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Crime and punishment in high frequency trading

Theer is another fascinating article by Michael Lewis in the latest issue of the glossy magazine Vanity Fair, which is fast establishing itself as a must-read destination for students of folly, drama and malfeasance in the world of financial markets (no shortage of good raw material there). His latest piece chronicles the curious case of a Russian computer programmer named Sergei Aleynikov, who was prosecuted for stealing computer code when he left Goldman Sachs to join a rival high frequency trading  operation. Mr Aleynikov’s conviction was quashed on appeal, but only after he had spent a year in jail. The article is interesting not just for the human story that Michael Lewis unfolds with his characteristic verve, but also for the light that it sheds on the phenomenon of high frequency trading. (Students of the phenomenon that is Goldman Sachs will also find plenty of evidence to support their prejudices, good or bad).

Here is one passage from the long article:

By mid-2007……Goldman’s equities department was adapting to radical changes in the U.S. stock market—just as that market was about to crash. A once sleepy oligopoly dominated by NASDAQ and the New York Stock Exchange was rapidly turning into something else. There were now 10 public stock exchanges in New Jersey alone, all trading the same stocks. Within a few years there would be more than 40 “dark pools,” or private exchanges, one of them owned by Goldman Sachs, also trading the same stocks. (Why the world needed 50 places, most of them in New Jersey, in which to buy and sell shares in Apple Inc. is a question for another day.)

The fragmentation of the American stock market was fueled, in part, by a rule created in 2007 by the S.E.C. The rule, known inelegantly as Reg NMS, was designed to protect investors from their brokers. Instead it wound up creating, as such rules often do, new ways for brokers to abuse their clients. Reg NMS requires stockbrokers to route their clients’ orders to whichever exchange offers the best price. For example: if you tell your Goldman Sachs broker to buy a million shares of Apple, and Apple shares are being offered at $400 a share on NASDAQ and $401 inside the Goldman Sachs dark pool, Goldman is now required to send your order first to NASDAQ. (You might think that brokers might do this naturally to please their clients. Think again.)

For reasons not entirely obvious (yet another question for another day), the new rule stimulated a huge amount of stock-market trading. Much of the new volume was generated not by old-fashioned investors but by extremely fast computers controlled by high-frequency-trading firms, like Getco and Citadel and D. E. Shaw and Renaissance Capital, and the high-frequency-trading divisions of big Wall Street firms, especially Goldman Sachs. Essentially, the more places there were to trade stocks, the greater the opportunity there was for high-frequency traders to interpose themselves between buyers on one exchange and sellers on another.

This was perverse. The initial promise of computer technology was to remove the intermediary from the financial market, or at least reduce the amount he could scalp from that market. The reality has turned out to be a boom in financial intermediation and an estimated take for Wall Street of somewhere between $10 and $20 billion a year, depending on whose estimates you wish to believe. As high-frequency-trading firms aren’t required to disclose their profits (with the exception of public firms, like Knight, which have disclosed profits in the past), and big banks like Goldman that engage in the practice are assumed to hide their own profits on their balance sheets, no one really knows just how much money is being made. But when a single high-frequency trader is paid $75 million in cash for a single year of trading (as was Misha Malyshev in 2008, when he worked at Citadel) and then quits because he is “dissatisfied,” a new beast is afoot.

Misha Malyshev is the trader who hired Aleynikov to build him a new high frequency trading platform for his startup firm, Teza Technologies. The battle for supremacy in the high frequency trading world, the article suggests, is as much a battle between rival robots as it is between competing traders, most of whom are working with broadly similar strategies. Speed of execution, measured in milliseconds, is the key to scooping the pool. Does all this activity serve a broader social purpose? It is hard, quite frankly, to see what purpose it does fulfil, but technology as we know has a way of expanding boundaries so quickly that such questions are always answered in hindsight, and typically after, rather than before, any adverse side effects have become apparent.

Written by Jonathan Davis

August 5, 2013 at 12:55 PM