- HF Trading: Setting The House On Fire To Stay Warm

A while back I sat in on a meeting with the head of Morgan Stanley’s Quantitative Trading unit. The topic of the discussion was high frequency trading, dark pools of liquidity, and ‘Information Leakage’. They had gone around to several major hedge funds to discuss their ideas about how the laws concerning high frequency trading and dark liquidity pools could be ‘gotten around’ to allow a distinct and specific advantage for any investor engaging in certain practices.

Those practices were all absolutely legal under the letter of the law, but only just. The fact is, the technology was simply WAY ahead of regulation and no one knew that better then Morgan Stanley. So they had stopped by offering to partner with us to help us capture the profit that they knew they couldn’t possible do on their own without incurring the wrath of the redistributionist mob that was camped out in front of Goldman Sach’s offices at the time. Basically the whole meeting was a solicitation for an investment. Let me say this again, what they were proposing was absolutely legal, but I think most people would have seen it as unethical.

My employer’s ethics being what they are, we instantly passed on the opportunity.

Still, it was pretty clear that someone somewhere would eventually be taking them up on their offer. And that person whoever it was, would be getting a pretty reliable profit, with a minimum of ‘risk’ as it’s presently understood. But the truth is, it didn't really matter. Even if Morgan Stanley never found a partner for their plans, there are a ton of people out there already doing precisely what they were proposing. And those people are destabilizing the entire financial markets.

Take this admittedly hyperbolic example:

Suppose there were only one HF trader and only 1 professional long term investor in the market. In reality there are many, but their views on some issues are so similar that in some regards they do tend to act as one.

Suppose that both the HF trader and the long term trader each have a fixed ‘draw down limit’ imposed by their risk management team. A drawdown limit is a maximum allowable loss from peak, and even a strategy that remains profitable can exceed this measure if they aren’t careful about their risk. For most firms that number is somewhere between 10% and 20%. If the market moves 10.1% in a single day, the long term trader could conceivably be over his draw down limit, but for the HF trader it’s not necessarily so. Since his exposure is reset at such a high rate, he could have been up and down several times during a single day’s move, even if it was all in one direction.

In this circumstance the long term investor would have his strategy shut down, and he would be out of business, or at a minimum he’d be dramatically scaled back to a lower risk level. Either way, the HF trader would now represent a larger portion of the overall market activity. And that would mean that the next huge ‘short term’ move will be even more pronounced than the last. And since that’s so, it will ‘take out’ the next long term strategy in the same way. And so on, and so on, and so on. This will continue until HF systems make up a majority of the market, like they do now. And the short term moves will become more and more pronounced until events like the ‘flash crash’ happen much more frequently - pretty much all the time.

It's a simple fact that most professional investors with similar holding periods in a given market will trade in very similar ways. This is true of HF traders and of investors with a longer term view. So although my example was simplified, it can very effectively be applied to the real world. And all you need to make the real world look exactly like that simplified example is enough observations. In other words... time. So long as longer term investors are not participating in the market, limiting the short term effect of HF traders, the whole market is on borrowed time.

I’ve been an ardent defender of HF trading in the past, since in a normal and ‘healthy’ market those programs serve a meaningful purpose. But like bright sunshine on a field, even if it would be helpful in combination with occasional rain and a cool evening or two, it can’t be the only thing you have or it’s a recipe for disaster. That ham-fisted analogy is what we’re now seeing, and although you might not personally see the smoke yet, I can assure you that today's markets are in flames.

Because of the uncertainty created by the economic crisis and the ‘change’ half of the Obama administration’s ‘hope and change’ mantra, long term investors have left the financial markets in astounding numbers. It’s been so pronounced in fact that Barclays has begun cutting staff in response to the drop-off in business. And as we speak, the HF trading programs are in the process of burning through the few professional long term investors that are left.

Somewhere out there someone is saying ‘Well there are some strategies which are doing very well right now’. In response let me say that I believe only three things will increase your Sharpe ratio in this environment. You can short volatility, you can short liquidity, or you can shorten your average holding period. The first two strategies are commonly referred to with the analogy ‘picking up pennies in front of the steam roller’, where they make a profit every day but blow up spectacularly at some future date. And the third is HF trading.

So even if some strategies are doing well, it’s a fair question to ask how long they will continue to do so. The effect of shorting volatility is well known in industry literature, and shorting liquidity is what created the initial crunch of the credit crisis. As for HF trading, it’s become a game played predominantly by people who are using dark liquidity pools in a manner that employs 'questionable ethics', to skirt around regulation and (in my opinion anyway) unfairly ‘game’ the markets.

The best analogy for that is that they’ve decided to set the house on fire to try to stay warm. Like most people in that situation, they had better hope it’s a short financial winter or it may all be over for all of us.