Topic: The bad of High Frequency Trading (Read 2104 times)

To attract volume, all market centers (the exchanges and the ECNs) now offer rebates of
about ¼ penny a share to broker dealers who post orders.  It can be a buy or sell order, as
long as it is offering to do something on the exchange or ECN in question.

 If the order is filled, the market center pays the broker dealer a rebate and charges a larger amount to the
 broker dealer who took liquidity away from the market.  This has led to trading strategies
solely designed to obtain the liquidity rebate.

More than half of all institutional algo orders are “pegged” to the National Best Bid or
Offer (NBBO).  The problem is, if one trader jumps ahead of another in price, it can cause
a second trader to go along side of the first one.  Very quickly, every algo trading order in
a given stock is following each other up or down (or down and up), creating huge, whip
like price movements on relatively little volume.

This has led to the development of predatory algo trading strategies.  These strategies are
designed to cause institutional algo orders to buy or sell shares at prices higher or lower
than where the stock had been trading, creating a situation where the predatory algo can
lock in a profit from the artificial increase or decrease in the price.

Automated market maker (AMM) firms run trading programs that ostensibly provide
liquidity to the NYSE, NASDAQ and ECNs.  AMMs are supposed to function like
computerized specialists or market makers, stepping in to provide inside buy and sells, to
make it easier for retail and institutional investors to trade.

AMMs, however, often work counter to real investors. AMMs have the ability to “ping”
stocks to identify reserve book orders.  In pinging, an AMM issues an order ultra fast, and
if nothing happens, it cancels it.  But if it is successful, the AMM learns a tremendous
amount of hidden information that it can use to its advantage.

To show how this works, this time our institutional trader has input discretion into the algo
to buy shares up to $20.03, but nobody in the outside world knows that.  First, the AMM
spots the institution as an algo order.  Next, the AMM starts to ping the algo.  The AMM
offers 100 shares at $20.05.  Nothing happens, and it immediately cancels.  It offers
$20.04.  Nothing happens, and it immediately cancels.

Then it offers $20.03 – and the institutional algo buys.  Now, the AMM knows it has found
a reserve book buyer willing to pay up to $20.03.  The AMM quickly goes back to a penny
above the institution’s original $20.00 bid, buys more shares at $20.01 before the
institutional algo can, and then sell those shares to the institution at $20.03.

1. Rebate traders trade for free.

2. Automated market makers co-locate their servers in the NASDAQ or the NYSE
building, right next to the exchanges’ servers.

3. People often wonder whether it is fair or legal for program traders to move the market
the way they do.  Everybody forgets, however, that in October 2007, just a little more
than a year ago, the NYSE very publicly  removed curbs that shut down program
trading if the market moved more than 2% in any direction.