Thursday, August 2, 2012

When the Machines Go Mad. The Evil Spawn of Regulation

In the film "Forbidden Planet", Morbius (Walter Pidgeon) is one of two survivors of a colony that reached for Utopia and miserably failed. Morbius discovers that the planet's extinct inhabitants, The Krell were of superior intellect, so much so that they created machines that were operated by telekinesis, and these machines would satisfy their required tasks. What the Krell did not foresee was when dreams and nightmares were also influencing the activities of their creations. These "Monsters from the Id" eventually destroyed the entire Krell civilization. Morbius ignored the Krell history, or was "willfully ignorant" of the Krell demise, and proceeded down the exact path of the Krell. You guessed it, the entire colony was wiped out by One Man's dreams and nightmares.

Our Morbius is a fellow by the name of Arthur Levitt. I will refer RFNJ readers to Uncle Artie's 2000 SEC Testimony where his Utopian Market beliefs ultimately lead  to machines going hay-wire.

Yesterday - we had another situation where electronic execution systems went seemingly out-of-control. We never found out what happened with the flash crash, but Congressmen and politicians were eager to hang a villain or at least try to tell the public that Evil Wall St Did This!!
I have said this time and again that Evil Banksters did not do this and the ultimate blame goes back to regulatory meddling.

How it began: At the time of the 1987 Crash, the legend was that dealers refused to answer their phones, or could not keep up with the client demand. No E-mail back then and all markets were some-what manual, with the exception of NASDAQ. As a result, "people" (which could mean competing dealers as well as institutions and individuals) were not getting their orders placed. The market tanked, but when you think about it, it may have been a blessing that these "investors" could not sell into the mess.
As a result, NASDAQ upgraded to allow the participation of Small Order Execution Services or SOES.
SOES could only execute maximum lot size of 1000 shares and required "real accounts" behind their orders.
SOES orders were automatically executed and "SOES Ahead" was a common response from a trading desk when trying to compete between dealer orders. Market Makers referred to them as SOES Bandits. Because they were not representing retail or institutional order flow.
Soon, SOES shops popped-up all over the place attracting individuals to "play" in the market with the company's bank roll or invest your own  dough. They were the Off-Track Betting equivalent to the equity Markets.
Soon the SOES Bandits were not satisfied with gaming the markets and gained friends in high places.
Law suits from SOES Clientele caught the attention of the SEC. The Manning Rule arose from a lawsuit where a SOES Bandit alleged that a Market Maker refused to trade with him.
Arthur Levitt decided it was time to make everything right.
Rather than outlawing SOES and analyzing the Broker Dealer liquidity argument, Arthur decided that SOES were the same as Grandma wanting to buy an odd-lot to pass on to her progeny... Oh, the Market Makers did not help their cause, as the Department of Justice wire-tapped trading lines to see if their was collusion or refusal to trade. Obviously there were some juicy bits on the phone lines. The SOES bandits also became the subject of SEC probes, but the market was poised to change into a row of nickel slot-machines.

Levitt outlines what the SEC thinks it should promote and at the same time testifies that the responsibility of making his dream a reality falls on the shoulders of the private sector.

  • Efficiency -- assuring the economically efficient execution of securities transactions.

  • Competition -- assuring fair competition among broker-dealers, among exchange markets, and between exchange markets and markets other than exchange markets.
  • Price transparency -- assuring the availability to investors and broker-dealers of information with respect to quotations for and transactions in securities.
  • Best execution -- assuring the practicality of brokers executing investors' orders in the best market.
  • Order interaction -- assuring an opportunity for investors' orders to be executed without the participation of a dealer.5
Arthur opened Pandora's box. The market became decimalized. Spreads were gone. Block Trading is the way of the Edsel. The SEC mandated automation and order display rules. Now Dealers were competing with individual orders. Anything Goes in Uncle Artie's Equity Shooting Gallery! Soon Artie though that ECN's like Instinet could operate as competing Exchanges. Instead of the centralized exchange models that existed forever, Artie believes that anyone with a computer could literally become an exchange. He allowed the decentralized Exchange which lead to the Trojan Horse of the Hybrid Market called NYSE/ARCA.
(Archipelago or ARCA Exchange was the spawn of Datek - a SOES firm, that morphed into The Island after Arthur's mandates).
"Of these five options, for example, one would require greater public disclosure concerning the execution quality of individual market centers (such as the various exchanges, market makers, and ECNs) and the order-routing practices of brokers. Such disclosures, by facilitating more informed decision-making by investors and brokers, potentially could strengthen the competitive forces that would lead to more efficient markets and the best execution of investor orders. Under any of the other four options, the Commission would not impose a fixed structure or system on the markets, but would adopt an intermarket trading rule designed to enhance the opportunity for price competition and best execution of investor orders. The markets therefore would be afforded maximum flexibility to design and implement any systems or linkages that might be needed to implement the trading rule. In recent years, advancing technology has opened up new horizons in terms of the types of communications systems and linkages available for achieving national market system objectives. Giving the private sector maximum flexibility to take advantage of innovative technology on an ongoing basis would be clearly superior to any approach under which the government attempted to impose a fixed solution that soon could be obsolete."
The system was not really broke, but for a few gunslingers and pot-shooters that weren't interested in long term investing. If you read the testimony you will see references to Best Execution. Till this day, no one can define Best Execution.
It's a lot of information, but it's out there. The SEC, The DoJ and the Clinton Administration killed market making and along with it eliminated massive tax revenues from the thousands of traders and dozens of broker dealers that were out of business. I would guess that they lost billions in tax revenues.
Arthur Levitt is still applauded as the man that changed the markets. One day I will have the opportunity to go on Bloomberg Radio and burst the Arthur Levitt Fanclub's Bubble. Till then, wilful ignorance rules the day, and the machines will lose your marbles when you least expect it.
The irony, SOES style prop-trading rapidly became a victim of the market evolving into a platform for High Frequency Trading.

38 comments:

Tom said...

Great analogy. Who would you cast in the Ann Francis role (who was smoking hot at the time BTW)?

frithguild said...

The "Krell Mind Booster" - reminds me of college ...

ikaika said...

Ann Francis - I guess we could throw Mandy Drury out there. She's blonde and naive

frithguild said...

I had a Datek account back in the day - mainly because trades were less expensive than those my broker did for me. Disruptive technology seems to me to be the driver a move away from the specialist.

Is it regulation or the absence of it that gives rise to high frequency trading? The setup now is clear - wall street bankers are the boogeyman do we need regulation. It also seems to me that HFT is not trading at all but a common law fraud. But that's just me.

Tom said...

HFT is a morally neutral phenomenon, so it's used to both noble and evil ends.

I think I told you the story of my conversation with a major investment bank back in the day about how they wanted to partner with us to abuse the letter of the law. That would be an example of the latter, while it has 'theoretically' added to liquidity and reduced bid-offer spreads, which would be an example of the former.

Think of the code around HF Trading as a gun. It's really all it is. A gun used poorly (or with malice) is a serious danger. But used well it makes things better for everyone.

As far as the regulation goes, that's a different issue. It looks to me to be mostly the animus that stupid people feel for smart people. The stupid people would be the congress-critters and mob that they are in front of, and the smart people would be the guys waging the techno-arms race in the HFT world.

ikaika said...

Some folks will say that I've been unfair on Uncle Artie, however, I did not have the bandwidth to write the E-Book required to demonstrate the origin, the actions and the ultimate regulatory mandates that made the markets what they are today. As an international trader, I look at Mexico and Brazil as examples of Functional Electronic Markets. I hae quant accounts that hate those markets because it's almost impossible for a non-broker or unaffiliated entity to break spread in tose markets. I am often confronted with "How does that help me?"
It's not my job to explain why the Bovespa doesn't like your style of trading. It is my job to make sure that the Bovespa respects thelimits and paramets of your orders.

ikaika said...

a side note: Knight Securities CEO was extremely vocal when the Facebook IPO went bonkers. He was "throwing stones" at NASDAQ or their inability to manage the volume of orders.

Here we are today and Knight is "living in a glass house".

Chess said...

Ikaika you should be a tenured prof with Lizzie Warren for that write up.. If you have some native american blood in you all the better.
One thing that eats at me is the computers that see the order milliseconds before others.To me that is insider trading. Its info that someone has before the public has it. To me insider is insider even if it millis instead of weeks. The exchanges cant go back. Tails are wagging dogs everywhere.
And this am the Sec has bagged a Bristol exec.. Good for public investors after yesterday?..
Hal? Hal? Hal/ Place my order dammit

Tom said...

It seems to me that the only thing driving financial regulation these days is the principle that Washington has identified anything financial as enemies of the people. Trading... bad... banks...bad... derivatives...bad... risk... bad... loans... (unless they are loans to politically selected sub groups) ... bad.

In reality it's all just a power grab. Expand the bureaucracy and get further control of the industry. Get all those clever guys in line. Make them pull the chariot of Washington in the direction we want. But in the end, that's going to be counter productive.

I personally think the HF game is too easy to abuse. But it requires so much knowledge just to explain the issues properly that the chance of a DC regulator being able to do anything about it is basically zero. Half the people in the industry don't understand it.

So I think we'll get some new regulation, and in the end I don't think it will really help anything. I think all it will do is smear the malice around and maybe in the process, make it a little more accessible or visible. But if I want to be honest, it's just as likely to make the whole market even more impenetrable.

Tom said...

Chess, there are no computers that actually literally see orders before others. It's more subtle than that.

ikaika said...

Its not really insider trading. It's a flaw in the system being exploited. While a computer could theoretically see an order before othe systems and humans can, the guy that built that program (oops he didn't build that) probably sold it all over the sreet.

Its acting on the information that raises the issue.

Chess said...

I thought there were firms that payed to have their comps tied into the exchanges? And I know it doesnt really affect my measley trades but I guess Im just mad that we have gotten to this point
And I remember the dude rippin the Naz a new ass but I really feel sorry for the 1500 employees who went home last night saying huh????

Tom said...

It's called co-location, and EVERYONE pays to have their computers co-located. Even the firms that execute your orders.

Like I said, it's a bit more subtle than that.

Tom said...

Take this simple example.

A system sends an order to an exchange for execution. The systems have to have processes in place to recover if they lose connectivity so the way things happen is that the first thing the exchange does – even before it registers the trade to be executed, is let the sending system know that the trade has been received. Suppose it takes 3ms to send that receipt and another 2 to then register the order to be filled. Total time 5ms.

Now, a system can’t react to the information of an order being sent or that would be ‘front running’ almost literally the ‘inside information’ you describe. But… it can’ react (legally if not ethically) to the receipt. So as long as you can get your system to register an order autonomously in less than 5ms (it takes 2 in the example above) then you can get your order in ‘ahead’ of the initiating order. You use a flaw in the electronics to sort of ‘cut the line’ and be in front of another order.

This is oversimplified, but it is one way that the systems can be 'gamed' without breaking the law. there are MANY others that involve more complex explanations but a higher probability of assured profit.


Most HF traders would never do that, but some would.

Chess said...

As I have said before always a good education over here...And ooops he wishes he hadnt built that,....Like I said I just feel bad for the secretaries .janitors etc who very well good end up with zip. And how many of em had some company stock in their 401s etc???

Tom said...

BTW, floor brokers used to do this all the time too, so getting rid of HF won't solve this issue.

Anonymous said...

Tom..You lost me? Which aint hard to do in your universe. What did the floor brokers do?.You mean see an order come in for a big block and get ahead of it?

Tom said...

That's right. It's called 'front running'. There have always been all kinds of tactics to hide it from notice.

The futures and options markets are still accused of it all the time, although I suspect the accusations are more common than the actual occurrence.

frithguild said...

I am way outside my wheelhouse on this, but HFT, morally neutral or not, to me is common law fraud - "Every fraud in its most general and fundamental conception consists of the obtaining of an undue advantage by means of some act or omission that is unconscientious or a violation of good faith."

To me, it is not a "market" when third party front running is built into the trade. All regulatory compliance be damned. Put 6 people in a box and show them how HFT's "cut in the line" and make a fortune. You don't need to prove intent to deceive to get rescission.

So what would a legal decision that says any execution effected by HFT can be rescinded do?

Tom said...

First of all, very few people would do something like that. Most people in the market interpret the rule as meaning ANY front running and act accordingly. Most... not everyone.

Second, I'm making a point here not describing actual phenomenon. In reality all of this is subject to probability distributions which surround every decision by a wide enough margin to obscure intent.

"Sure it could theoretically happen... but our design was to do X, not implement Y." To date, arguments like that have been persuasive.

Plus, the HF markets really have lowered spreads and dramatically reduced execution costs. More often than not I get paid to execute trades (I have a net negative execution cost). You can't leave benefits like those out of the equation.

ikaika said...

Before the Manning Rule, Market Makers and Brokers were allowed to prioritize orders.
Let's go back to 1995:

If a client had a limit order to buy Autodesk (ACAD back in the old days) let's say Buy 2500 ACAD @ 31 1/4.
That order was treated as "not held". The market maker knew the liquidity in the stock was thin and if he had an institution that decided to bid same limit but for size, the retail order would take a back seat.
The MM would bid 31 the fig (because ACAD had traded in half to three quarter point spread and tick size was in 1/4 point increments.

So your trader is biddin "out loud" 31 plain for large.
The inside market is 31 bid by 31 1/2 offer.

Let's say HRZG decides to break spread at 31 1/4, he owes you a call becuse you are best bid.
HRZG calls your desk: "10k ACAD at the fig for a number, HRZG"
Your trade says: " I bought your 10k ACAD @ 31 the fig, my number is 50 large, you got more?"
HRZG says: "I got 10k more and that cleans me up... I'm out of your way" HRZG Updates his market and the inside resumes to 31 -31 1/2.
If HRZG's Seller reloads, because of industry practice at the time he would call you first before breaking spread.

Now your MM is long 20k @ 31 1/2 and has revealed to a competitor that he is in the market to buy 50k total.

You call your retail rep and say "Where's my 2500 shares? I just saw 20k hit the tape below my limit?"

The rep calls the trader, trader says: "Tell your buyer he's got company" (what he should have done when the institutional buyer arrived is tell each party that they would split prints)

You aren't satisfied, your rep pound the table and says "just fill me and we'll be done with it"

Trader says: "If I get hit with another 10k at 31, take a report, I'm down ticking."

Sure enough, GSCO breaks spread and offers at 31 1/4 at that same time the trader is "Hit" with SOES 5 lots of 1000. The trader updates his market down 1/4, fills the retail guy and fills the Institutiion on 50k. GSC calls and says: "10k acad @ 31 the fig", trader replies: "SOES Ahead!"

Now the MM is short 17,500 ACAD @ 31 1/4 hoping that GSC has a real Seller.
If it's real - the MM could make a quarter to a half on his postition.

Turns-out GSCO did what it had to do and the market starts to up-tick. If HRZG comes back (you owe them a call if you create a new bid) you may be able to cover your short without pain.

Those days were fun. Today, it's video games. snore...

Tom said...

LOL ... nobody is going to able to follow that but you and I (and my few trader buddies who also read this.)

ikaika said...

I meant short 27500 - i've been up too long :~

ikaika said...

That was the point Tom.
When the Regulators tried to understand what Market Makers were doing, they were bewildered.

Since they failed to understand it, Arthuer Levitt decided that the system couldn't be Greek, but should be more like chinese Algebra.

When the small investor stepped into the old time arena, it was like a Beer Leaguer crowding the plate on Bob Gibson.

It had nothing to do with "levelling the playing field"
If you couldn't grasp the dynamic (It worked!), then let your broker fight your battles.

Today, every geek with a Schwab on-line account thinks that they are "traders".

ikaika said...

If you applied the SEC rationale to Grocery Markets, any fool with a sack of taters could walk into the A&P and set-up a stand.

Why? Because the SEC says farmer Joe with his sack of taters is a legitimate market participant. He has orders too!

frithguild said...

Now who can argue with that. Not only was it authentic frontier gibberish, it expressed a courage little seen in this day and age.

Anonymous said...

Ikaika...being im from St louis Gibson would be in a fight the 1st inning of every game.McCarver would just throw down a thumb and flip it and it would be Nhl on grass.Good old days when you could pitch inside...
I just picture 2001 and Hal telling Dave he is selling everything and just keeps selling and Dave saying stop.This ends badly someday with the maket down 1500 and theyre kicking trades for a whole day...
Frith ....Im wit you.. This is fraud and Im a victim of Tom and Ikaika ..I smell class action ....

Chess said...

That was from me just in case Frith can put something together ..And that tato talk wont hold up when Frith gets Ikaika on the stand

ikaika said...

Unfortunately, I am Frank Poole floating away in space after Hal goes bonkers

Tom said...

I guess I'm the angry bearded guy in the sequel who thinks HAL only broke because he was lied to.

ikaika said...

I'll stick to Forbidden Planet.
Tom can be the guy that takes the brain-boost, Frith can be leslie nielson's character and chess could be earl holloman - Kentucky Bourbon!

Chess said...

It only took 30 threads but I have to say you guys now have me chuckling..Well done on a day where Super Mario pulled the football away from Charlie Brown
Good talk from guys in the trenches and Frith jus going wtf?

ikaika said...

Unfortunately, when socialism fails, capitalism has to pay for the mess.

Chess said...

Agree. Very sad. Ive been selling my plasma to buy a repoed doublewide when fomo comes about. Almost there....
Hey.We all have to have goals to shoot for.

ikaika said...

make room for the veal

frithguild said...

Surely it is a good thing I left the Krell Mind Booster at the frat house.

And don't call me Shirley.

Chess said...

Jus' hang loose blooood. She goonna catch up on the`rebound a de medcide. Jiveman #2: What it is big mamma, my mamma didn't raise no dummy, I dug her rap. Woman : Cut me som' slac' jak! ...Chump don wan no help, chump don git no help. Jive ass dude don got no brains anyhow.

ikaika said...

It's amazing - John Bogle is spouting that we need a Transactrion Tax to prevent the Knight-type trading debacle...

The model promoted and approved bny Arthuir levitt is where the dysfunction exists.

Taxes won't change velocity or frequency.

That's like saying you need to consult your accountant everytime you enter commerce!