HFT, Front Running And The Abuse Of Power

If you haven’t read either the book or the article, what follows may not make a lot of sense. This commentary is not a book review.

What Lewis doesn't say is that some people understood HFT from the get-go. Some twisted it to their advantage. Here is an example that is not from the book. You see an offering, and you are a buyer in size. You ping it and do not get filled, and the offering disappears. Penny it, and still no fill. The HFT has seen you (mathematically) and assumed a block buyer was coming. That is what the HFT's math predicted. So he steps up, assembles a block, and waits for the unsuspecting investor to be duped and pay up for the large position. The book and the NYT article describe this process in great detail.

But not all algorithms are alike. For every trading formula, there can be a counter formula. There are foxes and there are out-foxes.

The other side of the trade – when skilled folks were involved who knew about this technique – is not described in the book. What did they do? They backed off and let the HFT take the block. They used limit orders. Now the HFT had to piece out the block without a buyer. An HFT has a limited attention span. The investor might be a longer-term holder. By stepping aside and pulling his bid, the true investor puts pressure on the HFT, who wants to exit. The HFT business is tiny amounts of profit on large volumes in (very) short periods of time. But a skilled investor can use an HFT to do the dirty work for him by letting the HFT assemble the block. Sometimes, the buyer who outfoxed the HFT ends up with the block at a discount.

Always and everywhere in the stock market there are two sides to a trade. And there are those who understand the process. Lewis discusses that point very thoroughly in his book. There are also those who do not understand. In the end, the stock market is a mostly level playing field populated by buyers and sellers. Access to information, analytical technique, and technology determine the outcome. If I have more and better information than you do or process it faster, is the process thereby “rigged?” Maybe yes and maybe no. That one is subject to debate.

Front Running

A broker, advisor, or institutional investor has an obligation to a client, customer, or affiliate to execute a trade on the client's behalf. There is a duty not to take advance information about a trade and use it to line one’s pocket at the expense of the customer. The client, customer, or affiliate comes first. Front running is illegal, and so in most advisory firms front running is forbidden and is grounds for termination of employment. That is true at Cumberland Advisors.

Lewis describes a different form of front running. HFT works because of slight timing differences in order processing that allow a fast HFT to read market information and move ahead of buyers. This gets more complicated when the broker is also handling order matching and working both sides of the trade. There is where the dark pool becomes soiled water.

Some securities brokers have strict anti-front-running policies. They will not utilize order entry systems of the type that Lewis describes in his book. Sean Gibson of LEK Securities sent me his firm's policy. I will excerpt just one small part of his note to me:

The current HFT controversy, however, is really just the computerized evolution of many aspects of market making and proprietary trading. The contra-party is accepting principal risk (using the advantages available from publically available information – that is, if you have the money to pay for a large, high-speed data center and a team of programmers). At LEK we are often approached by these groups who wish to execute orders, often at little or no cost (as they would love to analyze our flow in any given name and back test to see a regular pattern emerging). We do not send your orders to these venues. In fact transparency is so important to us at LEK that we allow all of our clients to see exactly how and where they are executing. We will not tip our hand (or yours) to the street by executing directly with an HFT (or similar computerized market making) group.

Lewis describes how regulatory decisions create opportunities by opening a new door while trying to close an old one. This has always been a theme in government's attempt to regulate. Lewis cites the examples which led to HFT. We agree with his observations.

Abuse of Power

The NY Times article doesn't cover a very important part of Lewis's book: the story of abuse of power and use of influence.

We will quote from Lewis's book (and encourage readers to delve into the full story).

This first quote is from pages 148-9:

The FBI's investigation before the arrest consisted of Goldman explaining some extremely complicated stuff to McSwain (FBI agent) that he admitted he did not fully understand – but trusted that Goldman did. Forty-eight hours after Goldman called the FBI, McSwain arrested Serge. Thus the only Goldman Sachs employee arrested by the FBI in the aftermath of a financial crisis Goldman had done so much to fuel was the employee Goldman asked the FBI to arrest.

The second quote from Lewis's book, which readers may evaluate for themselves, is found on page 254:

To put it another way. The process that ended with Serge Aleynikov sitting inside two holding facilities that housed dangerous offenders and then a federal prison may have started with the concern of some Goldman Sachs manager with his bonus.

The third quote is excerpted from page 257:

... the appeal of Serge Aleynikov was finally heard by the Second Circuit Court of Appeals.... The judges ordered Serge released on the grounds that the laws he stood accused of breaking did not actually apply to his case.

I strongly encourage you to read pages 257-9 of Lewis's book. Then you may decide for yourself who is the bad guy and who has undue influence and who has abused power.

I agree with Lewis's conclusion in the NY Times:

... to function properly, a financial market didn't need to be rigged in someone's favor. It didn't need payment for order flow and co-location and all sorts of unfair advantages possessed by a small handful of traders. All it needed was for investors to take responsibility for understanding it, and then seize its controls.

BY David R. Kotok