Monday 23 April 2018

Rapid-fire tech and algorithmic wizardry of flash traders

Automated-trading firms, the modern-day wolves of Wall Street, are once again setting off warning bells

Simon Rowe

Ireland is fast-becoming a European hub for controversial high-frequency trading firms who bag millions on the stock market in the blink of an eye.

Made famous by financial journalist Michael Lewis in his best-selling book Flash Boys, high-frequency trading is the automated trading of securities and derivatives using a combination of lightning-fast computers, high-speed data networks, and complex algorithms.

Critics of high-frequency trading claim that it causes flash crashes and brings volatility to the share market.

Its defenders say it brings liquidity to the market and has led to a massive reduction in the cost of trading.

But recent turbulence in the share markets has seen the finger of blame pointed again at flash-traders for causing and exaggerating stock-price volatility.

In recent days, the head of one of the biggest high-frequency trading companies in the world warned of an impending "catastrophe".

Highlighting "fault-lines" in the structure of increasingly automated financial markets, Mark Gorton, the founder and head of US-based Tower Research Capital, cautioned that increasing complexity has brought new dangers that needed to be mitigated.

Gorton is concerned over what he sees as a lack of risk controls at exchanges, which in his words constitutes a "large hole in the middle of the system that needs to be filled".

Gorton's remarks are a warning bell for the industry.

High-frequency trading is all about speed and volume. Using rapid-fire algorithms, traders can see 'buy' and 'sell' orders fractions of a second before their competitors in the electronic marketplace.

This means they can get ahead of other investors, from day traders to mutual funds, by seeing the intent of an investor to buy shares in a particular company.

High-frequency trading firms buy and sell enormous volumes of stock but start and end each day with few if any holdings. They only purchase blocks of shares ahead of the investor in order to sell them back to them at a higher price.

Flash traders make their profit from intra-day market moves, not from long-term investment. They may earn just a few cents on each share traded but, when the volumes rack up, the profits can run to millions.

The distortive effect that HFT has had on the equity markets has been compared to an investor placing bets with a bookmaker who already knows the final score before the game is played.

The pace of high-frequency trading is so fast that it is estimated that stocks are only held by any one buyer for an average of 22 seconds before being sold on. At the end of the Second World War, the average holding period for a stock was four years. By 2000, it was eight months. By 2008, it was two months. And by 2016, it is less than the time it took you to read this paragraph.

While regulators battle to keep up with the rapid-fire technology and algorithmic wizardry, there is only one sure bet: the glory days of bear-pit traders in bright-coloured jackets are over. The modern-day wolves of Wall Street, the flash traders, have eaten their breakfast - and now they're onto lunch.

The New York Stock Exchange, once the epicentre of US stock trading, has seen the amount of trades exchanging daily "on the floor" fall to just 13pc.

On European stock markets, about 30pc of trades are now done by HFT.

Closer to home, about one-in-10 trades on the Irish Stock Exchange is done by algorithms rather than by human traders. The growth of HFT worldwide has been staggering - and so too are the profits involved.

But the industry thrives on secrecy, stealth and speed, so most of the big players are notoriously media shy.

Two of the world's biggest high-frequency trading firms, Virtu Financial and Susquehanna Investment Group, have moved their operations into Dublin's docklands.

Virtu Financial moved to Dublin in 2013 with IDA support, and business is good.

Profits at its IFSC operation rose to €6.4m in 2014 from €5.8m in 2013, "driven by increased net trading revenue" which increased to €51.5m from nearly €48m in 2013. Before netting a tidy after-tax profit, Virtu's Dublin office was still able to pay a "related third-party fee" of €31m to parent companies for "compensation, technology and administrative services", according to its most recent set of accounts.


Former finance minister and gambling fan Charlie McCreevy, who sits on the board of Virtu, clearly hasn't lost his winning streak, either. He pockets a nice six-figure annual fee for his services along with his five fellow directors, who net a total of €824,000.

With staff numbers at just 28, the company's wage bill, including directors' salaries, amounts to €7,964,814, which suggests the average salary for traders is a whopping €280,000.

Virtu generated $500m in trading revenue in 2015 with trading spread across more than 11,000 assets and 225 exchanges. Famously, it has had only one losing day in its seven years of operation. To critics of HFT, this smacks of unfair advantage. For HFT cheerleaders, such criticism is viewed as sour grapes.

The only fly in the ointment so far is that Virtu had to postpone a planned IPO in the wake of the controversy surrounding Lewis's Flash Boys - the book that lifted the lid on the complex world of HFT.

In another minor setback, Virtu was hit with a €5m fine by French regulators for market manipulation on the Euronext exchange in December last year. The case, which dated back to 2009, involved Madison Tyler Holdings, a company that was only taken over by Virtu in 2011.

Virtu intends to "vigorously pursue our rights of appeal under French and EU law". However, the fine will hardly put a dent in the firm's profits, or its reputation.

Regulatory pressures are growing on high-frequency trading firms.

EU leaders recently signed-off on tough new restrictions on high-frequency trading in a series of sweeping reforms that will kick-in in 2018. Regulators are seeking to curb volatility and make markets safer with the new set of rules, amid concern that high-frequency trading could spark a market crash.

US regulators have signalled a move to curb high-speed trading in the futures market, with concern growing over sudden large price movements.

The Irish Stock Exchange is confident it is fireproofed from the risk of flash crashes as "there is less direct HFT participation on the ISE in comparison to other exchanges in Europe", a ISE spokeswoman said.

"A fundamental feature of our equity market is market integrity," she said. "We have a number of systems and 'human' market monitoring activities that ensure market integrity is maintained. For example, we have system-generated volatility interruptions which prevent sudden, extreme price movements in share prices. These in turn are monitored by our market-supervision team on a real-time basis."

Another fireproofing mechanism used by the ISE is a technical "throttle" mechanism, which limits the number of orders a member firm can submit per second to the system.

"This ensures that automated trading cannot impact on the overall integrity of the market as it prevents extremely high order-transmission rates," she said. "We monitor disclosures, news and market activity to identify potential breaches, disorderly trading and market abuse on a daily basis. Last year we implemented a new market-surveillance system which enhanced our market monitoring even further."

While high-frequency trades may be only a small proportion of business at the ISE, an HFT eco-system has grown up around Dublin's docklands in recent years, with the likes of fellow high-frequency traders Geneva Trading and fintech firms such as Corvil, Lab49 and ITG, providing the technological heft to support Ireland's burgeoning presence in this sector.

In a major breakthrough in the so-called 'arms race' for speed in electronic trading, Irish-based company Hibernia Networks has stolen a march on its rivals by launching a superfast transatlantic data cable between the US and Europe. Hibernia's Express service, which connects New York to London, went live last October at a cost of €270m but already the firm has confirmed it has accelerated its network performance and latency on its sub-sea cable connecting North America and the UK to 44.92ms - a whopping 14.6 milliseconds faster than the industry record of 58.9 milliseconds.

In a business where every millisecond counts, a 14 millisecond advantage is worth millions in profits to the fastest trader. And with high-frequency-trading activity making up about half of all trade on the US equity markets, and up to 30pc, on European markets, the higher the speed the higher the profit.

However, while profits can be made in milliseconds, conversely, when things go wrong, billions of euro can be lost in the blink of the eye, too.

With powerful algorithms executing millions of orders a second and scanning dozens of public and private marketplaces simultaneously, there is huge potential for a financial disaster. Flash-traders can create unprecedented volatility at a rate that human reactions simply cannot match.

"The speed, complexity and volume of what is being traded makes the market humanly unreadable," one industry expert has admitted.

Critics of HFT are quick to point out that algorithms and software merely chase mathematical patterns they are programmed to find, such as trends and momentum in stock movements. As a result, algorithms can continue to pile money and exaggerate a trade well beyond what the market would consider a correct response.

In a desperate bid to mitigate the disruptive effects of HFT, financial institutions established 'dark pools'.

Dark pools are alternative trading systems that let investors place buy and sell orders out of sight, and they were designed specifically to keep high-frequency traders out.

But financial institutions have run into trouble there, too.

Credit Suisse - which is reportedly in the process of setting up a major trading floor in Dublin - was fined $84m by US regulators earlier this month for its US "dark pool" trading operations.

The warning bells are sounding everywhere.

The first warning bell was sounded in 2012 when US-based HFT firm Knight Capital imploded after losing $10m a minute in a 45-minute electronic trading rampage that was blamed on a computer glitch.

A second warning bell was sounded earlier this month by one of the world's biggest high-frequency traders, who warned of an imminent "catastrophe".

The next time there is a major global-market crash caused by flash traders, blink and you'll miss it.

Sunday Indo Business

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