
A Fervent Defense of Front-running HFTs - spindritf
http://www.chrisstucchio.com/blog/2014/fervent_defense_of_frontrunning_hfts.html
======
chollida1
I think this article does a good job of illustrating why its so hard to have
an open dialog on this subject.

Start with asking "What is front running."? The market's definition would not
include what HFT do. But bring this up to someone without knowledge of the
public markets and their first reaction is to say, hey this is front running,
it must be wrong. "Front Running" has a specific definition and it only
relates to a broker and their own clients. You trading before me because you
are faster is not front running. You understanding my flow is not front
running.

You can then ask "What is public information". The fact that everyone can see
any tape they pay money to see so there doesn't seem to be any one acting on
"insider knowledge."

Now tell people that HFT's will use their fast machines to change their orders
due to a change on one exchanges tape before the main NBBO tape is updated and
some people will claim that this is obviously wrong.

The other argument I've seen made here is that trading on "insider knowledge
is obviously wrong." Well it isn't obviously wrong and the entire commodities
market assumes that anyone can trade legally on insider knowledge. Imagine you
are the biggest producer of oranges. You know that you are going to have a bad
crop so you but some orange futures so you can meet your demands. This is
insider information you've traded on and its the way the market is intended to
work.

------
elecengin
This is great - it hits major topics that should be part of this debate. It's
long, and it's a bit complicated... but so is the issue.

Some things you should be thinking about after reading this:

* What exactly constitutes front running? Does trading based on public data (albeit in expensive feeds) constitute front running?

* Large trades are almost all traded through algos. Are those algos better than proprietary "market making" algos? Why?

* What is adverse selection? How do dark pools contribute? Who benefits and who suffers?

Read more articles like this. Be suspicious of "simplified" discussions.

~~~
exelius
I have some questions based on yours:

* What constitutes public data?

* How likely are the types of front-running HFT algos that are discussed in this article to be the old, traditional players?

* What are the ethical (lol) rules against front-running your own customers if you're a market-maker? How could your customers even find out? What happens when the proprietary information is that a customer has just placed a large trade, and you drive up the price before it even hits the market? How is this fundamentally different than the commission these firms already charge?

~~~
reverend_gonzo
_What are the ethical (lol) rules against front-running your own customers if
you 're a market-maker? How could your customers even find out? What happens
when the proprietary information is that a customer has just placed a large
trade, and you drive up the price before it even hits the market? How is this
fundamentally different than the commission these firms already charge?_

Market makers are generally proprietary firms that trade their own money, and
don't have customers.

Brokerages (ie: Scottrade) have customers and it illegal for them to front run
their customers.

~~~
exelius
I'm not thinking retail brokerages -- I'm thinking investment banks like
Goldman. Often the big i-banks have both prop trading operations and the
ability to fill large orders for institutional clients (e.g. a pension fund
looking to buy $1 billion of Apple stock).

~~~
reverend_gonzo
For them, they have a fiduciary duty to their clients to act in their
customers' best interest. So, if their clients asks to purchase, for example
100,000 shares of AAPL, it would be illegal for them to first drive up the
price.

------
davidw
I've been following (sort of) the back and forth on this and find it quite
interesting. Here's a question though: what happens when the "whale" is really
something like an index fund that, ultimately, is composed mostly of retail
investors? Aren't they getting ripped off in that case? This isn't a
rhetorical question, I'm curious to know how it plays out.

~~~
harryh
Here's the CIO of Vanguard (who run some of the biggest index funds in the
world) saying that HFTs cut costs:

[http://www.cnbc.com/id/49434073](http://www.cnbc.com/id/49434073)

------
thatthatis
> Predatory traders detect information and split the profits with the
> counterparties (taking a cut in the process)

No. No they do not. They detect the information, and extract part of the value
without improving the situation of the seller.

The seller was going to get filled at $21 in either case, the only difference
is that the front-runner bought and resold those shares to the "whale" buyer.

This intellectual backflip is premised upon two mutually exclusive things
happening:

1) the predator trades on information that there is demand coming and 2) in
the counterfactual for the seller, that demand may never have come.

But because the front-runner is cutting the line, they only place trades once
the demand is in the order book.

As a work of acrobatics, this is impressive. As an intellectual work, it is
saddening.

~~~
yummyfajitas
_But because the front-runner is cutting the line, they only place trades once
the demand is in the order book._

There is no "cutting the line". If the demand were already in the order book
the trade would have occurred.

Please go read the tutorial before commenting further - you demonstrably do
not understand how a matching engine works.

~~~
thatthatis
I re read your article, and it appears I took information from your headline
and assumed it into your examples. I think you're talking about plain vanilla
market making and speculation. Nothing in there is what I would consider
predatory or HFT or front running.

These things exist, per my best reading of the wsj, and you said you were
defending HFT but as best I can tell merely defended computerized market
making and speculation.

~~~
dllthomas
The thing that is being called "front running" here involves multiple
exchanges. There is no cutting in any single line. There is more then one
line, and you can be in multiple simultaneously. In some cases, traders may go
through one line and then complain that HFT traders went and got in the other
line. In order to call that "cutting in line" and be well founded, you need to
come up with some framework for how that "line" works - it does not fall
trivially out of the actual lines in the two exchanges.

------
JumpCrisscross
Why isn't HFT front-running? Let me attempt an explanation without relying on
legalistic constructs.

Customers pay brokers a commission to execute their orders. This involves a
customer trusting a broker with their confidential order information. Until an
order goes to the exchanges, only the customer and broker know about it. The
order is material non-public information.

Brokers have a fiduciary obligation to look out for their customers'
interests. This applies even when the customer's interests conflict with the
broker's. For example, suppose a broker holds Tesla stock. A knowledgeable
customer calls the broker, seeking to sell 2 million shares. This would
depress Tesla's stock price. Front-running would involve the broker selling
his shares first, and then the customer's. This violates the broker's
fiduciary obligation. That is why it is fraudulent and thus illegal–an
_explicit_ trust relationship would be ruptured.

Across the trading floor from the brokers are us market makers. We trade our
own capital. We also have no customers and thus no fiduciary obligations. Our
income comes from the bid-ask spread (and liquidity-provider rebates from
exchanges). For example, here is how a phone call might go:

COUNTERPARTY: "2 million Tesla?"

MARKET MAKER: "209 at 210."

COUNTERPARTY: "Buy 2 million Tesla for 209."

The counterparty is looking to buy _or sell_ 2 million shares of Tesla stock.
They do not specify which in advance. The market maker says they will buy at
$209 or sell at $210. The customer then confirms that they want to buy, and
will buy at $210.

An order, when properly executed, does not betray its owner's intentions. This
applies as much in the meat space as in HFT. For example, here is how one
would _not_ place an order:

COUNTERPARTY: "I am looking to sell 2 million shares of Tesla stock at
whatever price you'll give me. My wife just left me for a Brazillian stripper
and I'm halfway through my handle of morning vodka."

This guy won't get 209 at 210. He might not even get 200. This isn't the
market maker front-running a customer. It's a liquidity provider protecting
his book and bottom line. This adversarial relationship is efficient - it
keeps markets from getting too clubby.

There are valid critiques against HFT. (My pet is that HFT has no obligation
to continue providing liquidity in adverse market conditions. This means they
can pull out when the seas get rough, i.e. precisely when liquidity is needed.
Traditional market makers cannot do that.) "Front-running" is not one of them.

~~~
300bps
_Until an order goes to the exchanges, only the customer and broker know about
it. The order is material non-public information._

The problem with your argument is that it doesn't address that certain
companies have paid money to co-locate their servers in the same datacenter as
the exchanges. This is unethical because:

T + 0.000 seconds order is sent to an exchange

T + 0.001 seconds order is received by colocated companies

T + 0.090 seconds order is received by non-colocated companies

For the first 90 milliseconds, the exchange has engaged in "selective
disclosure" which means the order is still material non-public information
after it has arrived at an Exchange. For colocated firms to then act on that
material non-public information is unethical at best.

Citation on "selective disclosure":

[http://www.investopedia.com/exam-guide/cfa-level-1/ethics-
st...](http://www.investopedia.com/exam-guide/cfa-level-1/ethics-
standards/standard-nonpublic-information.asp)

 _Selective disclosure? When information is disclosed selectively, i.e. just
to a handful of investment analysts, or perhaps on a conference call, or in an
email, the information may still be regarded as nonpublic. Companies are bound
by specific procedures designed to make the information truly public and to
ensure a system of fairness in which all market participants are given a
chance to act on the information._

~~~
harryh
If people couldn't pay to co-locate with the exchanges they would still
compete for latency reductions. They would try to get in the building across
the street. Or the one two blocks away. Or the one with a direct fiber
connection.

Being able to pay to co-locate with the exchange actually serves to
democratize things because it puts everyone on a level playing field where
they pay the exact same cost for the exact same access.

------
foobarqux
I think there is a lot of nuance being left out in these types of defences
which are misleading. For example,

> Note that the market maker at no point had the ability to change any order
> in response to Big Joe.

But they sort of can, specifically the canonical example in Lewis' book is
that HFT market makers change their standing order on other markets faster
than it takes the orders of buy/sellers taking liquidity to hit that venue.
That behavior isn't what a reasonable person would expect by default.

There is no mention of things like flash orders (which no longer exist in US
equities?), hide-not-slide, payment for order flow, maker/taker, etc, all of
which are potentially problematic and deserve discussion.

In short these defences are nearly as simplistic as the attacks they attempt
to counter.

~~~
kasey_junk
Agreed. But the difference is that the people defending them are not trying
through public perception, or regulation to change the current system. If they
are not asking for change, why should they be held to a higher standard than
the attackers.

For all of the potentially problematic items mentioned, there is an equally
problematic issue on the liquidity taker side. Invisible order books, iceberg
orders, preferred router agreements, and large block rebates are all
"features" that the markets provide to give advantages to the large
institutional investor that harm the rest of the market but they aren't
mentioned in the Lewis book, and are never referenced by folks trying to
defend "the little guy".

------
salmonellaeater
> If we had no price discrimination, perhaps because of a regulation requiring
> market makers to leave their quotes out in the market for 60 seconds, then
> ... [t]he net result is that Big Joe would pay more to trade and Little
> Billie would pay less.

The debate about HFT is largely about who gets to benefit from new
information. Suppose someone does a lot of research and discovers that a firm
is undervalued. Should they get to profit from the information, at the expense
of current stockholders? Or is it better for stockholders to quickly figure
out that their holdings are worth more? HFT helps the stockholders in this
case, because it moves the price faster to its eventual higher equilibrium
before the researcher can buy up many shares at the (low) current price. The
researcher may have expended a lot of time and effort to get this information,
and with the existence of HFT their work may not be sustainable.

Contrast this with someone who accidentally discovers public information that
could be profitable, or someone who engages in insider trading. In both these
cases it's hard to argue that we as a society should create rules that let
them profit at others' expense.

In other spheres of life (software patents, copyrights), the law over-protects
dubious discoveries and creations. Is information related to stock pricing
different? Are we under-protecting it, such that we should let someone with
new information collect more profit than they can today?

------
wavesounds
I'm not buying it. Healthy markets are markets where everyone has access to
the same information. HFT by definition means some traders have more access to
information than others. This is fundamentally unfair and bad for markets and
the economy. I don't see how HFT is any different then insider trading and
everyone agrees that should be illegal.

~~~
patio11
_Healthy markets are markets where everyone has access to the same
information._

If I want to sell 100,000 shares of Yelp (which is a multi-million dollar
transaction), the fact that several million dollars of Yelp is about to hit
the market is a really, really important bit of information. I have a reason
to hide that from the rest of the market at least until I can complete my
sale. HFTs profit by ascertaining my intentions faster than I can complete my
intended action and then broadcasting my intentions to other market
participants via the ticker tape, whereas previously my intentions were
proprietary information locked in my head.

An argument against HFT is, necessarily, an argument that I should be allowed
to benefit from material non-public information about the near-term state of
trading in Yelp.

~~~
klochner
That's _private_ information. It is an important distinction. You're saying
the market should have a right to know whether I plan on selling my shares
next year.

~~~
patio11
I'm saying that if anybody can successfully predict your intentions for next
year based on your observable actions to date then they have a right to the
fruit of those labors, and that you don't have a cognizable interest in
"Prevent that person from telling the rest of the world about my intentions
for next year", even though that might lead to you making less money than you
would but for our friend who reads actions well.

~~~
hackinthebochs
>I'm saying that if anybody can successfully predict your intentions for next
year based on your observable actions to date then they have a right to the
fruit of those labors

I don't see why this is so. If I have decided through some analysis that I am
going to sell X shares at some date, why shouldn't that information be
private? Front-running my _behavior_ is essentially front-running my analysis.
It would be unethical to hack my computer and read my analysis for yourself,
so how is analyzing my behavior to get at that same information any different?

~~~
logn
If you're buying a million dollars of Yelp (as posed in this hypothetical),
then it's going to take some time (microseconds, minutes, months, etc) for
people to realize that. For as long as no one catches on, the person making
this large order has a tremendous advantage because supply-demand is
misunderstood by everyone else. The market can't fairly price the stock as a
result. The HFTs are saying they'll pay the money to get order info in nano-
seconds so they can design algorithms to recognize these large orders and
react appropriately. They make money being a middleman but the benefit for the
rest of the market would be seeing a price change and also for small orders to
be filled at a fairer price to supply-demand.

~~~
hackinthebochs
>For as long as no one catches on, the person making this large order has a
tremendous advantage because supply-demand is misunderstood by everyone else

Why is the market entitled to knowledge that I'm currently in the process of
making a big order? This knowledge being disseminated clearly doesn't benefit
me. Should I not be entitled to the sole benefit of my reasoning in deciding
to make a big order? Furthermore, how does this knowledge being disseminated
mid-order rather than after the full order has completed benefit the market as
a whole?

~~~
dllthomas
Not that I think any of this outright determines how the argument should go,
but a couple points:

Your knowledge _that_ you're placing an order of size X, and _why_ you're
placing an order of size X, is always going to be more precise than what's
gleaned from observing your behavior, and thus you'll still have an advantage.

 _" Furthermore, how does this knowledge being disseminated mid-order rather
than after the full order has completed benefit the market as a whole?"_

For a large enough order in a sufficiently illiquid market, "after the full
order has completed" could be days later. More things being priced in means
more accurate prices, and that seems to be of some benefit to "the market as a
whole." Though to be sure, the longer time frame isn't terribly relevant to
the "predatory traders" across exchanges that Chris had been discussing.

Edited to add: Also, the market doesn't learn anything about _you in
particular_ \- orders are anonymous. What we learn directly is "a trade
happened for X lots at $Y", along with possibly which side was the aggressor
(depending on the exchange).

------
jalopy
TL;DR: Defending HFT’s argues for rewarding market participants who simply
jump in front of the line b/c they see other people doing it, at the expense
of participants who have worked hard to decided which line to get into.

Here's a more fundamental question to ask:

What kind of behavior do you want to reward in the stock market?

If you view the stock market as a bunch of numbers that wiggle around, where
"information" is conveyed by the actions of other people participating in the
market (ie, what they’re buying and selling), then the HFT's play a legitimate
role in spreading that information around.

If you view the market as a place to buy and sell businesses (equivalently -
shares of businesses), where capital is allocated to businesses commensurate
with the value they provide to society, HFT's are parasites on the effort of
others.

There are participants in the market that spent an enormous amount of time,
diligence and thought into deciding allocating capital to businesses according
to the value they ascribe to the businesses. For these participants, the
signal they send by putting out their orders is currently taken advantage of
by other participants who spend enormous time, effort and money into trying to
“tap into” the result of the efforts put forward by the first group and rush
to another exchange to buy up that company before anyone else gets there.

So: Do we really want to reward all of the effort spent building faster
machines, communication links, and algorithms to jump right in front of
someone in line? Or do we want to reward those people who are actually
determining which businesses have intrinsic value and which do not?

It's easy to hate Einhorn or Ackman b/c they're rich. What's important to keep
in mind is that they are custodians of and act on behalf of thousands,
probably even millions of other people to improve their financial situation.
Pensions, endowments, sovereign wealth funds, etc make up the bulk of the
funds that Einhorn, Ackman and others invest. The fact that they're rich an
indication of their legitimate hard work at researching and allocating capital
and enhancing the financial well-being of their clients. (Note: yes, there are
always bad apples that get rich by illicit (read: insider) means, but that is
an exceedingly small amount of participants and over time they usually get
caught).

Warren Buffett has often said that a perfectly good stock market would be one
which is open only one day a year, where participants put up orders based on
the value they actually ascribe to a business. If those orders cross, then
trades occur - all in one day.

Makes you wonder what would happen to society in that market. Would people
would be able to find a way to channel all the frenetic activity currently
employed in chasing prices and watching others’ actions into a more productive
endeavor?

~~~
tptacek
David Einhorn is a hedge fund manager, not a mutual fund manager. Vanguard,
one of the world's most reputable mutual fund managers, is on record as saying
that HFT has improved their cost to trade.

That was an easy point in your comment to respond to. The rest of it doesn't
appear to have been based on Chris Stucchio's post at all; you could just as
easily have posted it in every thread on HN about HFT. I must be missing
something; what is it?

~~~
yummyfajitas
My attempt at a charitable interpretation of Jalopy's post is that he is
saying it's actually a bad thing to transfer wealth from informed traders.
This is because David Einhorn has demonstrated great competence at trading,
and if HFTs predate him it reduces his incentive to continue transmitting
useful information to the markets.

I find this to be an argument I can't dismiss easily.

I've added a link to your comment to the original post. It's important to
spread this idea as well.

~~~
jalopy
Thanks - you captured a good part of my argument. I'd make a small correction
though. I don't consider it "trading" as much as "investing".

As a former quant trader and a current (and forevermore) value investor -
there is a big difference.

------
bakhy
reading about the stock market is always kinda disgusting to me. "If a
speculator believes AAPL is undervalued, he buys a bunch of shares of AAPL.
This drives up the price until AAPL is no longer undervalued - then the
speculator can sell his AAPL and reap the profits." \-- the part after the
dash shocked me :) seems like the entire purpose of the market is speculation?
does anyone actually invest in companies any more? :D

i did like reading this, informative. gave me a nice other perspective on HFT.

however: (a) Goldman Sachs does not have it's own HFT outfit? they are the
"helpless victims" here? sounds a little unbelievable. (b) why is it exactly
socially beneficial that some HFT company performs this "robin hood" act
(lol)? particularly if it exposes us all to the risk of market volatility due
to mindless algorithms performing enormous, senseless trade volumes with each
other?

all in all, i'd vote for that very small tax on trades, just to get rid of
this as-yet-unseen level of speculation.

~~~
bakhy
p.s. how does moderation on this site work? i have been downvoted, and i
wonder - is this an act of some admin moderating, or do users with sufficient
karma get a downvote button and one of them simply dislikes my comment?..

~~~
probably_wrong
> ..., or do users with sufficient karma get a downvote button (...)?

Yes, they do. I always forget the threshold, but there is one. Check the 4th
point in the FAQ:
[http://ycombinator.com/newsfaq.html](http://ycombinator.com/newsfaq.html)

~~~
bakhy
thanks!

------
bertil
As I understand it, the main issue with HFT are two fold:

* some cases of insider trading at under-a-microsecond rhythm, that sound like faster-than-light favoritism but are actually covered by existing legislation (you just need to update judges and the SEC on basic technological feasibility);

* dangerous unmanned behaviour -- flash-crashes.

Front-running has always been presented as controversial at best, i.e. taking
cents from people who could spare dollars; more often illustrative of
finance’s excess (spending the GDP of a large country to establish even faster
lines between cities already well connected, not that makes any more sense
than blaming Formula 1 racing for going above the legal limit).

I understand his passion, and the “I’m a geek and I work for a small company
facing Goldman” inferiority complex must be crushing -- he writes himself ‘A
_fervent_ defense’. However, that seems to be missing the key issues most
people have with such technology left unmonitored.

------
politician
If HFTs liberate access to price information, then does that make them the
"open-source software" equivalent of our current economic operating system?
That is, in the same sense that OSS delivers bundles of information about how
to do various computational tasks efficiently via source code, HFTs deliver
bundles of information about how to value companies efficiently via the ticker
tape.

In the same way that the source code reveals the genius of the programmer's
understanding, the excellance of an HFT is revealed by the report of the
ticker tape.

------
MaggieL
I'd be more impressed by a "fervent defense of HFT" from somebody who isn't in
the business.

~~~
yummyfajitas
Do you disagree with my arguments or are you appealing to the genetic fallacy?

Not that it matters - I left HFT a long time ago.

------
jellicle
TL;DR: Stucchio thinks that front-running people is fine in circumstances
where it's not prohibited by law. It's legal, therefore morally right, is his
argument.

Other people (including very many securities regulators) think that the
problem here is that the law is missing a prohibition.

~~~
exelius
You'll find this attitude (it's legal, therefore it's morally right) is very
prevalent in the investment finance industry. It's as if these guys lack a
moral compass of their own...

~~~
kasey_junk
That sort of smear may or may not be true, but it isn't what is happening in
this case. What is happening in this case is that 2 groups (large liquidity
purchasers and liquidity providers) have a natural antagonistic relationship
with each other. Purchaser always want to lower the price and providers want
to raise it. This is good for the markets operation.

But there is a PR/Power imbalance currently in the market. The large
purchasers have tons of money had influence. They are using it to smear the
sellers of the product they want. The sellers happen to be an easy group to
smear (they are highly technical, secretive, and operate in a world that no
one seems to understand).

If anything is immoral in all this is that they are actively trying to
obfiscate what is happening in the markets and thereby spreading fear.

~~~
crdoconnor
> The sellers happen to be an easy group to smear (they are highly technical,
> secretive, and operate in a world that no one seems to understand).

Once you understand what it is that they are doing, it's pretty clear that
it's wrong.

Unfortunately, they like to muddy the issue. Hell, the OP does that every time
it comes up on HN by asking people to explain what their problem with it is
using obtuse industry jargon (e.g. "which part of FIX/OUCH enables front
running?").

~~~
kasey_junk
This is a really late reply, and probably futile in any case, but your
comments on this subject make me think you don't actually understand "what it
is that they are doing". When people try to explain it to you , you accuse
them of using "obtuse industry jargon". Yet you've left them little choice.

An analogy (flawed as they all are) is if you came onto these forums and
claimed that udp networks were evil and a tool whereby network consultants got
rich on the back of "regular internet users". To back this up you pointed to
some articles in People that claimed "Don't trust your UDP network, it might
delete your traffic!" When anyone who actually understood networks said
something like, "well it's nuanced, error checking is valuable in some cases
and not valuable in others" you said, "DON'T MUDDY THE WATERS WITH YOUR
JARGON!"

At this point, because networking is such a widely dispersed information set,
and there aren't any high profile authors backing up your assertion that "UDP
IS DANGEROUS IT LOSES PACKETS!" members of this forum would start down voting
you into oblivion and making cogent arguments about why you are so very, very
ignorant.

The only reason this hasn't happened yet is that knowledge of electronic
trading systems is not as widely disseminated and every one with a 401k and a
DSL modem thinks they know what electronic trading is about.

I will tell you this much, everyone who has ever actually traded
electronically sees your comments and thinks of you as the "UDP is evil" guy.
That we are in the minority means that we can't just laugh at and/or ignore
you like we could if you were claiming nonsense about networks. For all I know
you are a senator. So with that said, ask a straight forward question, I will
answer it without any equivocations given that they aren't covered by IP
agreements.

------
crdoconnor
>Predatory traders break this information advantage. Instead of Goldman, David
Einhorn or other informed traders gaining the full benefit of their
information, predatory traders detect that information and split the profits
with the counterparties (taking a cut in the process). Predatory traders
improve market efficiency by turning information about market demand into
price movements. They are simply criticized because the price movement happens
before the whale actually wanted it to.

This is the exact same defense used against insider trading and front running
in general.

There is __nothing __special about HFT in this respect, other than the fact
that it is currently still legal.

Edit: downvoting without responding. classy.

