This morning, we started scratching the surface of high-frequency, rebate-capture trading strategies that have become such a topic of fascination lately.
Quick explanation: The various exchanges offer a $.0025 per-trade rebate to these high-frequency players, who are then able to use various techniques to buy and sell stock at the exact same price, taking the rebate on both trades, and exploiting big-block institutional order flow. The white paper from Themis Trading outlines all of the various techniques these traders have to game the market and “front run” big institutional orders.
OK, so a lot of big and small players are getting into this game and making a lot of money at it. But that doesn’t necessarily mean it’s a scam.
- The goal of these rebates is to increase market liquidity. In order to say this kind of trading is a “scam” or even a tax on investors, you have to show that without the rebates, the decreased liquidity wouldn’t end up costing investors even more with wider spreads.
- If you don’t think the rebates are, in fact, adding more liquidity to the system, then why are the ECNs (Exchange Communication Networks) paying this price?
- The authors of the white paper suggest the issue could be solved by forcing the high-frequency traders to keep offers open for at least a second. So then why doesn’t an ECN on its own institute this rule as an inducement for institutional traders to trade there?
- Why aren’t the big institutional traders up in arms, threatening to move business away from treacherous, shark-infested exchanges?
- Also, by the authors’ own admission, this game can be played by tiny funds, capitalised with just a few million dollars. If this is so, then the trade will become crowded, fast, and any temporary profits/tax will soon disappear. In other words, what looks like a permanent flaw will be revealed as a temporary arbitrage opportunity, the likes of which you’d expect to see whenever a market goes through some significant change. If only monster firms, with tremendous technical expertise could do this, then you’d expect the “tax” to hang around for a while. That doesn’t seem to be the case.
And, sorry, but the authors of the paper sound absolutely ridiculous right off the bat when they start their paper by saying:
Retail and institutional investors have been stunned at recent stock market volatility. The
general thinking is that everything is related to the global financial crisis, starting, for the
most part, in August 2007, when the Volatility Index, or VIX, started to climb. We
believe, however, that there are more fundamental reasons behind the explosion in trading
volume and the speed at which stock prices and indexes are changing. It has to do with the
way electronic trading, the new for-profit exchanges and ECNs, the NYSE Hybrid and the
SEC’s Regulation NMS have all come together in unexpected ways, starting, coincidently,
in late summer of 2007.
Can they honestly be saying that the financial crisis was less of a factor in market volatility than this high-frequency bogeyman?
Later on they say, again:
Volatility has skyrocketed. The markets’ average daily price swing year to date is
about 4% versus 1% last year. According to recent findings by Goldman Sachs,
spreads on S&P 500 stocks have doubled in October 2008 as compared to earlier in the
year. Spreads in Russell 2000 stocks have tripled and quoted depth has been cut in
Seriously? What happened in October, 2008? We had an epic market crash and a series of unexpected events like we’ve never seen before. And they’re blaming rebate traders for the widened spreads?
Look, as we said above, we don’t doubt that traders are finding clever ways to game the market. There have always been ways to game the market, and institutional, big-block traders pay top-dollar to Russian mathematicians, who help them chop up their trades in such a way the orders an be executed smoothly, without giving up too much of a vig to the sharks on the other end. Some version of the sharks and whales game will always be around and this may be the latest version of it. The problem will go away, we suspect, on its own — the real danger is if politicians and regulators get a hold of this idea, limit comptuer trading and impose some kind of forced limitation/latency , and cement in place a less-liquid environment that really does serve as an ongoing investor tax.
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