Last night, after all the March Madness college basketball games were finished, CBS ran a 60 Minutes piece profiling Michael Lewis’ new book – Flash Boys.
Lewis’ new book centres on the problems associated with High Frequency Trading (HFT). The hero of the book is an unlikely fellow that worked at my old firm – RBC. Although he started after I left, Brad Katsuyama worked with many of my old colleagues. Most of what Brad and Michael Lewis highlighted is not new to me, but it was shocking to learn how much in the dark even the larger hedge funds and money managers were in terms of the abuses of HFT.
I have long held the belief that HFT was just glorified front running. Although many HFT firms tried to make it sound more glamorous by calling it “stat arb” or by talking about all of their genius “algorithms”, I always thought that this was all misdirection.
Over my years at RBC, and on our own, we have engaged in many types of automated electronic arbitrage. We have seen the market place change and become increasingly automated. At one point during the mid 2000s, we had direct lines to the exchanges in an attempt to eliminate being picked off by the ever aggressive HFT traders. However it was definitely an arms race that was very difficult for smaller players like ourselves to compete and we eventually just gave up with the direct lines, focusing instead on different areas of opportunities.
Although I am by no means an expert, I am in a position to understand the dynamics of HFT better than most.
In the mid to late 2000s, as I examined the business, I became more and more convinced that the bulk of the money earned by these HFT traders was simply earned by front running electronic orders.
Today, as many market participants begin to understand the HFT narrative, this conclusion is now being accepted, but for a long time, the fancy buzz words and claims of “superior algorithms” from the HFT firms kept clients confused enough not to question where all that alpha was coming from.
Just in case you doubt this conclusion, have a look at the Daily P&L distribution for HFT firm Virtu Financial:
Over the course of the last four years, they only had one losing day! This is not the P&L distribution of a risk taking trading firm – this is the P&L of a front running racket!
Now, before you think that I am buying this whole Michael Lewis narrative hook line and sinker, let’s talk about some things that Michael has conveniently left out.
Firstly, although the HFT guys are indeed front running, there is also another strategy of trading against a resting bid/offer that most likely is profitable and also requires speed. In this strategy, if there is a resting order to buy 5,000 shares at 12.04, the HFT guys buy 12.05s (or even 12.04s on another exchange), hoping to either re-sell them higher, or if the market turns, sell them out against the 12.04 resting bid. This is no where near as riskless as front running, but it does require HFT technology. This strategy in itself does not harm the marketplace and should be part of the game.
Secondly, Michael talks about how much money the HFT guys are siphoning off the end investors, but he forgets about the previous system of NYSE specialists. If you think that HFT front running for a penny is a big deal, try getting your face completely ripped off by some shark that has had the IBM specialist post handed down over three generations. These “specialists” were masters at knowing (and using) every trick in the book. I used to joke that I wanted my daughter to marry a neuro surgeon or even better – a NYSE specialist. As bad as the current HFT environment is – it used to be way worse.
Thirdly, the success of RBC in combatting the HFT traders is in itself a sign that the system will correct itself. I think that the system would be better off (and would reach this equilibrium faster) if the government would regulate the exchanges to eliminate the speed advantages, but left to its own devices, this advantage would eventually be arbitraged away.
However, this is not what I think will happen. Although I deeply respect my American friends, I am continually amazed at their ability to run from one side of the boat to the other, spending very little time in the middle. At one moment they are showering particular business leaders as heroes, and then the next day they are hauling them in front of congress as bums.
My suspicion is that now that HFT has made it into the public eye as problem, the authorities will aggressively attack it. I just hope that cooler heads prevail and they realize that on the whole, the system has been getting better. Yes, there are a lot of things that could be improved, but the direction is headed the right way. Don’t reverse course – a slight re-alignment is all that is required.
Recently HFT firm Virtu Financial filed in preparation to go public. My guess is that they will never float their company, and that they will be lucky to simply continue their business. Their greed at not only being obscenely profitable, but at also trying to monetize future revenue will prove to be the top in the HFT story.
Things that I am worrying about
Canadian dollar short
I am short CAD as I expect the US economy to outperform Canada’s in the coming year. I expect the Fed to be increasingly hawkish and at the margin for the Bank of Canada to stay neutral. The interest rate differential will increasingly favour the American dollar.
We have seen this scenario play out in the spread between the later year USD Eurodollar contracts versus the Canadian Banker acceptance contracts:
ED Jun 2016 (white line) vs BAX Jun 2016 (yellow line)</a> </div>
This should at the margin keep the Loonie “on offer.”
Although I feel very comfortable about my long BAX versus short USD Eurodollar contracts, I have a nagging worry about my short CAD trade.
When it broke above the 1.12 and held for a day, I added to the trade.
USDCAD rate- higher is a weaker Loonie</a> </div></p>
However, during the past week the CAD has been fairly strong.
Part of this might be due to the fact that Karl Peledeau’s entrance into the Quebec political arena has hurt the Parti Quebecois. His staunchly pro-sovereignest comments have backfired as the Quebec public seem to have less of a desire for another referendum as the PQ hoped. Over the last couple of weeks, the support for the PQ has dipped:
But I am worried that there is more going on than simply a little readjustment from a Quebec poll.
I continue to stick to my thesis that the American economy will outperform Canada’s, but I think that the CAD might already reflect this reality. It might be fully baked in.
As you know, I hate trades that are popular with the hedge funds. No, I take that back. I detest trades that are popular with hedge funds.
I don’t hold this belief for any philosophical reason. I have learned over the years that when they exit a position, the doorway is extremely narrow. Therefore if you are caught offside with them, it ends up costing way more than it should. Therefore on the whole, I find it better to steer clear of trades that they all have on.
Over the past year the CAD short has been extremely popular with the hedge funds. Have a look at the CME Short Speculative Short interest over the past few years:
CAD speculative short interest</a> </div></p>
The amount of speculative shorts is still hovering quite near the highs.
It seems like they all have the trade on. I have even heard one hedge fund type describe the short CAD trade as a “career making” type trade.
When they go to cover, it is not going to be pretty.
Given that the Australian dollar seems to be trading better, that copper has stopped going down and that the pessimism regarding commodity countries is running pretty thick, I am going to take this opportunity to simply exit my short CAD before the rush really starts. I am going to stick to my long BAX short Eurodollar as the preferred way to express this view.
I might be wrong, but I would rather be wrong all alone than with a bunch of hedge funds.