companies but everyday consumers
immensely. -

~~~
kasey_junk
Without market makers and other speculative market participants you would not
have rational commodity markets or liquid price efficient equities.

HFT versions of those market participants are dramatically more efficient and
fair than the participants they are replacing. That efficiency is shared with
every other participant.

If you believe in public commodities and equities markets, it is extremely
hard to argue against HFT and in favor of pit traders...

------
SeanDav
I used to work at Merrill Lynch, I saw what the focus on short term results
did and the culture it created. It was almost always about the quarterly
results. I once saw an entire team of bond traders fired because their
quarterly results weren't up to scratch, only to literally be hired back
within days at a much, much higher cost, because the market suddenly turned
almost overnight and Merrill Lynch was caught without a bond team in that area
and had to frantically scramble to get one at almost any price.

That particular team had been highly profitable, but their last quarterly
result were poor. It mattered not that overall they were still vastly ahead in
terms of profit for the company. They had a bad quarter and the next was
looking poor, so they had to go, in order for the managers to have something
to say to their investors.

If the share price dropped a few cents or if the results weren't up to or
exceeding market expectations, they would fire a few thousand people. I kid
you not, this is how investment bank culture works. You are only as good as
your last quarter.

Traders would take very risky positions with huge or unknown long term risks,
in order to make short term gains - for which they are richly rewarded. No one
cared that this wonderful basket of exotic options was actually full of
potential toxic waste, as long as it was printing money right now. By the time
it exploded, most of those traders and managers would have made their millions
and be retired or working somewhere else.

It was and probably still is this intense focus on the short term that caused
ML to very nearly go under and why ML is now called Bank of America ML. I
doubt they have learned and the next black swan event is going to take them
out, or the one after that.

------
gd1
An article written by a journalist, about a book written by a journalist. And
neither of them have a clue. Layers upon layers of idiocy.

------
7Figures2Commas
> Now, there are some rockstar CEOs — who oftentimes happen to be founders,
> such as Bezos, Steve Jobs, Reid Hastings — who have the ability to resist
> the pressure that the markets put on them.

Another possibility the author should consider: there are some CEOs who have
the ability to convince human investors that their long-term visions are
worthy and deserving of steadfast support.

What the author fails to address is the fact that not every chief executive
has a great long-term vision, and not every chief executive is capable of
persuading investors that he or she is capable of realizing such a vision. The
implied notion that investors are somehow obligated to give the companies they
invest in an arbitrarily long period of time in which to execute regardless of
evidence of tangible progress is foolish.

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roschdal
The Oslo Børs stock exchange in Norway has a fee that will affect
unnecessarily high order activity in the stock market, to prevent high
freqiency trading. Here's more info:

[http://www.ft.com/intl/cms/s/0/b1a73be4-a57b-11e1-a77b-00144...](http://www.ft.com/intl/cms/s/0/b1a73be4-a57b-11e1-a77b-00144feabdc0.html)

[http://www.oslobors.no/ob_eng/Oslo-Boers/About-us/Press-
room...](http://www.oslobors.no/ob_eng/Oslo-Boers/About-us/Press-room/News-
from-Oslo-Boers/Oslo-Boers-to-discourage-excessive-order-activity)

------
Permit
Time and time again this discussion is hampered by the term "high frequency
trading" which is much too general. An instance of a HFT algorithm behaving
poorly should not condemn the practice as a whole.

Saying "HFT is bad, just look at electronic front-running" is like saying
"Sorting algorithms are slow, just look at bubble sort".

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hooande
So the problem with traditional buy and hold investing based on fundamentals
is that it's very slow. I don't mean slow in terms of latency and distance to
servers, I mean that financial returns accumulate slowly. Investing in the
market as a whole will return roughly 10%-15% depending on the year. This
beats what most individual day traders and money managers can do, but is
nothing close to what a well positioned HFT trading firm can make.

"Sophisticated" trading strategies exist because the finance industry has
focused itself on one goal to the exclusion of all others: Make as much money
as possible. It doesn't matter if it's a zero sum game or if the most fit
companies are being selected based on research in a darwinian process. A
rational actor is going to chose 30% over 10% every time.

The bottom line is that predicting the success of a given company is hard.
Predicting what the other actors in the market are going to do is also
difficult, but is much easier by comparison. Asa participant in the market you
want to be in Keynes' newspaper contest, not in the business of making broad
predictions about the future. As a member of society we'd prefer that capital
be allocated to the firms that will use it to our most benefit. I don't think
anyone wants to use the law to change the current system so that it is more
useful to society. A lot of people are also unhappy with a lot of finance
being in its own bubble of "irrelevance". This is a decision that we're all
going to have to make about how we want the financial markets to work. Things
seem to be working out ok now, in a general sense, so change might be a long
time coming.

~~~
SkyMarshal
>This beats what most individual day traders and money managers can do, but is
nothing close to what a well positioned HFT trading firm can make.

I don't know if this is actually true if you average up all the successes and
failures. Probably more like, for every successful [daytrader|money
manager|HFT firm] there are 9 that lose money or go bankrupt and nobody ever
hears about again or includes in average return calculations.

It's just that the rewards to the few successes are so tantalizing, there's
never any shortage of folks jumping into the game trying their hand at it.

------
hkmurakami
I really can't take any lessons derived from Lewis's book on HFT to heart,
because every HFT friend I talk to (even the ones who are quite objective
about its role in the markets) insist that much of the book is simply wrong.

~~~
apo
Which parts?

~~~
kasey_junk
The major problems with the book fall into 3 major categories:

A) He implies (but never proves) that HFT market makers use low latency
connections, to buy shares ahead of other market participants, to sell back to
them risk free. This is not how HFT market making works. HFT market makers are
pricing on all the exchanges at the same time. So what they are doing is not
buying something and selling it back to you risk free, but changing the price
of their own offering to reflect new demand.

B) That any of this is secret or requires insider information. It is all
available on public websites, including governmental agency ones (for instance
all "exotic" order types go through a public approval process). Further, in
the book the only proof of ill gotten proprietary information being used for
profit was from the supposed "heroes" of the story.

C) That HFT is a large force that abuses it's power to take advantage of buy
side participants who have "Main streets" best interest at heart. In fact, HFT
firms are the small guys bringing efficiency at the cost of the powerful
entrenched buy side middle men.

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jwilliams
I see HFT as a form of arbitrage. If you have huge volumes you can make money
on FX markets too - but basically you get price convergence. The big players
make enough of it to make it worthwhile, but it's really on the fringes.

~~~
nickff
I have never heard of any firm making consistent positive returns on foreign
exchange markets, in fact, it is often cited as an example of an efficient
market, because it is so unpredictable. Alan Greenspan's autobiography
mentions a discussion he had while working at Goldman Sachs, where he asked
them how GS was making a consistent profit on FX (because no one else seemed
to be able to), and they responded that it was because they got a commission
from making the trades on behalf of the customers, but GS never traded FX on
its own accounts.

------
IanDrake
The first part about Keynes is depressing. It presupposes there is only one
winner. This is what anti-capitalists want everyone to believe. One winner,
everyone else is a loser.

------
washedup
HFT is a very small subset of finance. I doubt it will drive the whole
industry to irrelevance. It will only drive itself to irrelevance.

------
JohnTHaller
We still need to stop calling it High Frequency Trading and refer to it by
what it is: Digital Front Running.

~~~
nickff
HFT is completely distinct from front-running.[1][2] Front-running means that
you (as an investment bank or other trading company) buy and sell stocks
according to the orders you have received, but not yet executed from your
clients (usually large institutional investors). HFT just means that you are
quickly executing trades based on some algorithm(s).

[1] [http://en.wikipedia.org/wiki/High-
frequency_trading](http://en.wikipedia.org/wiki/High-frequency_trading)

[2]
[http://en.wikipedia.org/wiki/Front_running](http://en.wikipedia.org/wiki/Front_running)

------
bobcostas55
I am so tired of clueless pundits talking about HFT...

------
michaelochurch
Three words on this "race to irrelevance": _lead versus leave_.

Our society is in a state of _secessionism_. Much of the escalating economic
inequality comes from that impulse. The rich of yesterday (1945-73) saw
themselves as _leaders_ of the society. The rich of the new Gilded Age
(1974-2014+) have given up and just want to escape it. They want private
schools, country clubs, and closed social networks. They don't want to lead
the masses, they want to leave them.

Silicon Valley has been making its secessionist impulse visible of late, but
HFT and "high finance" show a different secessionist tendency: the desire to
get outside of any given industry or company and "float among" them as a
financier. The brightest young people are being told not to join the regular
economy with the proles, but to become part of an elite system of hedge funds,
private equity shops, and overcapitalized "startups" whose products are
meaningless other than advertising expenses to get middle-management
positions, 10 years earlier than otherwise, for the founders.

The smartest people have given up, sadly, on leading. This makes "leave" the
attractive option. If you become a management consultant or investment banker,
you don't have to commit to one industry or business. You float around until
you make friends who can place you at high levels.

After spending 8 years in a number of places but much of it in "the real
economy" I can't say that I blame the leavers. The leavers are now ahead of
me, career wise, as venture capitalists and the like; and there isn't much out
here in "the rest of the economy" to lead. Perhaps paradoxically, the world
ends up being run by leavers, because average people don't want to be led by
the highest level of talent; they want leaders they can relate to.

~~~
maxxxxx
You are making some good points here.

