Thanks to Michael Lewis’ book the HFT debate has become even more dualised, than it already was. (*note to person on twitter who patronisingly corrected me that I probably meant duelised not dualised — I didn’t. I specifically meant dualised, as in the dualism that brings us the philosophical/metaphysical fight between good vs bad.)
This is a shame.
It’s a shame because I don’t think it’s ever useful to make things into a good vs evil debate. Real life is much more complex. There’s good and evil in hft, but there’s good and evil in the opposing position as well.
I tend to fear absolutism because there’s usually a little truth in everything (even Bitcoin and gold). This is why, I guess, I can appear annoyingly contradictory at times. Personally, I don’t see it as contradictory. I see it as an unhealthy curiosity in life’s paradoxes. Some situations simply are paradoxical.
A lot of opposition to the HFT rationalists is focused on the fact that HFT traders are cheaters, anti-capitalistic and/or get unfair advantage by cutting deals with exchanges, and/or are insincere.
A typical comment: “We need market makers & they need to be rewarded by the exchange but MMing isnt about front running, spoofing & quote stuffing”
First of all WHAT is market making really?
Mostly, it is the actual bread and butter activity of the main dealer banks.
The bulk of trading at the big wall street banks is and always has been market-making or swap dealing (matching long and short smartly). Though, the fact that the banks deploy their own balance sheets to facilitate that matching makes it principal trading to some degree.
The reason they make so much money out of this is because banks have always attracted the sort of order flow that made them liquidity hubs. How they choose to process that flow is how they make money. They can take it to the public exchange, wear it on their own book (take the opposite position of their client) , find a better deal for the client off exchange or nowadays take it to a competing market place. Either way, they have the information flow advantage, mainly because they can see both sides of the flow and act upon it. They make money because they are popular with lots of different types of people essentially.
The clue of course is in the name “broker dealer”. Conventional commission-based brokers don’t take positions. They match buy and sell orders for a fee by working the orders around the market until they get done.
That’s great but it can take a while to get done, and the market can move in the meantime. Bids and offers can fall through as well. Yes, people get flaked on in the world of voice broking all the time as well!
But broker dealers guarantee you a bid, because they take the risk of matching that flow onto their own balance sheets.
For decades that meant if you were a big institutional buyer or fund, which sent a lot of predictable or informed flow to the broker dealer in question you would get preferential treatment vs the little guy, whose order flow was much less significant and thus much less of an information advantage to the broker dealer. Broker dealers competed for large informed flow as a result.
This meant there were multitudes of different prices in the market depending on your size and your relationship with the broker dealer. And more often than not the little guy couldn’t hope to trade at public exchange prices let alone preferential ones.
A dedicated market maker on an exchange, meanwhile, was obliged to make prices no matter what for the sake of public liquidity. This of course was risky if you got the price wrong because you could be wiped out. Hence why market maker spreads widen whenever conditions become illiquid or distressed.
A market maker who was affiliated with a large dealer bank had an information advantage when making those prices and could more often than not charge tighter spreads. Those who didnt have flow advantage had to use their nouse instead. That more often than not meant acquiring information in more conventional forms, everything from being cushy with the buyside and market participants (with charm alone!) to running or specialising in strategies that were known arbitrages. (Whether that was arbitraging two different regional markets, or asset classes or whatever.)
In any case exchanges always had deals with market makers because they helped to guarantee them liquidity, which was what their business depended on. From the market makers’ point of view they had the opportunity to benefit from winning strategies, relationships or wider order flow. And in some cases to influence the public market.
But to become a market maker and benefit from the liquidity of the public exchange took a) a relationship with the exchange b) capital and c) reputation. It was a small privileged market.
And that remained the case for as long as the market structure depended on one public exchange and the broker dealer network.
But then came market liberalisation and the formation of competing liquidity hubs. For a long time this benefited the banks directly. A) they knew competing hubs couldn’t make it unless they dedicated their flow to them, meaning the hubs were dependent on good relationships with the banks (or in some cases were owned by them) and b) the market fragmentation allowed them to benefit from alternative arbitrage opportunities (jurisdicational, a la ICE vs CME, or latency effects.)
The point of liberalisation of course was to breakdown the monopoly of the public exchanges and allow banks and other participants to get a slice of the action in these markets instead. From the point of view of the banks it was a no-brainer to want to get involved, especially given the flow advantage they had.
The social media equivalent
Think of it in terms of Facebook. Until liberslisation there was only one public platform. If you were a major social animal you had flow and popularity regardless. Facebook was just an outlet that allowed you to enhance your own popularity and allow you to plug into an even wider network when you needed it. It also allowed you to influence that network. Nevertheless Facebook was more dependent on your commitment to its platform than you were to it. You using facebook brought your friends and relations with it.
Liberalisation however allowed you to sponsor Google plus with your popularity too (or even form your own hub). If you were influential enough you would bring your friends and relations with you (your flow).
If you continued to operate on both platforms that would create an information asymmetry between the two platforms requiring frequent updating and/or forming a need for your friends to monitor two hubs instead of one just in case they missed out something. In other words you could never get the full story just from Facebook. That created an information advantage to anyone who could be bothered to watch both spaces. Especially if that information was split in a way that benefited you. (Say the friends on Google were professional and the ones on FB were your friends and family).
If information is power, withholding some of it from facebook in favour of another platform — especially if access to the other is controlled (by charging fees or allocating the info say to just work friends instead of relatives, or depending on the fact that most of your technologically challenged friends wont have time to monitor two hubs) — empowers you the informant. It also creates a market in the restricted or harder to acquire information.
What the banks didn’t anticipate was that liberalisation would allow a new type of market trader to arbitrage that intentional fragmentation, by effectively spotting and publishing the differences between the two markets.
They also failed to anticipate that those new entrants — the equivalent of the paparazzi — would want to draw out the information withheld from all the public platforms (including FB) and do so by essentially sending out false info to the public market to see what the banks ended up denying or not. We are talking about “forensic” methods used to do figure out the really important stuff which you don’t want anyone to know because it could entirely change how your public profile influences the public sphere. In some ways no different to the methods used by Newsweek to deduce the identity of Satoshi.
This of course made the banks seek out even more private venues where the paps were not welcome. Which, of course, made the paps want to peer into those venues even more.
The question is are the “paps” evil? Especially given the nature of the information they are exposing and the “public” methods they are using? Not to mention the demand from the public about truthful information
They, like Newsweek, are using publicly accessible data and the testing of that data in the market to arrive at informed opinions about the truth (a.k.a prices), the sort that are as close to the real truth (which for the most part is retained from the market) as possible.
Sometimes they have to pay for that data, sweet talk sources, or appoint spies that can tip them off about misleading or real information heading elsewhere. Consider the way paps work with doormen for advanced knowledge about celebrity arrivals.
But it is all public domain. And anyone has the chance to make a better offer to the doorman if they feel inclined.
At the same time it is also understandable why celebs get upset about their real lives, which don’t quite match their public profiles, being exposed. Their ability to misdirect is impeded, and warts and all are exposed in a way that makes the public at large question whether such celebs should be entitled to the special treatment they are used to, or whether we need them at all.
People don’t like paps because they are predatory and make markets in information others would rather not give out. But we still take the information they provide hungrily.
The celebrity defence so far has been PR misdirection, voluntary distribution of favourable data and the growing tendency to cut deals.
Overall, the direct result is more information for the little guy than he knows what to do with, and the chance for him to form opinions based on much more information to hand, more quickly.
Predators are part of nature
For me it’s hard to argue for or against the predatory nature of the information gatherer. On one hand information dispersal of this sort empowers the little guy and limits the power of a select few “popular” entities to misdirect or overly influence (in their favour) the wider public disingenuously. It may not be nice but it’s fair game, especially if we are pretending that we operate in a free market which allows for gaming strategies of all sorts. Predatory strategies are after all a part of nature. If you move too far the other way you end up in a collaborative collusion model instead.
On the other hand, their techniques can be equally disingenuous and might result in a privacy cost to all of us in the long run.
Which begs the question what are the real costs of total market information efficiency?
The most obvious I would say is the end of privacy and arbitrage itself.
But what sort of unintended consequences might the presumption that there is no information advantage and no such thing as privacy have on social behaviour more generally?
Would we move towards an almost religious framework where the “crowd sees all”? Where every behaviour against the interests of the group is known about and thus punished/mitigated effectively?
Is the behavioural implication one of increased collaboration, on the basis that actions that benefit you disproportionately are known about and gamed instantaneously rendering them pointless?
Or does perfect information efficiency perhaps end up oppressing us in a way that kills our natural diversity and turns us all into the borg?
It is really hard to know the consequences. The alternative, of course, is purposefully maintaining information asymmetry that benefits some over others for the sake of human diversity.
That kind of suggests that life without information asymmetry isn’t very meaningful, or worse still cancels itself out completely.
I’m not a physicist, but doesn’t that echo our understanding of how the material universe came about in the first place?
Perhaps creating information asymmetry (where there otherwise would be none) really is god’s work?