[ExI] Fwd: The New Speed of Money, Reshaping Markets

Keith Henson hkeithhenson at gmail.com
Sun May 1 14:06:33 UTC 2011


Closely related to the recent threads here:

"One debate has focused on whether some traders are firing off fake
orders thousands of times a second to slow down exchanges and mislead
others. Michael Durbin, who helped build high-frequency trading
systems for companies like Citadel and is the author of the book “All
About High-Frequency Trading,” says that most of the industry is
legitimate and benefits investors. But, he says, the rules need to be
strengthened to curb some disturbing practices.

“Markets are there for capital formation and long-term investment, not
for gaming,” he says.

"As it tries to work out the implications of the technology, the
S.E.C. is a year into a continuing review of the new market
structure."

Keith

http://www.nytimes.com/2011/01/02/business/02speed.html?src=busln
============================================================
January 1, 2011

The New Speed of Money, Reshaping Markets

By GRAHAM BOWLEY

Secaucus, N.J.

A SUBSTANTIAL part of all stock trading in the United States takes
place in a warehouse in a nondescript business park just off the New
Jersey Turnpike.

Few humans are present in this vast technological sanctum, known as
New York Four. Instead, the building, nearly the size of three
football fields, is filled with long avenues of computer servers
illuminated by energy-efficient blue phosphorescent light.

Countless metal cages contain racks of computers that perform all
kinds of trades for Wall Street banks, hedge funds, brokerage firms
and other institutions. And within just one of these cages ­ a tight
space measuring 40 feet by 45 feet and festooned with blue and white
wires ­ is an array of servers that together form the mechanized heart
of one of the top four stock exchanges in the United States.

The exchange is called Direct Edge, hardly a household name. But as
the lights pulse on its servers, you can almost see the holdings in
your 401(k) zip by.

“This,” says Steven Bonanno, the chief technology officer of the
exchange, looking on proudly, “is where everyone does their magic.”

In many of the world’s markets, nearly all stock trading is now
conducted by computers talking to other computers at high speeds. As
the machines have taken over, trading has been migrating from raucous,
populated trading floors like those of the New York Stock Exchange to
dozens of separate, rival electronic exchanges. They rely on data
centers like this one, many in the suburbs of northern New Jersey.

While this “Tron” landscape is dominated by the titans of Wall Street,
it affects nearly everyone who owns shares of stock or mutual funds,
or who has a stake in a pension fund or works for a public company.
For better or for worse, part of your wealth, your livelihood, is
throbbing through these wires.

The advantages of this new technological order are clear. Trading
costs have plummeted, and anyone can buy stocks from anywhere in
seconds with the simple click of a mouse or a tap on a smartphone’s
screen.

But some experts wonder whether the technology is getting dangerously
out of control. Even apart from the huge amounts of energy the
megacomputers consume, and the dangers of putting so much of the
economy’s plumbing in one place, they wonder whether the new world is
a fairer one ­ and whether traders with access to the fastest machines
win at the expense of ordinary investors.

It also seems to be a much more hair-trigger market. The so-called
flash crash in the market last May ­ when stock prices plunged
hundreds of points before recovering ­ showed how unpredictable the
new systems could be. Fear of this volatile, blindingly fast market
may be why ordinary investors have been withdrawing money from
domestic stock mutual funds ­$90 billion worth since May, according to
figures from the Investment Company Institute.

No one knows whether this is a better world, and that includes the
regulators, who are struggling to keep up with the pace of innovation
in the great technological arms race that the stock market has become.

WILLIAM O’BRIEN, a former lawyer for Goldman Sachs, crosses the Hudson
River each day from New York to reach his Jersey City destination ­ a
shiny blue building opposite a Courtyard by Marriott.

Mr. O’Brien, 40, works there as chief executive of Direct Edge, the
young electronic stock exchange that is part of New Jersey’s
burgeoning financial ecosystem. Seven miles away, in Secaucus, is the
New York Four warehouse that houses Direct Edge’s servers. Another
cluster of data centers, serving various companies, is five miles
north, in Weehawken, at the western mouth of the Lincoln Tunnel. And
yet another is planted 20 miles south on the New Jersey Turnpike, at
Exit 12, in Carteret, N.J.

As Mr. O’Brien says, “New Jersey is the new heart of Wall Street.”

Direct Edge’s office demonstrates that it doesn’t take many people to
become a major outfit in today’s electronic market. The firm, whose
motto is “Everybody needs some edge,” has only 90 employees, most of
them on this building’s sixth floor. There are lines of cubicles for
programmers and a small operations room where two men watch a wall of
screens, checking that market-order traffic moves smoothly and, of
course, quickly. Direct Edge receives up to 10,000 orders a second.

Mr. O’Brien’s personal story reflects the recent history of
stock-exchange upheaval. A fit, blue-eyed Wall Street veteran, who
wears the monogram “W O’B” on his purple shirt cuff, Mr. O’Brien is
the son of a seat holder and trader on the floor of the New York Stock
Exchange in the 1970s, when the Big Board was by far the biggest game
around.

But in the 1980s, Nasdaq, a new electronic competitor, challenged that
dominance. And a bigger upheaval came in the late 1990s and early
2000s, after the Securities and Exchange Commission enacted a series
of regulations to foster competition and drive down commission costs
for ordinary investors.

These changes forced the New York Stock Exchange and Nasdaq to post
orders electronically and execute them immediately, at the best price
available in the United States ­ suddenly giving an advantage to
start-up operations that were faster and cheaper. Mr. O’Brien went to
work for one of them, called Brut. The N.Y.S.E. and Nasdaq fought
back, buying up smaller rivals: Nasdaq, for example, acquired Brut.
And to give itself greater firepower, the N.Y.S.E., which had been
member-owned, became a public, for-profit company.

Brokerage firms and traders came to fear that a Nasdaq-N.Y.S.E.
duopoly was asserting itself, one that would charge them heavily for
the right to trade, so they created their own exchanges. One was
Direct Edge, which formally became an exchange six months ago.
Another, the BATS Exchange, is located in another unlikely capital of
stock market trading: Kansas City, Mo.

Direct Edge now trails the N.Y.S.E. and Nasdaq in size; it vies with
BATS for third place. Direct Edge is backed by a powerful roster of
financial players: Goldman Sachs, Knight Capital, Citadel Securities
and the International Securities Exchange, its largest shareholder.
JPMorgan also holds a stake. Direct Edge still occupies the same
building as its original founder, Knight Capital, in Jersey City.

The exchange now accounts for about 10 percent of stock market trading
in the United States, according to the exchange and the TABB Group, a
specialist on the markets. Of the 8.5 billion shares traded daily in
the United States, about 833 million are bought and sold on Mr.
O’Brien’s platforms.

As it has grown, Direct Edge and other new venues have sucked volumes
away from the Big Board and Nasdaq. The N.Y.S.E. accounted for more
than 70 percent of trading in N.Y.S.E.-listed stocks just five years
ago. Now, the Big Board handles only 36 percent of those trades
itself. The remaining market share is divided among about 12 other
public exchanges, several electronic trading platforms and vast
so-called unlit markets, including those known as dark pools.

THE Big Board is embracing the new warp-speed world. Although it
maintains a Wall Street trading floor, even that is mostly electronic.
The exchange also has its own, separate electronic arm, Arca, and
opened a new data center last year for its computers in Mahwah, N.J.

>From his office in New Jersey, Mr. O’Brien looks back across the water
to Manhattan and his former office on the 50th floor of the Nasdaq
building at One Liberty Plaza, and he reflects wistfully on the huge
changes that have taken place.

“To walk out of there to go across the river to Jersey City,” he says.
“That was a big leap of faith.”

His colleague, Bryan Harkins, the exchange’s chief operating officer,
sounds confident about the impact of the past decade’s changes. The
new world is fairer, he says, because it is more competitive. “We
helped break the grip of the New York Stock Exchange,” he says.

In this high-tech stock market, Direct Edge and the other exchanges
are sprinting for advantage. All the exchanges have pushed down their
latencies ­ the fancy word for the less-than-a-blink-of-an-eye that it
takes them to complete a trade. Almost each week, it seems, one
exchange or another claims a new record: Nasdaq, for example, says its
time for an average order “round trip” is 98 microseconds ­ a
mind-numbing speed equal to 98 millionths of a second.

The exchanges have gone warp speed because traders have demanded it.
Even mainstream banks and old-fashioned mutual funds have embraced the
change.

“Broker-dealers, hedge funds, traditional asset managers have been
forced to play keep-up to stay in the game,” Adam Honoré, research
director of the Aite Group, wrote in a recent report.

Even the savings of many long-term mutual fund investors are swept up
in this maelstrom, when fund managers make changes in their holdings.
But the exchanges are catering mostly to a different market breed ­ to
high-frequency traders who have turned speed into a new art form. They
use algorithms to zip in and out of markets, often changing orders and
strategies within seconds. They make a living by being the first to
react to events, dashing past slower investors ­ a category that
includes most investors ­ to take advantage of mispricing between
stocks, for example, or differences in prices quoted across exchanges.

One new strategy is to use powerful computers to speed-read news
reports ­ even Twitter messages ­ automatically, then to let their
machines interpret and trade on them.

By using such techniques, traders may make only the tiniest fraction
of a cent on each trade. But multiplied many times a second over an
entire day, those fractions add up to real money. According to Kevin
McPartland of the TABB Group, high-frequency traders now account for
56 percent of total stock market trading. A measure of their
importance is that rather than charging them commissions, some
exchanges now even pay high-frequency traders to bring orders to their
machines.

High-frequency traders are “the reason for the massive
infrastructure,” Mr. McPartland says. “Everyone realizes you have to
attract the high-speed traders.”

As everyone goes warp speed, a number of high-tech construction
projects are under way.

One such project is a 428,000-square-foot data center in the western
suburbs of Chicago opened by the CME Group, which owns the Chicago
Mercantile Exchange. It houses the exchange’s Globex electronic
futures and options trading platform and space for traders to install
computers next to the exchange’s machines, a practice known as
co-location ­ at a cost of about $25,000 a month per rack of
computers.

The exchange is making its investment because derivatives as well as
stocks are being swept up in the high-frequency revolution. The
Commodity Futures Trading Commission estimates that high-frequency
traders now account for about one-third of all volume on domestic
futures exchanges.

In August, Spread Networks of Ridgeland, Miss., completed an 825-mile
fiber optic network connecting the South Loop of Chicago to Cartaret,
N.J., cutting a swath across central Pennsylvania and reducing the
round-trip trading time between Chicago and New York by three
milliseconds, to 13.33 milliseconds.

Then there are the international projects. Fractions of a second are
regularly being shaved off of the busy Frankfurt-to-London route. And
in October, a company called Hibernia Atlantic announced plans for a
new fiber-optic link beneath the Atlantic from Halifax, Nova Scotia,
to Somerset, England that will be able to send shares from London to
New York and back in 60 milliseconds.

Bjarni Thorvardarson, chief executive of Hibernia Atlantic, says the
link, due to open in 2012, is primarily intended to meet the needs of
high-frequency algorithmic traders and will cost “hundreds of millions
of dollars.”

“People are going over the lake and through the church, whatever it
takes,” he says. “It is very important for these algorithmic traders
to have the most advanced technology.”

The pace of investment, of course, reflects the billions of dollars
that are at stake.

The data center in Weehawken is a modern building that looks more like
a shopping mall than a center for equity trading. But one recent
afternoon, the hammering and drilling of the latest phase of expansion
seemed to conjure up the wealth being dug out of the stock market.

As the basement was being transformed into a fourth floor for yet more
computers, one banker who was touring the complex explained the matter
bluntly: “Speed,” he said, “is money. “

THE “flash crash,” the harrowing plunge in share prices that shook the
stock market during the afternoon of May 6 last year, crystallized the
fears of some in the industry that technology was getting ahead of the
regulators. In their investigation into the plunge, the S.E.C. and
Commodity Futures Trading Commission found that the drop was
precipitated not by a rogue high-frequency firm, but by the sale of a
single $4.1 billion block of E-Mini Standard & Poor’s 500 futures
contracts on the Chicago Mercantile Exchange by a mutual fund company.

The fund company, Waddell & Reed Financial of Overland Park, Kan.,
conducted its sale through a computer algorithm provided by Barclays
Capital, one of the many off-the shelf programs available to investors
these days. The algorithm automatically dripped the billions of
dollars of sell orders into the futures market over 20 minutes,
continuing even as prices started to drop when other traders jumped
in.

The sale may have been a case of inept timing ­ the markets were
already roiled by the debt crisis in Europe. But there was no
purposeful attempt to disrupt the market, the regulators found.

But there was a role played by some high-frequency machines, the
investigation found. As they detected the big sale and the choppy
conditions, some of them shut down automatically. As the number of
buyers plunged, so, too, did the Dow Jones Industrial Average, losing
more than 700 points in minutes before the computers returned and
prices recovered just as quickly. More than 20,000 trades were ruled
invalid.

The episode seemed to demonstrate the vulnerabilities of the new
market, and just what could happen when no humans are in charge to
correct the machines.

Since the flash crash, the S.E.C. and the exchanges have introduced
marketwide circuit breakers on individual stocks to halt trading if a
price falls 10 percent within a five-minute period.

But some analysts fear that some aspects of the flash crash may
portend dangers greater than mere mechanical failure. They say some
wild swings in prices may suggest that a small group of high-frequency
traders could manipulate the market. Since May, there have been
regular mini-flash crashes in individual stocks for which, some say,
there are still no satisfactory explanations. Some experts say these
drops in individual stocks could herald a future cataclysm.

In a speech last month, Bart Chilton, a member of the futures trading
commission, raised concerns about the effect of high-frequency trading
on the markets. “With the advent of ‘ Star Trek’-like, gee-whiz H.F.T.
technology, we are witnessing one of the most game-changing and
tumultuous shifts we have ever seen in financial markets,” Mr. Chilton
said. “We also have to think about the myriad ramifications of
technology.”

One debate has focused on whether some traders are firing off fake
orders thousands of times a second to slow down exchanges and mislead
others. Michael Durbin, who helped build high-frequency trading
systems for companies like Citadel and is the author of the book “All
About High-Frequency Trading,” says that most of the industry is
legitimate and benefits investors. But, he says, the rules need to be
strengthened to curb some disturbing practices.

“Markets are there for capital formation and long-term investment, not
for gaming,” he says.

As it tries to work out the implications of the technology, the S.E.C.
is a year into a continuing review of the new market structure. Mary
L. Schapiro, the S.E.C. chairwoman, has already proposed creating a
consolidated audit trail, so that buying and selling records from
different exchanges can be examined together in one place.

In speeches, Ms. Schapiro has also raised the idea of limiting the
speed at which machines can trade, or requiring high-frequency traders
to stay in markets as buyers or sellers even in volatile conditions.
just as human market makers often did on the floor of the New York
Stock Exchange. .

“The emergence of multiple trading venues that offer investors the
benefits of greater competition also has made our market structure
more complex,” she said in Senate testimony last month, adding, “We
should not attempt to turn the clock back to the days of trading
crowds on exchange floors.”

MOST of the exchanges have already eliminated a controversial
electronic trading technique known as flash orders, which allow
traders’ computers to peek at other investors’ orders a tiny fraction
of a second before they are sent to the wider marketplace. Direct
Edge, however, still offers a version of this service.

The futures trading commission is considering how to regulate data
centers, and the practice of co-location. The regulators are also
examining the implications of so-called dark pools, another product of
the technological revolution, in which large blocks of shares are
traded electronically and without the scrutiny exercised on public
markets. Their very name raises questions about the transparency of
markets. About 30 percent of domestic equities are traded on these and
other “unlit” venues, the S.E.C. says.

For Mr. O’Brien, the benefits of technology are clear. “One thing has
surprised me: people have looked at this as a bad thing,” he says.
“There is almost no other industry where people say we need less
technology. Fifteen years ago, trades took much longer to execute and
were much more expensive by any measure” because market power was more
concentrated in a few large firms. “Now someone can execute a trade
from their mobile from anywhere on the planet. That seems to me like a
market that is fairer.”

For others who work at the company or elsewhere in the financial
ecosystem of New Jersey, it has been a boon.

“A lot of my friends work here or in this area,” says Andrei Girenkov,
28, one of Direct Edge’s chief programmers, over lunch recently in
Dorrian’s restaurant in Direct Edge’s building. “It changed my life.”

But some analysts question whether everyone benefits from this
technological upending.

“It is a technological arms race in financial markets and the
regulators are a bit caught unaware of how quickly the technology has
evolved,” says Andrew Lo, director of the Laboratory for Financial
Engineering at M.I.T. “Sometimes, too much technology without the
ability to manage it effectively can yield some unintended
consequences. We need to ask the hard questions about how much of this
do we really need. It is the Wild, Wild West in trading.”

Mr. Lo suggests a need for a civilizing influence. “Finally,” he says,
“it gets to the point where we have a massive traffic jam and we need
to install traffic lights.”




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