High-speed 'cowboys' trade pennies into $7 billion
A cowboy-hat-wearing robot with "Sell" emblazoned across its chest adorns a mural at RGM Advisors in Austin, Texas. Another robot, with Buy on it, wobbles toward a green Wall Street sign as two machines tote spark-emitting high-speed cables.
"We explained to a local artist that we wanted a mural that represented our business, and he came up with the design," RGM Chief Executive Officer Richard Gorelick says in a 16th-floor office that calls to mind a Scandinavian design firm rather than a company that trades hundreds of millions of shares a day.
As a cue to RGM's 120 employees that their job is to eke out a fraction of a cent profit on each of those trades, five stone urns in the lobby are stuffed with pennies. "It's a lot easier for us to teach really smart scientists about markets and trading than to teach traders about programming," Gorelick, 39, says.
High-frequency firms such as Gorelick's are the rebellious new force in securities markets. Armed with algorithms and computers that shave milliseconds off the speed of a trade, programmers, math whizzes and even some former dot-commers such as Gorelick have set up shop from Austin to Chicago to Red Bank, N.J.
These firms don't analyze a company's value or bet on financial news. They use computers to scour public and private markets for deviations from historical prices and leap on discrepancies, rather than betting on the value of a company, currency or commodity.
"Speed is now the defining characteristic of the market," says Adam Sussman, director of research at Tabb Group, who has studied the role of high-frequency firms in financial markets.
Fast-paced trading played a part in the 10-minute stock market crash on May 6. Regulators said an unidentified firm, which two people with knowledge of the findings say is mutual fund company Waddell & Reed Financial Inc., set off the plunge by selling 75,000 contracts on the Standard & Poor's 500 Index known as E-mini futures, according to an Oct. 1 report by the Securities and Exchange Commission and Commodity Futures Trading Commission. The automated sales of the contracts, valued at about $4.1 billion, sparked a burst of trading among high-frequency firms, the report said.
Some high-frequency companies set themselves up as market makers, offering prices to buy and sell shares. Others exist specifically to profit from mismatches among stocks.
Nanex says some activities are underhanded. Researchers at the Winnetka, Ill., data firm have found instances in which thousands of quotes a second in a particular stock are fired and canceled immediately, overwhelming trading systems.
This process has added the term "quote stuffing" to the lexicon. "High-frequency traders are not interested in the fundamental worth of a company," says George Feiger, CEO of Contango Capital Advisors Inc., a San Francisco money management firm. "They are only interested in making a quick killing and moving on."
Regulators are fumbling with how to rein in the HFT crowd. The SEC is looking into establishing and then enforcing a minimum time period, such as 50 milliseconds, that a quote to buy or sell a stock would have to remain valid, according to firms who have met with the SEC. Such a move could limit cancellations. The SEC is considering whether to require HFT firms to remain in a market during tough times to maintain a supply of stock. Such changes assume enforcers are as agile as high-frequency firms.
"Technological advances have outstripped our ability to regulate them," says Andrew Lo, director of MIT's Laboratory for Financial Engineering and chief scientific officer of hedge fund AlphaSimplex Group. "It's like the Wild Wild West."
The burgeoning HFT industry has spawned legions of techies who arm their machines to outwit rivals. Programmers write formulas to sniff out the buy-and-sell intentions of mutual funds and jump in ahead of them in a practice called gaming. Institutional investors use strategies such as iceberging: breaking a single large order into chunks, and leaving a tiny order, or the tip, visible. The gamers, called sharks, unleash small buy-and-sell orders to uncover the hidden ones.
In a run-up to the May 6 crash, some high-frequency traders submitted and then canceled tens of thousands of buy and sell orders a second, overloading trading systems, Nanex founder Eric Scott Hunsader says.
The SEC hasn't accused any firm of quote stuffing. The practice hasn't gone away. On an average day, 15 to 20 stocks get more than 5,000 quotes a second that never turn into a trade, Hunsader says. "If the number of quote-stuffing incidences continues, one or more systems will get saturated," he says. and markets.
Proponents of high-frequency trading — and the companies themselves — say they lubricate the gears of capitalism, making markets more efficient and slashing trading costs.
"The equity market has created an intense and healthy competition in providing liquidity," says Liam Connell, CEO of Allston Trading, a Chicago high-frequency firm that deals in options, futures contracts and foreign exchange. "We're ripping each other's throats for fractions of a penny."
They deny quote stuffing. In fact, most HFT firms say they slowed trading — or shut down altogether — as May 6 unfolded because they were unsure of whether the quotes they were seeing were accurate. Now, some are balking at any requirement that would force them to remain in the market during such times.
High-frequency traders didn't have their HFT acronym when Gorelick started RGM in 2001 with Robbie Robinette and Mark Melton, the R and M of the firm.
Gorelick, who has a law degree from Georgetown University in Washington, D.C., had been general counsel and later chief strategy officer for message board search and shopping-comparison website Deja.com Inc. After the technology bubble burst in 2000, Deja.com shelved its IPO plans and sold its shopping service to EBay Inc. and its newsgroup search archives to Google Inc.
"Not one of us was a trader," Gorelick says. He met Robinette, a software developer, at Deja.com; Melton, who specialized in data mining and pattern recognition, was Robinette's cycling buddy.
The three started a company to apply mathematical models to detect trading patterns. "We liked a business where solving difficult technical problems led very directly to business success," Gorelick says.
Supporters and opponents agree high-frequency trading is here to stay. "You can't put the genie back in the lamp," says Tim Sargent, CEO of Quantitative Services Group, which analyzes trading costs.
The trick for regulators will be to weave some magic of their own to keep financial markets humming without letting fast computers bent on quick profits get the upper hand.
