Busted

Excerpt from All About High-Frequency Trading
(McGraw-Hill 2010) by Michael Durbin

I always wondered how long it would take for word to get out.

I got my own look in 2003. That’s when I went to work for the Citadel Investment Group, Ken Griffin’s hedge fund, to help them build a high frequency trading system for the US options markets. There was only one fully automated options exchange in the US at that time, the International Securities Exchange in New York. Before the ISE opened for business in 2000, no exchange would allow an options market-maker to submit their all important quotations—bids to buy and offers to sell—electronically. For the most part, those were still communicated verbally by human traders with loud voices and sharp elbows, standing in open outcry trading pits. ISE founders David Krell and Gary Katz knew it was time to change that, and their explosive success proved to any remaining doubters how absolutely right they were. The ISE was the quintessential game-changer. Their explosive success forced the traditional, floor-based options exchanges to make their own plans for electronic quoting. And Ken Griffin wanted Citadel to take advantage of it.

I had been managing financial systems development for several years by 2003, mostly for the pricing of derivative securities. The Citadel system, though, would not only calculate hundreds of thousands of option prices simultaneously—an impressive feat in its own right—but also inject streams of bids and offers into the markets at super-human speed. The custom-built quoting engines would tirelessly inject many millions of quotes into the markets every day, each of them a binding commitment to buy or sell an option at some specified price, each one the result of a software program running on a computer. And while the quoters were busy doing that, Citadel’s “electronic eyes” would scan everyone else’s quotations and orders—hundreds of millions per day—all in real time. It was like standing at the end of an open fire hose, examining each drop of water before it hit the ground, looking for something good.

When the EE found someone offering to buy an option for more than it was worth, or sell it for less, it would immediately submit an order to take the other side of the trade for a tiny profit. It was a dazzling sight, watching these machines pick the markets clean of its inefficiencies. I would have loved to talk about it back then, to tell friends and family what was going on in the gleaming glass tower at Dearborn and Adams in Chicago’s Loop. Bt the confidentiality agreements one has to sign for employers like Citadel are very effective. In this business, everyone knows that loose lips get pink slips. So like everyone I kept my mouth shut, and talked only with my small group of colleagues on the 37th floor.

By the time I left Citadel in 2005, that options market-making system—the product of a dozen or so developers and traders, a team smaller than the roster of the Chicago Cubs—was responsible for more than 10 percent of all options trading in the US, or more than a million contracts a day. Within three years its market share had reportedly grown to a commanding 30%. The US options market had become dominated by the extraordinary machines of just a handful of secretive firms like Citadel. Still, nobody on the outside seemed to have a clue that trading was no longer done by traders. That all changed in 2009.

As people licked their wounds in the aftermath of the 2008 market meltdown, wondering where all the money went, word got out that something like $20 billion of it went to folks known as “high frequency traders.” The term was well known inside firms like Citadel but not so much outside.

Now, it was bad enough that anyone made out like bandits in the horrible year that was 2008, but a far more frightening contemplation crossed more than one mind: Was high frequency trading somehow culpable? Did it cause the mother-of-all-crashes, or accelerate it once it began? After all, the 1987 market crash was widely attributed to program trading. Did the computers do it again?

Word went around that 50% of all stock trading—maybe 60% or even 70%—was attributable to HFT computers trading with each other, supposedly just to collect tiny kickbacks from the exchange known as rebates.

The HFT firms weren’t even holding onto their stock. Once bought, they’d immediately turn around and sell it, sometimes buying and selling the same stock hundreds or thousands of times a day. All this trading at ungodly speeds, it was said, was creating massive fluctuations in prices—something called volatility—that otherwise wouldn’t exist.

Can this be good? Nerves were not settled when a former Goldman Sachs employee was arrested for allegedly stealing proprietary computer code for high frequency trading, with the bank asserting ominously “there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways. ” Computer code to manipulate markets? What’s going on here?

“Dude,” you could almost hear people asking, fatigued and more than a little ticked off, “What happened to our stock market?” Was it no longer what it used to be, a place to simply invest in companies with the idea of holding onto that stock for a while? Were we all naïve to still think like that? Maybe we had all been reduced to easy marks for sharpies with fast computers and math skills far better than our own, like dummies on the boardwalk, sized up and seized by the hucksters.

Do the markets still work? Or have they been hijacked?

Nah. But it can seem that way.