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Weekend Reading Re: Knight Capital and HFT

Posted by Larry Doyle on August 4, 2012 7:09 AM |

Investors are constantly confronting the question whether it is safe to go in the water, that is, to commit capital and make an investment.

With so much concern already surrounding the structure of and practices within our equity exchanges, there was serious fuel added to these fires with the malfunction and accompanying meltdown at Knight Capital this week.

This story and situation deserve serious attention. To that end, when I want to know what goes on within the equity markets, I immediately go to the most reliable source. Who is that? Our resident Sense on Cents’ Hall of Famers Joe Saluzzi and Sal Arnuk at Themis Trading. What do these ‘men in the arena’ have to say about the Knight Capital debacle and the structure of the equity markets overall?  

First off we need to state that we are saddened, and we take no pleasure in seeing events like yesterday’s unfold. Thousands of really good people at Knight, NYSE, NASDAQ, Goldman, and countless other industry firms – including ours, have been/are/will be adversely harmed by these continued market structure and trading glitches that demonstrate a broken market.

All of us within the industry and outside of it are harmed. A black eye on NASDAQ or BATS or Knight is a black eye for all of us. We all prosper when investors are confident and eagerly participating in the investment function, and we are hurt by the inverse. Technological glitches will always be a certainty, but a structure that can handle them better is what is desperately needed and what we all strive for.

Read the entire story of how Thomas Goes Off the Rails.

Additionally, what do Joe and Sal and others believe must occur to address a real shortcoming within the structure of the equity exchanges?

Under the leadership of Chairman Arthur Levitt, the SEC implemented the Order Handling Rules, Reg ATS, eliminated Rule 390, implemented decimalization and allowed the stock exchanges to demutualize.  After Mr. Levitt left office in 2001, the SEC continued their push with more regulations.

In February 2004, they proposed Reg NMS that was fully implemented in 2007.  After a decade long push of new regulations, we have ended up with a fragmented web of market centers held together by a very weak structure.  This weakness was very apparent when the Knight software bug ripped through the market for 45 minutes.

For his part, Mr. Levitt, now an advisor to Goldman Sachs and GETCO, shockingly owned up yesterday on Bloomberg radio when he said:

 The irony of all this is that the change in order handling rules that were instituted under my watch at the commission has resulted in the proliferation of markets, technologies and automation that brought about the flash crash and yesterdays events.  I think public confidence is severely shaken by things of this kind.”

You read that right.  Mr. Levitt said that the rules he helped implement have created the current market structure which brought about the flash crash and the Knight algo issue.

So, what do we do now?  We have one simple suggestion that we think can fix many of the current problems in today’s market structure and it won’t require Congressional approval:

Eliminate the maker/taker model

The maker/taker model is the system in which brokers route orders not necessarily to the equity exchanges showing the best prices but to exchanges which might pay the broker the largest rebate (payments for order flow). This practice is rife with conflicts of interest.

Read all of what Joe and Sal have to say on this topic in Dear SEC, It’s Time to Abolish the Maker Taker Model.

If you are sufficiently intrigued by the highly questionable practices ongoing within our equity exchanges, there is one more must read commentary. Thanks to the widely read Zero Hedge for providing a link to a fascinating insider’s look to the world of high frequency trading.

While the attached interview between the Casey Report and HFT expert Garrett from CalibratedConfidence will not reveal much unknown new to those who have been following the high frequency trading topic ever since ZH made it a mainstream issue in April of 2009, it will serve as a great foundation for all those new to the topic who are looking for an honest, unbiased introduction to what is otherwise a nebulous and complicated matter. We urge everyone who is even remotely interested in market structure, broken markets and the future of trading to read the observations presented below.

Interview with a High-Frequency Trader

That interview is a fascinating read.

After absorbing much of what is presented in these reviews, I think you will concur that our equity exchanges are broken and truly little more than shark-infested waters. Little wonder why equity volumes are down so precipitously over the last few years.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.



  • Peter S.

    In the dog eat dog broker dealer world, is it possible that algorithms are being created not to anticipate market movement, but to anticipate the behavior of a competitor’s algorithm? Absolutely. In just one decade our markets have been hyjacked by gamers turned traders.

    The wicked algorithm neither admitted nor denied the allegation.

  • John B. Egan

    (1) Remove Trading Computers from the Exchanges (2) Disallow ‘Front Running’. No more peeks at the orders before they are processed. No more unfair advantage allowing stop-running (3) If retail traders can only trade pennies, then nobody should be allowed to trade 5 places from the decimal. (4) Algos/Bots should be required to leave their trades in place for a specified period of time. No more dangling the worm and pulling it away before the trade occurs just to run up/down the price. Trades must go through. A bid/ask is a deal. (5) Algos, HFTs, Bots, should all be backed by real money. If retail traders have to wait 3 days to clear, or exist on margin, so should they.

    I could go on, but really it’s simply returning fairness to retail traders. We have handed over our retirements and cash to ‘the machine’, which already has an unfair advantage. Why do we allow them to run rampant through our markets?

  • Navigate accordingly? Given that the entire financial system is rigged, corrupted, gamed, and manipulated, where does that leave us? Bonds? Equities? Money market accounts? Derivatives? Nothing is safe given the decisions that policy makers and central bankers are making. The foxes are guarding the henhouse. What are the hens to do? Is there are parallel universe somewhere that is being run honestly? Diversification is only effective if all those asset classes have real value. What can be trusted?

    • LD


      I concur…and thus we should all ‘navigate accordingly.’

      • Farmland with a water source?

    • Bill

      I think auction rate securities are the investment gold standard for tne individual investor, especially his retirement money.

  • Larry

    What we don’t need, and I think you’ll agree, is another DC dog and pony show, ala Jamie Dimon on the London trade.

    • LD

      I concur. The simple fact is the super highway that is our equity exchanges has no speed limit and thus major accidents will continue to occur.

  • Gamma

    Larry, I am simply speechless right now.

    Except I wonder where that $440MM went . . .

    • LD

      Pretty amazing isn’t it? They have turned the equity exchanges into virtual casinos in which the house has a huge advantage but in this case the systems of the house

      Flash Crash in May 2010, the IPO for the BATS exchange a few months back was a disaster, the Facebook IPO was a disaster, and now this…

      Why would any investor ever want to go in these waters?

      The money lost was on transactions which were executed and Knight Capital lost and the trades were not cancelled. Some trades were cancelled but not all. Some traders likely made a quick and tidy fortune and some investors probably got run over and/or whipsawed.

  • Bill

    I read the interview, and it’s worthwhile. Significantly he counsels against using stop losses. I don’t see how one could stop losses in this environment. I had a stop in on an eft trading around 70 during the famous flash crash and was damned lucky it didn’t execute as the price went to zero. My account is with Fidelity and can only assume they intervened when the chaos commenced. With an outfit like TD Ameritrade I probably would have gotten a TS slip.

  • fred


    As it turns out the SEC had a role in the Wed AM Knight Capital fiasco. The SEC gave the NYSE permission to implement it’s own HFT to undercut business sent off exchange. Knight was put in the position of upgrading its HFT to better the NYSE HFT, the only problem all the bugs weren’t worked out.

    Knight was left with an enormous unhedged long position which it layed off on GS for a fee $400 mil. What did GS do with those longs, maybe the rally on F had more behind it than a manipulated Gov’t employment report.

    All this HFT related volitility has to ensure better pricing for the retail investor right?

    The NYSE is now for profit, why does the SEC believe the exchange still defend the small retail investors interest?

    If the NYSE can undercut it’s own listed prices doesn’t that make those prices inaccurate?

  • fred


    This is speculation on my part, but I’m trying to put the pieces together.

    HFT relies on “pinging”, which is the submission of a bid or an ask, to become the inside position in the order book posted by the exchange. The HFT then acts as market maker by arbitraging the bid and ask of legitimate orders without effectively “taking posession”. No posession no risk.

    The key for a HFT is to remove the “ping” before they trigger trades that require HFT to “take posession” and assume the liability of the position. As the game of pinging “one upsmanship” continues, new software must be developed to compete, each time exposing the markets to “flash crash” risk.

    Never fear Goldman’s here to assume your “flash crash risk”, for a fee of course. But GS will only take on the risk of the position if they can put the market up. 1) What happens if they can’t? 2)When GS put’s the market up or down, don’t investors get bad prices?

    Legitimate orders are required to post in pennies while HFTs can post in fractions of a penney? Doesn’t this give HFT’s an unfair advantage?

    • LD

      Yes, the HFT see the order flow coming into the market given the co-location of their computers literally on the floors of the exchanges. They then read the order flow as it comes in and “front run” these orders prior to filling them at more expensive levels for investors.

      It is a racket.

  • fred


    Correct me if I’m wrong.

    So what’s really going on? When the exchanges became for profit and earnestly pursued cost savings thru full implementation of automation, traditional market makers were forced out of business.

    But, just as with the repeal of Glass Stegall, regulators failed to fully consider the ramifications. Traditional market makers were required by “not for profit” exchanges to make a market and keep the market orderly in times of volitility. They had exclusive access to the bid ask book so, just as in the case of a casino, they were all but assured extreme profitability longer term. It should be noted, that by default they represented the best interest of the “little guy” the majority of the time because to do otherwise would subject them to loss of there most privaledged status at the exchange.

    In the absence of traditional market makers, the dual markets that have emerged (w/o traditional market makers) are dominated by high frequency trading and dark pool trading. Simply put, HFTs seek to exploit the bid ask spread at the extremes, whereas dark pools (utilized by institutions), seek to exploit the bid ask spread at the mean. In both instances the party on the other side of the trade is the small investor.

    One of the primary reason exchange traded volume continues to decline is the emergence and growth of dark pools as the primary trading arena of institutions.

    Make no mistake, the big loser in both trading arenas, is the small investor. HFT’s force them into trades opposite their interest at either the bid or the ask and dark pools force them to sell or buy at the mean which is never the best available price because of its variance from both the bid and the ask.

    I think most people have at least a basic understanding of HFTs but dark pools have been flying under the radar. However, I’m certain that if a valid study were to be done, except in the instance of “flash crash” type move, either up or down, the loss to the small investor would be similar in both situations.

    Dark pools are created at places like a “Fidelity” where huge amount of trades are entered by small investors, but rather than going to an exchange for a fill Fidelity attempts to match orders internally, using Knight Capital type software, at the average of the bid and the ask.

    Frequently, on one side of a dark pool trade are hundreds or thousands of small investors and on the other side a big institution.

    So what’s the problem (or the loss) to the small investor in a dark pool? If the order were transacted on an exchange, the large institutional buy order would bid up the price and the small individual sellers, would more likely get a price closer to the ask price rather than settling for the average (of the bid or ask).

    In either case, as a small investor you are forced to “pick your poison”. Knowledge is power. Now more than ever, where are the regulators fighting for and promoting the best interest of the individual investor?

  • Have a look at the way the bots were in action last week during the US Presidential election courtesy of Carl Weiss from sceeto

    High Frequency Trading and these type of algos as a matter of fact are responsible these days for more than 70 to 80% of all the daily US volume. HFTS have been quote stuffing, i.e placing massive buy sell orders within milliseconds for a long time now.

    Sceeto is one of the first small companies anywhere in the world that tracks the hft’s in real time across various markets. Have a look for yourself ,Carl Weiss has done numerous videos on these algos.

    The chief software developer of sceeto he has for a decade tested to come up with software designed a system to sniff these out and try to at least agin level the playing field a bit for the ordinary investor.

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