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:

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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/

Time to Decide Whether to Take the Red Pill or the Blue Pill…

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Readers of this blog will know our inherent distrust of the high-frequency trading ecosystem that has become prevalent in the global financial markets.

Now there is solid research that indicates that the HFT bots are engaging in predatory behavior that mimics an out-of-balance predator/prey natural ecosystem, and humans are unable to control or even understand most of the algorithm behavior. Good times. Thanks for deregulating the markets, SEC and CFTC!!! Look at what thou hath wrought:

http://io9.com/a-new-digital-world-is-emerging-thats-too-fast-for-us-1286428447

I, For One, Welcome Our New Robot Overlords. Or Not…

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So today we have two items tangentially related to All Things Auditing, but they’re interesting and potentially extremely important to larger society as well, so here goes…

Ever heard of Apache Hadoop? Me neither, until last week’s completely unsurprising revelations that the NSA knows my Amazon.com wishlist and that I like to watch cat videos on YouTube. At any rate, Andrew Leonard over at Salon has written a revealing and somewhat terrifying piece detailing the prevalence of this open-source software ecosystem and the potential implications for those of us who are affected by big data. In other words, everyone:

Netflix, Facebook – and the NSA: They’re All in it Together

The other noteworthy item this week is an ongoing media brou-ha-ha centering around our machine friends, specifically the High Frequency Trading Platforms that are now used to buy and sell the majority of equities in the global financial markets.

I gotta say, when even notorious corporate shills CNBC has reservations about you, you just MIGHT be evil (see above link). This week’s controversy centers around the fact that many market research organizations are now selling their data to the HFTs ahead of their release to other paying customers/the general public. And when I say ahead, I mean often only a second or two ahead of everyone else.

Why is this a big deal, you ask? Well, because the HFTs consist of enormous arrays of concentrated computing power that are programmed to analyze enormous amounts of data input and make trading decisions on that information in time increments that are measured in picoseconds. Therefore, a two second jump on the rest of us is more than enough time to front-run us mere mortals and place massive, market-moving orders on either side of any given entity (from http://www.seekingalpha.com):

How Two Seconds Can Be Worth Millions –  The WSJ shines a light on the high-speed traders who receive access to various non-government economic reports two seconds before everybody else, allowing them to make tens of millions of dollars through algorithmic trading. When a recent University of Michigan consumer report came in below expectations, for example, various firms bet nearly 7M shares that stocks would decline, which they did. And it’s all perfectly legal.

On one hand, the owners of the various HFTs (investment banks, hedge funds, this guy, this other guy, etc.) argue that sure, they gain an advantage from the early access to economic data, but they pay a private company for it, no harm, no foul.

I see their point, but there are a couple of issues here that trouble me: First, as an average-joe investor, it seems to me that no matter what, I’m going to be front-run by the machines no matter how quickly I make a move in the equity markets. Then again, how is that any different than things have always been? As George Carlin said, to paraphrase, “It’s a big club, and you ain’t in it.”

The other thing that bothers me about the HFTs is that, as an auditor, how can I even come close to effectively auditing these behemoths? I’m glad I don’t work for the SEC, because I might end up becoming so disillusioned and frustrated that I give up and just do this all day. Is anyone really surprised that a hedge fund or Wall St. investment bank is able to invent and deploy a money-making apparatus that is fundamentally opaque and appears to be impossible to effectively regulate or oversee?

On that happy note, have a fun weekend!

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