In the Belly of the Beast, or: How I learned to Stop Worrying and Love High-Frequency Trading Algorithms

Things are getting weird(er)

Sure, your money is safe with us...

Sure, your money is safe with us…

As part of my so-called career development plan, I was able to somehow convince my primary employer to sponsor my membership in a local leadership program here in the Greater Kansas City Metroplex.

Part of the curriculum is visiting local businesses of note, and thus recently I found myself in lovely Lenexa, Kansas, preparing to enter one of the single most dangerous places in America: The headquarters of BATS, the electronic stock exchange that allegedly facilitates a great deal of overt and covert fraud perpetrated on you, the honest, hardworking, gun-and-internet-porn-loving American people.

Stay out of Malibu, Lebowski...

Stay out of Malibu, Lebowski…

Beyond the clearly obvious, which is that BATS doesn’t bother to conduct background checks on visitors (or I would never have been allowed in), I noticed a gripping similarity with other spooky places I’ve visited (think Dachau, any midwestern Wal-Mart, etc.) where great evil has occurred/is occurring: The sheer banality of evil. For a stock exchange that regularly has the highest daily trading volume in the world, BATS keeps it real: subdued furniture and finishes throughout, appropriately frumpy/vaguely-hostile receptionist, etc.

Overall, the aesthetic was remarkably similar to what anyone would run across in a mid-size insurance agency in, say, Sheboygan (not to disparage my Wisconsonite friends, I love that place. Go Badgers!) In a way, it’s a reminder that without the fingernail scratches on the walls inside the “showers” or the cast-iron entrance-gate reminder that “Arbeit Macht Frei,” Auschwitz appears to be just another dreary German summer camp.

Anyway, I suppose I should back up a bit. Who/what the Hell is BATS, and why should we care? A fair question…

In a proverbial nutshell, BATS is an electronic stock exchange, one created to replace the “classic” version of a stock exchange, which in the 20th-century collective consciousness is usually pictured as a bunch of angry white dudes in colored jackets screaming prices at each other on a trading “floor.” If you take nothing else from this post, take this: That image and the world it represents is gone. History. Doesn’t exist anymore. Stocks are now traded electronically, utilizing extremely fast computer networks. In addition to many other changes in the equity-trading world, these computer networks and the entities that deploy them are engaged in a hugely complex and opaque struggle to produce obscene profits, through a variety of legal and no-so-legal means.

One of the strategies for creating profit is called High-Frequency Trading (HFT), and it’s pretty much what it sounds like: Using computers to make kajillions of stock trades, in some cases buying and selling millions of shares within microseconds. HFTs hire lots of very smart computer programmers to create HFT algorithms. These algorithms can evaluate an enormous array of input information, on which they then make trading decisions. Everything from market news to weather patterns to trending Twitter hashtags can (and are) used as input for the HFT algos.

In some fashion, this is remotely similar to the way equities have always traded, even when us slow humans made the trading decisions. For example, I see that Google has missed their quarterly earnings projection, and I become concerned that perhaps Google’s revenue and earnings growth in the future is in jeopardy, and I decide to place a “sell” order on my Google stock. Nothin’ wrong with that (unless I had inside info. on the earnings before they were publicly released, and I acted on it in order to benefit financially. That’s called insider-trading, and ask Martha Stewart how that can turn out.)

But the HFT algos go way, way farther than that quaint example. As detailed in Michael Lewis’ excellent new book Flash Boys: A Wall Street Revolt*, The HFT programmers and traders have figured out a plethora of ways to garner information about stocks BEFORE that knowledge is publicly available, thus allowing them to use their blinding speed to execute stock transactions and profit from the information advantage that they have over not only other investors, BUT THEIR OWN CUSTOMERS.  BATS was specifically designed from the ground up as a platform for HFT traders to employ these strategies.

“But wait,” you say; “Isn’t that basically front-running?”:

Front running (noun): The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients have been given the information.

Well, sure. But if there’s one thing that the last ten years of economic history have proven, it’s that ethics and the law are no match for human greed. Besides, this stuff is super-duper complex, and involves a lot of math and computer code, and it’s not like it’s something TRULY criminal and scary, like, you know, a brown person wearing a hoody and acting suspicous.

So it continues to happen, nobody is charged with a crime or goes to jail, the SEC and other regulatory entities don’t really do anything about it, and we all just accept the mafia tax on our investments that involve equities, to the tune of billions of dollars per year. It’s not like any of us earned and need that money or anything…

All of This is Very Interesting, But What Does it Have to do With Your Visit to BATS?

Well, it just so happened that in addition to our tour of BATS headquarters, we were supposed to have a meeting with Joe Ratterman, BATS CEO and until recently, President and Board Chairperson. After our facility tour, and prior to our scheduled meeting with Mr. Ratterman, our group of fifteen watched a short PR video on BATS and engaged in a brief Q&A with BATS CFO Brian Schell.

I think Mr. Schell thought it was going to be a ‘grip and grin,’ softball-type interaction. Luckily, one other person in our group besides myself had read Flash Boys and understood what BATS was up to, and he began to politely, but firmly, question the CFO about BATS and their role in facilitating HFT front-running. Schell acted stunned that anyone would dare to ask that type of question, and proceeded to enter into a long, confusing narrative that essentially asserted that:

  1. This stuff is really complex, Man. Lotta ins, lotta outs, lotta what-have-yous, Maude.
  2. Michael Lewis doesn’t know what he’s talking about, and he made shit up for the sake of a better narrative for his book.
  3. Anyway, the SEC is totally on the case in regards to any potential fraud in HFT trading.

Okay, up to this point, it’s just typical corporate weaseldom. Dude makes a boatload of dough for lying to himself and the public, and that’s that. This is not a moral hazard unique to the officers of BATS, that’s for sure. But here’s where it gets much more interesting…

After that third non-answer, I ask CFO Schell a follow-up question: “So you’re saying the SEC now has a full audit trail capability, even into trades that are conducted on dark pools?” The moment I finished the question, I saw our PR handler, who had greeted us and conducted the office tour, quickly rise from the back of the conference room and exit a side door into a main corridor. Hmmm.

Mr. Schell continued to try and use dry-erase markers on a whiteboard to show that BATS was shocked, shocked I tell you, that there could be any HFT front-running facilitated by his stock exchange. A few minutes later, the PR staffer returned to the room and announced that our time was up, and that unfortunately, CEO Ratterman had been called away to an urgent meeting and couldn’t meet with us after all. They then shuffled us out a side door, collected our visitor badges, and sent us on our way.

I want to be clear that I have no proof that Ratterman decided to bag out on our meeting because he didn’t want to answer any non-softball questions. However, the circumstances were interesting, to say the least. Couple our abrupt itinierary change with the fact that I took this photo of Ratterman’s office door during our tour, and draw your own conclusions:

Image

I know I did.

Note: For those interested in learning more about the material detailed in Flash Boys, and delving into the sordid underbelly of the financial world, I suggest the quasi-anonymous website www.zerohedge.com
Additional Note: For a good review of Flash Boys and some additional analysis, see my fellow blogger Thoughts of a Raving Geek at: https://wordpress.com/read/post/id/20156723/303/

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