High-frequency traders can’t front-run anyone

I am not a high frequency trader. But I have been involved in the capital markets for almost 20 years and I've specialized in algorithmic trading, so I know about HFT and there are a few things in the recent debate that warrant clarifying — first and foremost, this idea of front-running.

Some allege that HFTs front-run other players' orders because HFTs have access to direct feeds from various exchanges, while "regular" investors generally rely on the SIP-provided national best bid-offer (NBBO), which aggregates all the various exchanges' order books, but which also arrives with considerable latency (due not to conspiracy, but to outdated technology). As a recent University of Michigan report claims, "[b]y anticipating future NBBO, an HFT algorithm can capitalize on cross-market disparities before they are reflected in the public price quote, in effect jumping ahead of incoming orders[...]". This is blatantly false.

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What's actually happening behind the scenes may be frustratingly complicated, but it's not immoral, unethical, harmful or illegal. Nor does it cost the non-HFT anything. HFTs generally use direct connections to exchanges in order to post bids and offers and collect market data, rather than relying on the centralized SIP feed. This is because the SIP feed is unacceptably slow. Surely we cannot expect market makers to make markets without actually knowing what the current market is. When an order is placed, it takes some time to be reflected in the NBBO. But that order is already in the market before the HFT can see it, even on the direct feed, by definition. HFTs never know what a customer's order is before it's in the market. HFTs have no customers.

HFTs cannot front-run anyone.

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HFTs can, by virtue of having invested in superior infrastructure, react faster to the information embedded in a new order, but let us not confuse speed with front-running. This information is public and available to anyone willing to overcome the challenges of acquiring and processing it very quickly. If there were no computers trading, it is easy to imagine that some human traders would be able to get and process information more quickly than others. In fact, we don't have to imagine. We can simply recall. Decades ago, by being physically closer to the action (co-location, anyone?) was a major advantage for those who invested in it.

Even simpler: what of the difference simply between paying for a conventional real-time data feed and using freely available market data from the Internet with its standard 20-minute delay? Can the real-time data subscriber front-run the delayed data user? Obviously not. We correctly attribute the speed advantage of the real-time data subscriber to his investment in the data stream. But even with a difference in speed of 20 minutes, not 20 microseconds, we understand that the advantage is in reaction time. In this way, speed always has been and will always be an advantage.

In the mid-1800s, Paul Reuter created a network of carrier pigeons to more quickly disseminate news. His biggest customers? Financial firms, who predictably abandoned pigeons with the advent of the direct telegraph. Just so today, except that the value of speed has diminished over time, and with it, the advantage of being fastest.

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Thus, much of the confusion around HFTs derives from a complicated market structure that makes perfectly legitimate behavior seem predatory to the uninitiated. Most of the rest is attributable to a problem of convoluting the types of players involved in our complex market ecosystem and misunderstanding how they interact.

Retail investors have accounts at brokerage firms. Brokerage firms generally get their customers' orders executed by sending them to market makers known as order flow internalizers (e.g., Knight Trading). The internalizers usually pay the brokers for this"order flow." Brokers do this for a variety of reasons, which mostly boil down to lower operating costs and higher profit margins. Note that sophisticated brokers (e.g., Goldman Sachs) build internalization capabilities for themselves — it is profitable enough to warrant the investment.

The internalizer, having acquired inventory from the retail customer, now turns to the exchanges to unload this inventory. Internalizers needn't be particularly fast in providing liquidity: they have plenty of time to deal with customer orders. Internalizers care about being fast only when they are trying to unload those positions to HFTs and other market participants on the exchanges. Thus, the orders that are done on the exchanges, where HFTs trade, are almost entirely devoid of any retail participation. Traders who face off with HFTs, then, are neither moms nor pops. They're professional traders working for Wall Street, in all likelihood.

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I do not believe that the U.S. equity market is perfect. But it's the most cost-effective equity market in the world for a retail or institutional investor, and it's a better market today than it's ever been before.The kinds of improvements that need to be implemented are mostly incremental: making the NBBO real-time, enforcing rigorously against any unfair advantage given to any participant, getting rid of the ban on zero-spread (i.e., locked) markets. These changes will improve transparency and reduce complexity.

Internalization of order flow, and other off-exchange transactions (such as those done in dark pools) also warrant close inspection. There are legitimate and interesting concerns about conflicts of interest, free rider problems and market integrity that need addressing. But these issues have nothing to do with HFT. So, even as we strive for improvements, we should try to understand that we have never in our history seen a more level playing field in any equity market.

And tell me this: Why are we OK with the myriad advantages Warren Buffett enjoys over every retail investor (and most professionals)? Is this not evidence of a two-tiered system, not at a microsecond timescale, but on a much grander and more impactful one?

Rishi K Narang is the founding principal of T2AM LLC, a hedge-fund advisory firm located in Los Angeles. He was also co-founder, with his brother, Manoj Narang, of the high-frequency trading firm Tradeworx. He is the author of "Inside the Black Box: A Simple Guide to Quantitative and High Frequency Trading." Follow him on Twitter at @rishiknarang.