Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Is Fed Making Life Tougher for High-Speed Traders?

The Federal Reserve's aggressive easing policies have had plenty of critics, but now there could be a new enemy — Wall Street's high frequency traders.

In an attention-getting post, the Tabb Group's Paul Rowady suggests that the central bank's money creation is disrupting the financial markets and in particular HFT platforms that try to stay ahead of the various factors that influence asset prices.

Rowady argues that the Fed's interventions are rendering trend analysis used to construct trading algorithms useless, and in turn driving volume from the markets.

"As a result of this exodus, the machinations of central banks are becoming a proportionately greater force in capital markets," Rowady wrote on the Tabb Forum, which is an invitation-only idea exchange for traders to discuss technology and other issues in the markets.

High-frequency traders use computer programs based on mathematical algorithms to trade at rapid speed, capitalizing often on tiny moves in stock prices. The industry itself has received widespread blame for market instability. A report in Wednesday's Wall Street Journal, for instance, questions whether exchanges give some HFTs preferential treatment in placing orders.

As for the Fed, its latest foray into the financial markets came Thursday when it announced a third and likely perpetual round of quantitative easing in which it will buy $40 billion of mortgage-backed securitieseach month.

The effort both will aim to drive down mortgage rates and be tied to the unemployment rate. The Fed anticipates the open-ended easing will create housing wealth that will in turn drive people to spend more money, revitalize the economy and encourage hiring.

That, at least, is the Fed's hope.

As for its actual effect on the markets, Rowady contends that the suspense that the Fed's will-they-or-won't-they approach creates is disruptive and makes conditions more difficult for traders.

At the crux of his argument is the point that algorithms rely on patterns of behavior, but those patterns are distorted by the Fed's unpredictable and unprecedented interventions.

The critical passage in Rowady's essay:

"Consider that algorithmic trading is little more than pattern recognition. Patterns are simply manifestations of consistent behaviors. The behaviors of market actors left behind in the data – like so many clues – represent the patterns that automated methods are designed to home in on."

"Converting theoretical, yet (hopefully) persistent, patterns (or 'theoretical alpha') into harvested or actual alpha is the name of the game."

But he contends that the only thing HFTs can count on from the Fed is that it won't "allow markets to fall very far or very fast" and does not act in a predictable manner.

"We don’t know how forceful (or desperate) they will behave going forward, nor how coordinated their efforts globally, nor which markets they will seek to influence at any given time, nor when they will stop," he said. "However, one thing’s for sure, the record of their activities is preserved in the data; increasingly, their fingerprints are on more and more of the data."

Finally, Rowady offers a warning: "Going forward, keen awareness of changing demographics, methods of strategy deployment, and cross-market forces are among the skill requirements for ongoing success with automated methods. And, above all, never forget that the Fed uses algos too."

As for how much traction Rowady's argument has, the first obstacle is that HFTs, with their checkered history through Flash Crashes and the recent Knight Capitalfiasco, generate little sympathy from most quarters.

Even in the industry, there were doubts about his position.

One HFT veteran who read Rowady's post dismissed it as it "a rant" while others debated the wisdom of the Fed's moves but weren't sure how much they directly affected the industry.

"The market is not a closed system; outside influences change the market in ways that cannot be predicted solely by the preceding market data," one Tabb poster said. "From natural disasters, to discovery and depletion of natural resources, to political changes and technology innovations, many types of external events influence the markets. Why should central bank intervention be singled out?"

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