Would You Like To Understand High Frequency Trading?

My friend Pete Kovac got so peeved about Michael Lewis’ Flash Boys that he wrote a response, in the form of a book, called Flash Boys Not So Fast – An Insider’s Perspective On High Frequency Trading.

fight clubThe highly unusual part about this book is that high frequency trading up until now has basically been like Fight Club, in so far as the first rule of high frequency trading is that nobody talks about high frequency trading.

Well, here’s Pete actually talking (ok, writing) about it. He agrees with my objection to Flash Boys, which is that Lewis appears to have not gotten any access to actual real live high frequency traders, in the course of investigating his book. Which is kind of a problem.

Pete’s formal bio is as follows:

Kovac was COO of the electronic market making firm EWT from 2004 to 2011, managing regulatory compliance, risk management, finance, trading operations, and portions of the technology teams. During his tenure, EWT grew to one of the largest market making firms in the U.S., trading hundreds of millions of shares daily, an, together with its affiliates traded in over 50 markets worldwide. Kovac has been a frequent commenter to the SEC on regulatory issues.

And Pete’s informal description of his role:

“I am an industry insider, the kind of person who could have saved Lewis from making some really basic mistakes. I started programming trading strategies in 2003. After years in the trenches, I moved into management and ultimately became chief operating officer of my firm, EWT. I handled regulatory compliance, risk management, finance, trading operations, and a portion of the IT and software development teams – and I had to know every aspect of the stock market inside and out. By 2008, our company was one of the largest automated market-making firms in the U.S., trading hundreds of millions of shares of stock daily, and had expanded into many other asset classes domestically and internationally. I left it all three years ago when EWT was sold to Virtu Financial (in which, in the interest of full disclosure, I still retain a small stake).

Those eight years at EWT provided me with a front row seat to all the events described in Flash Boys, and much more. During that time, I shared my experience and perspective in discussions with regulators and lawmakers here and abroad, advocating for the continued improvement of the markets discussed in the book. Many of my comment letters on these topics are publicly available on the SEC website. Even though I no longer work in trading, I can still get answers from a diverse set of close sources when a truly new question arises.”

So – If that’s intrigued you – you can download the book here.

 

Please see related posts

An Excerpt of a Quant Trader’s Critique of Flash Boys

The Rise of The Machines

The Katsuyama Revolution Continues

Please see related book reviews:

Inside the Black Box, by Rishi Narang

Flash Boys, by Michael Lewis

 

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Excerpt From Critique of Michael Lewis’ Flash Boys

Pete Kovac, a friend who worked for a quantitative trading firm, got in touch with me soon after Michael Lewis’s Flash Boys came out last Spring to let me know he thought the book had serious errors.

My friend became so alarmed at the Michael Lewis version of quant trading – which appears to have been quickly adopted by regulators and politicians – that he set out to write a response and correction to the flawed Lewis narrative.

high frequency trading volume

What’s so interesting about Kovac’s response is that quant traders have generally shunned describing publically how they make money. As a result, they are at a huge disadvantage in telling the quantitative trading version of things when competing with a writer like Lewis. Yet, one of the weaknesses of Lewis’ book is that he appears to have had very little access to quant traders themselves. So how does a quant get his version of the truth out?

Kovac releases his book this week, and I’ve included an excerpt below.

To set up the excerpt – and for those who haven’t read Flash Boys yet – here’s a quick primer.

The premise of Flash Boys (reviewed here) is that a new set of quantitative (or algorithmic) firms emerged in the past decade that engage in an unfair technology race that allows them to front-run other investors. According to Lewis, the quant firms use a combination of:

  1. Paying exchanges for trading order flow to gain information milliseconds before other traders.
  2. Locating trading machines physically closer to central exchanges to get millisecond information advantages over other traders.
  3. Engaging in untraceable trading activity within a broker-sponsored ‘dark pool’ exchange to front-run slower traders.
  4. Sending rapid-fire trade inquiries and cancellations to exchanges or dark pools to manipulate market liquidity.

In addition, Lewis describes a plunky band of misfits led by Brad Katsuyama who cobble together an alternative stock exchange – The IEX – using old newspapers, string, and wadded up chewing gum to launch a better, fairer, slower exchange to keep out the quant trading baddies.

Kovac wrote his critique – excerpted below – to correct what he sees as the biggest errors of Lewis’ book.

 

Excerpt of Kovac’s Flash Boys Critique

 

I’ll link to the full book, available on Amazon, as soon as it gets posted.

 

Please see related book reviews:

Inside the Black Box, by Rishi Narang

 

Flash Boys, by Michael Lewis

Please also see related posts:

The Rise of The Machines

The Katsuyama Revolution Continues

 

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Political Markets: Democrats’ Chances Of Holding The Senate Just Doubled

I generally trust markets when it comes to political forecasting, which is why I dabbled in trading contracts on the Iowa Political Markets in both 2008 and 2012.

iowa political marketsI’d rather trust in people’s actual money-on-the-line to indicate an aggregated belief in who will win an election, rather than your average poll – or worse – a political commentator. Markets are great at collecting and reflecting back prices that reflect expectations of future results. Markets can be wrong, and markets can be irrational, but generally and in the long run they tend to be right.

This is a sort of restatement of the efficient market hypothesis, which you can read more about either from Nate Silver or Burton Malkiel in A Random Walk Down Wall Street.

At the very least, you should know what the markets say about the future before you go leaping in a different direction.

Anyway…I checked back in the Iowa Political Markets Senate race today, and its totally different today – than it has been any time in the last few months.

Conventional wisdom, and the Iowa political markets, had only given Dems a 20% chance or less of holding the Senate after next week’s election.

Suddenly, today, the ‘market’ has jumped to a 40% chance of Democrats retaining the Senate, on the Iowa Political Markets.

The interesting, quirky, thing about the Iowa Political Markets is that they operate on tiny amounts of money in the system – by design – as individuals may only seed their account with a maximum of $500 total. In addition, the markets don’t see much volume much of the time, except in the hottest moments of a Presidential race, which we’re not in now. That has always meant that the Iowa markets could be temporarily manipulated – presumably for political reasons – without a tremendous amount of effort.

And yet…I don’t know.

Nate Silver’s 538.com says that the probability of Republicans taking over the Senate has stayed consistently around 63% for the past month, presumably leaving Dems with a 37% chance of retaining control.

iowa political market senate race
The “DS.hold14” (The price of a “Democrats hold the Senate” contract) price doubled since yesterday

Yet the Iowa market ‘price’ (roughly, the chance of Democrats retaining control) has bounced around well below 20% for the past month. Until today…now it’s at 40%.

Why did the Democrats’ chance of retaining the Senate just double from yesterday to today?

 

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On Retirement, From a Millennial’s Perspective

surfer retirementA thoughtful reader sent me this Time Magazine article, with musings on retirement written by a 24 year old.

The first question the article prompted: Is Time Magazine still around? I had no idea!

Anyway, the next set of questions posed by the article are worth contemplating:

1. Why does a rational 24 year-old decide to put away retirement savings? Stated another way, how can someone like me best convince a 24 year-old of the extraordinary opportunity for wealth-creation by starting to save for retirement now? (I know my answer has something to do with teaching compound interest, my obsessive-compulsive favorite topic.)

2. With the decline in private pensions and (possibly) the future insolvency of Social Security, how much should individuals expect to be responsible for their own retirement?

3. In retirement, should the goal goal be to live with similarly-situated seniors, or rather a mixed up community of all ages and styles? (I know my own preferences at this point, but who knows how I’ll feel later.)

4. Is the point of retirement to do nothing except pursue leisure activities? Or is it possible to find passionate work that one can do, regardless of the compensation? (I know that’s my conclusion in this post.)

An author-acquaintance of mine – age approximately 75 – once told me his thoughts on retirement. “As a writer, how could I ever retire? Who would I even tell? Who would care? I’m just going to keep on writing.” I’m attracted to that type of passion about one’s work.

That never-retire view actually seems to be the conclusion of the 24 year old author, whose solution to the work and retirement questions – so far – is to just write magazines article for the next 60 years and never quit.

Which is kind of hilarious, since a 24 year old should know that magazines probably only will be around for another 2 or 3 years. But what do I know? I could be wrong. I had no idea Time Magazine still existed.

retirement21

Please see related posts:

What is Wealthy?

On Entrepreneurship Part III: The Taxes, The Air, The Retirement

 

 

 

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Rebalancing, Explained

Editor’s Note: A version of this post appeared today in the San Antonio Express News:

BalancingA former student at Trinity sent me a Facebook message recently. He linked to an advertisement message for an investment advisory company that emphasized the importance of ‘rebalancing’ one’s investment portfolio every quarter or every year.

I realized I had not taught that principal at Trinity in our personal finance course last Spring. When the link came in on Facebook with the simple query from my student: “What is rebalancing?” I thought “Uh-oh, I missed that one.”

To make it up to that student, as well as to anyone else who might have the same question, here’s the quick explanation of rebalancing.

Rebalancing is one of those investment things you should do regularly, like brushing your teeth (only less frequently) or going to your college reunion (only more frequently). Once a year rebalancing is fine.
The point of rebalancing is to avoid two big No-Nos of investing:
1. Overexposure to one particular type of risk; and
2. The “Buy-high, Sell-low” investment behavior that everybody unwittingly does.
I’ll illustrate the simplest form of rebalancing with an example, assuming you have just two types of investments in your portfolio: a stock mutual fund and a bond mutual fund.
Let’s say you and your investment advisor agreed that you needed the 60/40 allocation to stocks and bonds that 98.75 percent of all investment advisors inevitably urge on their clients.
[Quick aside: I totally disagree with this allocation, and I’m not an investment advisor, so for both reasons please don’t think I’m recommending this for you. In fact I wouldn’t recommend it for the vast majority of people, but that’s a whole other column – or series of columns to come – in the future.]

Ok, back to my example, which will happen to match up – by pure coincidence! – with how 98.75 percent of your investment advisors have set up your portfolio.]

After one bad year in the stock market in our example here, let’s say stocks have dropped by 12 percent and bonds have returned a positive 5 percent, and now your portfolio allocation has shifted due to the market.
The new portfolio at the end of Year 1 now has a 56 percent stocks to 44 percent bonds allocation.

Here’s where the rebalancing part comes in.
When rebalancing at the end of the year you would sell some of your bonds – in my example 9.6% of your bond allocation so that it only makes up 40 percent of your portfolio again. With the proceeds of the bond sale you would purchase stocks, also returning stocks to just 60 percent of your portfolio. You would now begin Year 2 with your previously agreed-upon 60/40 asset allocation.
Next year, let’s say the stock market rebounds, returning a positive 18 percent, while bonds return just 1 percent overall.
Using numbers from my example, you end up with a 0.66% larger portfolio at the end of Year 2 through rebalancing. That may not seem like much, but those little amounts add up over time. If you have a $100,000 portfolio you would be $660 richer after just one rebalancing.

Let’s extend the example one more year. At the end of Year 2, before rebalancing, you have a 63.6% stocks and 36.4% bond mix. We’ll have to sell about 5.6 percent of our stocks to return to our preferred 60/40 mix.
In Year 3, let’s say stocks return a positive 8 percent and bonds return positive 3 percent. You will now have a portfolio 2.1% higher than if you had never rebalanced, or $2,100 on your original $100,000 portfolio. The math works in your favor this way with any asset allocation in which assets have different returns in different years. It also works just as well with more than two types of assets.

calculating_rebalancing
A screenshot of the spreadsheet I used for calculations

I’d like to list a few more important points about rebalancing, why it works, and also some caveats.

First, the act of regular rebalancing forces you to “Buy-low, Sell-high,” at least on a relative basis. Whichever asset class has outperformed the others will be the one you sell (high) and whichever asset class has underperformed will be the one you buy (low).

Second, while regular rebalancing makes sense, I doubt it makes sense to do this more than once a year. If you have a taxable account (a non-retirement account) then the tax costs of selling winners may outweigh the benefits. Also, frequent trading is always a mistake, so rebalance with moderation.

Third, because of point number two, if it’s possible for you, the best way to rebalance is not through selling existing investments, but rather through new investments. If you regularly contribute to an investment account, you can ‘rebalance’ your portfolio without tax consequences by simply purchasing more of whatever has become underweighted in your portfolio. This has the happy effect of allowing you to buy (relatively) low with your new investments, rather than to do what everybody else does, which is chase whatever hot sector has recently outperformed.
This may seem super-duper obvious and it is indeed super-duper easy to do.

But!
Most people don’t do it. After Year 1 of losing 12 percent in the stock market, for example, few people have the guts, rebalancing discipline, or a nudgy-enough financial advisor to remind them that their allocation is out of whack. Simple rebalancing will help correct that whack.
We get scared to buy something down 12 percent. After Year 2, we also have a hard time selling something that just soared 18 percent in a year. “Ride that winner!” we tell ourselves, to our later regret.

 

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Mortgage Lending Made Easy Makes Me Uneasy

home_mortgagesYesterday was a pretty big day in the slow unwinding of post-crisis mortgage-lending policy making, according to the Wall Street Journal.

I’m not going to jump up and down and declare that this latest negotiated relaxation of federal mortgage standards means we’re back to the pre-Crisis madness.

On the other hand, it appears that all the tough policy talk – about shoring up lending standards, winding down Fannie and Freddie, requiring strict 20% down payments for new mortgages, and requiring mortgage securitization banks to retain at least 5% of the bonds they make to have ‘skin in the game’ – just went flying out the window yesterday.

As I mentioned recently, HUD is very focused on increasing lending, even if it means pushing banks back into the subprime space. One problem that HUD and the Federal Housing Finance Agency face is that mortgage standards appear high and tight for anyone with less than perfect credit or the traditional hefty 20% down payments.

In addition, mortgage originator and aggregator banks are scared to death of any misstep in the underwriting process, because that allows Fannie and Freddie to kick the mortgage back onto the mortgage bank’s balance sheet. Mis-steps, even tiny ones, also expose banks to the kinds of government lawsuits for which they’ve paid many billions of dollars in recent years, in what I basically believe to be “settle and quickly move on” situations for banks, rather than outright winnable cases for the government (but that’s another long story.)

Yesterday, Mel Watts of the Federal Housing Finance Agency announced in a speech to the Mortgage Lender’s Association:

1. A relaxation of the 20% down payment requirement for conforming loans, to as low as 3% down for certain qualifying buyers. Details to follow in coming weeks.

2. A new set of easier requirements that make it less likely Fannie or Freddie will kick back non-underwriting compliant loans to underwriting banks.

Separately, the FHFA indicated that banks will not have to carry 5% of the risk of mortgage bonds, if borrowers did not provide a 20% down payments. Banks hated that rule, and they got their wish.

These steps will clearly please both mortgage banks and borrowers in the short run.

In the medium to long run, we’ve definitely taken a giant leap toward riskier mortgage lending.

John Carney at the WSJ says

The rule [regarding banks holding 5% of mortgage securities themselves] isn’t just a small step back for mortgages, it is a giant leap backward for the entire financial system.

Those are fightin’ words.

 

Please see related posts:

New HUD Secretary seems to advocate for increased subprime lending

HUD disagrees that they advocate subprime lending, so let’s go to the transcript

Mortgages Part VIII – The Cause of the 2008 Crisis

Mortgages Part V – I Want A New Drug

On Housing Part III – 7 Big Opportunities

 

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