Back in 2009 Zero Hedge was first the only, and shortly thereafter, one of very few non-conformist voices objecting to pervasive high frequency trading and other type of quantitative market manipulation in the form of Flash Trading (which has recently reemerged in yet another form of frontrunning known as "Hide not Slide" practices) quote stuffing, and naturally latency arbitrage: one of the most subversive means to rob the less than sophisticated investor blind, due to an illegal coordination between market markers, exchanges and regulators, which effectively encouraged a two-tier market (one for the ultra fast frontrunning professionals, and one for everyone else). A week ago we were amused to see that the SEC charged the NYSE with a wristslap, one for $5 million dollars and where the NYSE naturally neither admitted nor denied guilt, accusing it of doing precisely what we said it, and all others, had been doing for years: namely getting paid by wealthy traders, those using the prop data feed OpenBook Ultra and other paid systems, to create and perpetuate a two-tiered market, all the while the regulator, i.e., the SEC was paid to look the other way.

The graphic summary of the empty action against the NYSE which will do nothing to change the broken market:

This action was nothing but a desperate, and futile, attempt to regain some investor confidence in the market. It has failed, and since said "enforcement" action has done nothing to restore confidence, expect to see more exchanges slapped with fines for actively perpetuating latency arbitrage opportunities for "some" clients.

Well, since the SEC will be desperate to come up with more means of "restoring credibility" of both the market and its regulator, another exchange it may want to look at is the NASDAQ, which as Nanex demonstrates, may well have been engaging in comparable (most likely not pro-bono) latency arbitrage benefitting some: those paying for its direct feed aka TotalView, and thus not harming others, or those relying on the Consolidated Feed (UQDF) for data dissemination.

From Nanex:

TotalView vs Consolidated Feed

In Facebook at 13:50:01 on May 18, 2012, when we compare Nasdaq's quote sent to the direct feed (TotalView) with the same quote sent to the Consolidated Feed (UQDF) we find a difference, or delay, of at least 120 milliseconds. That is, quotes sent to the direct feed appeared 120 milliseconds before the same quotes appeared in the consolidated feed. Comparing quotes and trades from other exchanges allows us to rule out the consolidated feed causing this delay. In other words, the delay must have occurred sometime before it reached the consolidated feed processors. Last week, the SEC fined the NYSE for sending a quote faster to their direct feed than the consolidated feed.

Here, are a few more examples of quotes, appearing before trades.

The first 2 charts compare the Nasdaq Quote from TotalView (Red) and the consolidated feed (gray). All charts show data at 1-millisecond intervals over 1/2 second of time.
1. Nasdaq Quote spread from TotalView (red) and the Consolidated Feed (gray).
The offset of the gray shading to the right of the red shading represents the amount of delay.

2. Same as chart 1, but includes trade executions. Data from Totalview is red, data from Consolidated feed is black/gray.
Note how trade executions line up with the direct feed, but appear ahead of the consolidated quote.

For more visual proof of latency arbitrage via Nasdaq go here.

Back in the summer of 2010, when the SEC was still desperate to (laughably) scapegoat the May 6 Flash Crash on Waddell and Reed, in an attempt to telegraph to the public that it was in control of the HFT takeover of the stock market (an attempt which has since failed miserably as days in which there are no occult trading phenomena have become the outlier and have resulted in the wholesale dereliction of stock trading by retail investors), we first presented and endorsed the Nanex proposal that the flash crash was an "on demand" (either on purpose or by mistake) event, one which occurred as a result of massive quote stuffing which prevented regular way trading from occuring and resulting in a 1000 DJIA point plunge in minutes  (the audio track to which is still a must hear for anyone who harbor any doubt the market is "safe"). It turns out that in the nearly 3 years since that fateful market crash, not only has nothing been done to repair the market (ostensibly broken beyond repair and only another wholesale crash, this time without DKed trades, and bailed out banks, could possible do something to change the status quo) but the Denial of Service (DoS) attacks that HFT algos launch, for whatever reason, have become a daily occurrence as the following demonstrations from Nanex confirm beyond a shadow of a doubt.

And while none of this is surprising: after all why should the algos and their HFT-coding masters change their ways if the SEC still has no idea how to approach and regulate a market that is fractured beyond comprehension in the aftermath of Reg NMS and Reg ATS, what the below data also confirms is what we noted two weeks ago, namely that "stock market fragility is rapidly approaching "flash crash" levels."  The only question is whether anyone will even notice, or care about, the next inevitable 1000 point DJIA plunge...

From Nanex:

DoS Algo's Effect on Trades

While working on identifying and cataloguing the high quote traffic generated by Denial Of Service algo from 01-Nov-2012, we here at Nanex stumbled upon something interesting. Below is an image that shows the trades per second and quotes per second in Bank Of America (BAC) from 9:30-13:45 ET. Each data point represents any second that contained 1000 quotes or more per second in BAC.

The blue represents the number of quotes in a second, the orange represents the number of trades for that same second. When you graph them together using multiple axis, a distinct pattern emerges. For those seconds that contain abnormally high quote traffic, the number of trades drops dramatically.

And conversely, the seconds that contained a higher amount of trades appear when the quote traffic is less.

There might be a few reasons for this:

1. Other HFT algos were smart enough to pick up on this behavior and pulled out during that time period.
2. The various computational and network systems in place that route, analyze and do computations on this data can do nothing but handle raw quote traffic, so not as many trades can be processed during that time.

Below are similar graphs for the other securities that were affected:

• Ford Motor Company (F)
• Intel Corporation (INTC)
• KeyCorp (KEY)
• Morgan Stanley (MS)
• Sirius XM Radio Inc (SIRI)
• Yahoo (YHOO)

Note The data below was taken where the security had 100 or more quotes per second.

1. F - 333 seconds had 1,000 quotes or more. 40 of those seconds had 10,000 or more quotes per second.

Here is the entire day in Ford showing every second that had 100 or more quotes per second.

2. INTC - 242 seconds had 1,000 quotes or more. 61 of those seconds had 10,000 or more quotes per second.

Here is the entire day in Intel showing every second that had 100 or more quotes per second.

3. KEY - 386 seconds had 1,000 quotes or more. 347 of those seconds had 10,000 or more quotes per second.

Here is the entire day in KeyCorp showing every second that had 100 or more quotes per second.

4. MS - 140 seconds had 1,000 quotes or more. 89 of those seconds had 10,000 or more quotes per second.

Here is the entire day in Morgan Stanley showing every second that had 100 or more quotes per second.

5. SIRI - 110 seconds had 1,000 quotes or more. 62 of those seconds had 10,000 or more quotes per second.

Here is the entire day in Sirius XM Radio showing every second that had 100 or more quotes per second.

6. YHOO - 157 seconds had 1,000 quotes or more. 51 of those seconds had 10,000 or more quotes per second.

Here is the entire day in Yahoo showing every second that had 100 or more quotes per second.

The official word on the street is that this abnormally high traffic had a "modest impact", I think the data speaks otherwise. During those seconds where there were abnormally high amounts of quote traffic (10,000+ quotes/sec), the number of trades that were occurring simultaneously dropped significantly. In total there were 651 seconds (almost 11 minutes) of market time today that were affected. That's 11 min of potential future economic growth. These seemingly small increments of time eventually add up and serve to slowly erode the confidence of investors small and large.

Just in case anyone wanted to know what not to say to defend the absolute horrific mess of self-aware vacuum tubes and errant algos, formerly known as "the market", here is a great primer from Credit Suisse's trading strategist Phil Mackintosh.

Bullets summarized by Bloomberg:

• U.S. Stock Market ‘More Reliable’ Despite Crashes

This one really needs no comment

• Computers “make it easier” to find outliers in terms of price, volume helping to make the markets “more reliable” now compared to the period before computerized trading

So forget about actual value, just look for millisecond momentum mean reversion patterns out of whack and trade on that. Wait, what about the market being a discounting mechanism? Um, nevermind. Also, what can possibly go wrong with simply trading momentum. Speaking of, has anyone head of JAT Capital lately?

• 10 worst days in Dow all happened before computerized trading

So there were no computers involved in the "dynamic" hedging involved in Portfolio Insurance and the debacle which became Black Monday? But yes, it was mostly human traders dealing with the epic disaster in the aftermath of computerized Garbage In, Garbage Out models (kinda like those used by every polling Wunderkind nowadays). One can only imagine what would happen if momentum accelerating algos had been involved in 1987...

• More stocks gapped 1% in 1 minute in the early 2000’s than now, improved as computer use grew

A fine example of spurious correlation, because one can refute that infinitely more stocks gapped from their NBBO to $0 or infinity after 2000, and especially after the adoption of Reg NMS and ATS, both of which completely broke the market.

• Concluded reaction to trades “much faster than a typical asset manager would most likely be able to move” suggesting“ short term traders do provide value” by adding significant liquidity, transferring risks.

Go ahead and tell that to BATS and its catastrophic IPO... And no, fast trade reaction simply means that mean reversion algos kick in without regard for the actual underlying news. Also the only transfer of risk that takes place is that from collocated boxes to the slower retail platforms which are always left holding the stick. Because so much happens in the 10 nanoseconds after a headline sends a stock to $0 and back. Also, the only value short-term traders provide is churn and chaos in the immediate aftermath of big news. Because otherwise what is the rationale to halt a stock when it is up or down 10%.

Finally:

• Notes daily value of U.S. stocks traded of $220b more than double rest of world combined, shows “vote of confidence”

Look up Stockholm Syndrome Phil. Then look up how much money exchanges make from High Frequency Churning, pardon Trading. Finally look up any of the thousand examples caught on Zero Hedge showing quote stuffing, subpennying, flash crashing, internalizing, dark pooling, and last but not least, how HFT has never, repeat never, added to market liquidity (as predicted by us one year ahead of the Flash Crash), when said liquidity can be literally pulled with the pull of power switch out of a socket: the proverbial HFT STOP.

So no, Phil, "despite crashes" the stock market is not "more reliable." Quite the opposite. But please issue more sad, yet entertaining, defense pieces such as this one. All it shows is the desperation with which you and your peers are approaching the wholesale disgust that most people who manage money are now exhibiting toward the complete fraud that the stock market has become. That's ok, though. The upside is one day you, too, will learn a socially beneficial skill, as opposed to finding sub-nanosecond arbitrage opportunities in a market which is only where it is thanks to $14 trillion in monetary injections (and rising at an exponential rate) from the central planners.

A few days ago, Credit Suisse did something profoundly unexpected: its Trading Strategy team led by Jonathan Tse released a report titled "High Frequency Trading - Measurement, Detection and Response" in which the firm - one of the biggest flow and prop traders by equity volume in both light and dark venues -  admitted what Zero Hedge has been alleging for years (and has gotten sick and tired of preaching), and which the regulators have been unable to grasp and comprehend: that high frequency trading is a predatory system which abuses market structure and topology, which virtually constantly engages in such abusive trading practices as the Nanex-branded quote stuffing, as well as layering, spoofing, order book fading, and, last but not least, momentum ignition.

This is Credit Suisse, an entity whose incremental input we are confident will be very much welcome by Congress and the regulators, not some fringe, tinfoil hat blog.

While we we cover the full report in the next few days and all its SEC-humiliating implications, it is the last aspect that we wish to focus on because while all the prior ones have been extensively covered on these pages in the past, it is the phenomenon of momentum ignition that goes straight at the dark beating heart of today's zombie markets: momentum, momentum, and more momentum, in which nothing but stop hunts and even more momentum, define the "fair value" of any risk asset - i.e., reflexivity at its absolute worst  (in addition to Fed intervention of course), where value is implied by technicals and trading patterns, and where algos buy simply because other algos are buying. Behold robotic stop hunts: HFT-facilitated "Momentum Ignition."

From Credit Suisse:

MOMENTUM IGNITION

What is Momentum Ignition?

Momentum ignition refers to a strategy that attempts to trigger a number of other participants to trade quickly and cause a rapid price move.

Why Trigger Momentum Ignition?

By trying to instigate other participants to buy or sell quickly, the instigator of momentum ignition can profit either having taken a pre-position or by laddering the book, knowing the price is likely to revert after the initial rapid price move, and trading out afterwards.

Likelihood and Rapid Price Moves

Momentum ignition does not occur in the blink of an eye, but its perpetrators benefit from an ultra-fast reaction time. Generally, the instigator takes a pre-position; instigates other market participants to trade aggressively in response, causing a price move; then trades out. We identify momentum ignition with a combination of factors, targeting volume spikes and outsized price moves - see Exhibit 18 for a example of this pattern in Daimler on 13th July, 2012:

To pinpoint momentum ignition, we search for:

1. Stable prices and a spike in volume (Box 1 in Exhibit 18)
2. A large price move compared to the intraday volatility (Box 2)
3. Reversion (Box 3)

Though we cannot conclusively determine the intention behind every trade, this is the kind of pattern we would expect to emerge from momentum ignition. We use this as a proxy to estimate the likelihood and frequency of these events (further details are provided in Appendix 4).

Likelihood and Rapid Price Moves

As shown in Figure 19, we estimate that momentum ignition occured on average 1.6 times per stock per day for STOXX 600 names in Q3 2012, with almost every stock in the STOXX600 exhibiting this pattern on average once a day or more.

In addition, we note that the average price move is 38bps (but over 5% are more than 75bps, with some significantly higher – see Exhibit 20), and the time it takes for that move to occur is approximately 1.5 minutes (see Exhibit 21).

While 38bps may not sound like a big move, it is a bit more significant when compared to the average duration of these events (1.5 minutes) and the average spread on the STOXX600 (approximately 8bps).

Though not all momentum ignition events result in massive price moves, those that do can cause significant impact. Percentage of volume orders that would normally execute over hours may complete in minutes on the back of “false” volume ( one of the causes of the 2010 flash crash was a straightforward percentage of volume order). AES offers a variety of protections to help mitigate this kind of dislocation, including customised circuit breakers, active limits (that kick in when the stock decouples from a specified index) and fair value limits.

* * *

Much more on HFT being finally exposed by "credible" sources tomorrow.

One of the topics most often discussed on Zero Hedge before the wholesale takeover of capital markets by central planners was finally accepted by everyone, was the domination of market structure (first in equities, and now in commodities, FX and even credit) by new technologies such as High Frequency Trading as a result of a shift in the market to a technological platform domination, away from the specialist model, and one where the entire concept of discounting, the primary role of the market in the Old Normal, has been made redundant courtesy of a race to be the first to react to events (i.e., backward looking, and direct contravention with the primary function of markets) courtesy of milli- and nanosecond, collocated servers which collect pennies in front of steamroller and generate profits purely by "virtue" of being the first to trade.

This new "technology paradigm" developed in the aftermath of the regulator complicit adoption of Reg NMS (and to a smaller extend Reg ATS) which unleashed a veritable cornucopia of "SkyNet"-controlled algorithmic traders, even as regulators did not and still do not, to this day understand all the evils that rapid technologization of the stock market has brought, most vividly captured in the May 2010 flash crash, and daily subsequent mini flash crashes, which have achieved one thing only: the total collapse of faith in the stock market by ordinary investors, who now see it for what it is (and always has been but to a far lesser extent) - a gamed casino, in which not only the house always wins and the regulators are either corrupt or clueless, or both.

And while more and more "dumb money" Joe Sixpacks awake every day to the farce that is the stock market, one entity that continues to ignore it, whether due to its own incompetence, due to conflicts of interest, due to corruption, due to co-option, or for whatever other reason, are the regulators, in this case the Securities and Exchange Commission: arguably the most incapable entity to handle the topological nightmare that the current market landscape has become. Which is to be expected: after all only an idiot would expect that when the SEC invites a GETCO, or a DE Shaw to explain and observe the fragmentation of the market, and the evils brought upon by HFT, either in a closed session or before congress, that they would voluntarily expose their business for the parasitic fallout of what once was known as capital formation. After all, it is their bread and butter: to expect them to commit professional suicide by truly showcasing the ugliness beneath it all is beyond stupid. And the flip side are various fringe blogs, which must be relegated to the tinfoil crackpot ranks of conspiracy theorist (even as conspiracy theory after conspiracy theory becomes conspiracy fact after conspiracy fact).

So instead of uttering one more word in a long, seemingly endless tirade that stretches all the way to April 2009, we will this time let such dignified members of the credible, veritable status quo as Credit Suisse, who have released a two part primer on everything HFT related, with an emphasis on the broken market left in the wake of the "high freaks", which is so simple even a member of congress will understand (we would say a member of the SEC, but even at this level of simplicity its comprehension by the rank and file of the SEC is arguable). As Credit Suisse conveniently points out "market manipulation is already banned", but that doesn't mean that there are numerous loophole that HFT can manifest themselves in negative strategies that have virtually the same impact on a two-tiered market (those that have access to HFT and those that do not) as manipulation. Among such strategies are:

• Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
• Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
• Order Book Fade: lightning-fast reactions to news and order book pressure lead to disappearing liquidity
• Momentum ignition: an HFT trader detects a large order targeting a percentage of volume, and front-runs it.

So to all those who still foolish believe in a fair and efficient market: read on, because that concept died long ago, and every day you keep money in the market is one more in which the deck is stacked entirely in the house's favor, and on a long enough timeline, a total loss of capital is virtually assured.

And for all the regulators, who are somehow still uncorrupted, unconflicted and uncoopted - those very, very few of you - and who still harbor a hope that one day retail investors may regain their faith in the stock market (a critical milestone needed to enable Bernanke's plan of rekindling the "animal spirits"), read on so you too can now what should be the focus of both regulation and enforcement in a world in which government supervision is several decades behind the curve.

Part 1: High Frequency Trading – The Good, The Bad, and The Regulation

Part 2: High Frequency Trading – Measurement, Detection and Response

While prosecuting the wrongdoers is clearly not part of the new normal (see Sokol et al.), what Nanex found this morning beggars belief - both in its method of manipulation and clarity that our regulators are clueless. As they note, the high frequency traders (HFT) are at it again. Contorting the spirit of the rules, because those who wrote the rules aren't technically savvy. On January 4, 2013, we found another instance of HFT morphing their manipulative and illegal quote stuffing strategy in an effort to fly under the radar. Why they don't just stop this manipulative practice altogether tells us a few things. First, this isn't some coding error, this is sophisticated cheating. And second, because they are spending valuable programming time on this strategy, there must be some real economic advantage. Which mean a disadvantage to everyone trading against them.

Via Nanex, Seconds In a Microsecond World,

The Strategy

Each exchange has been setting limits for the number of canceled orders allowed per second. We know that one exchange has a limit of 300 canceled orders per second per stock.. It's rare to find 300 or more canceled orders in one stock in any one second from that exchange. But you will find tens of thousands of seconds where a stock has 299 canceled orders.

In the charts below, we show a new strategy they have cooked up: send a blast of orders (all immediately canceled) over a very short period of time, 100 milliseconds (ms) in this case, and then silence for the balance of the second. They know that exchanges measure the number of canceled orders on a per second basis, so that blast of orders sent in 100ms will be diluted by another 900ms of silence. But networks operate on a much smaller time-scale, microseconds. A microsecond is a millionth of a second.

If an exchange sets a limit of 1000 canceled orders per second, these nefarious HFT will blast a 1000 orders in 100 milliseconds (ms), followed by silence for the balance of the second. The exchange will only see 1000 orders in a second, which is at the limit, so no problem. But the network that carries those orders to other participants won't see it that way.

A network that can carry 1000 orders in a second, can carry only 1 order per millisecond (1/1000th of a second) before latency (delay) occurs. Which means blasting 1000 orders in 100ms will begin overloading the network and causing delays after just the first 100 messages. Which means 900 messages will arrive late to other traders (competitors) computers. Which is the whole point of this high technology warfare.

1. GWR - Bids and Asks color coded by exchange and NBBO (gray shading)
Note the pattern of quote blasts followed by silence. What is this all about?

2. GWR - Trades color coded by exchange and NBBO (gray shading)

3. GWR - Bids and Asks color coded by exchange and NBBO (gray shading)

4. GWR - Bids and Asks color coded by exchange and NBBO (gray shading)
The blasts occur 1 second apart. This is to get around exchanges limiting HFT to X quotes per second. Networks operate on milliseconds.

5. GWR - Zooming out, showing Bids and Asks color coded by exchange and NBBO (gray shading)
The quote rate on a 1 second interval is somewhat modest. Spread out between 6 exchanges, means each exchange won't see a problem.

6. GWR - Zooming out, showing trades color coded by exchange and NBBO (gray shading)

7. GWR - Tick Chart

Nanex Research

After exposing the stock market manipulative arsenal that is High Frequency Trading, quote stuffing, flash trading, packet churning, layering, sub-pennying, liquidity, latency and dark pool arbitrage, NBBO and Reg NMS exemptions, "hide-not-sliding", collocation, and much, much more for four years, or so long even Credit Suisse joined the chorus we started in April of 2009, we are glad to learn that finally, with a ridiculous Rip Van Winklesian delay, but better late than never, "the FBI has teamed up with securities regulators to tackle the potential threat of market manipulation posed by new computer trading methods that have taken operations beyond the scope of traditional policing."

In other words, the SEC has finally realized it can no longer pretend it is not co-opted, but because it has no clue where to even start with HFT, has asked the help of the Feds. Which in itself is hardly reason for optimism, but if there is one thing Hans Gruber has taught us, it is that when the Feds get involved, the first thing they do is cut the power, and in this algo-based market that will end some 99% of all daily manipulative practices we have all grown to love and look forward to every single day.

From the FT:

FBI agents have joined forces with a new unit within the Securities and Exchange Commission that examines hedge funds and other firms that are using algorithm trading strategies.

 

The SEC’s Quantitative Analysis Unit is focusing on the emergence of high-frequency trading firms and the rise of dark pools. Traders using these methods can manipulate the market by flooding it with quotes, known as quote stuffing, or placing millions of orders that are quickly cancelled, to drive others to trade in ways that benefit their position, a practice known as layering.

 

Some of these trading strategies have been accused of destabilising the market and putting retail investors at a disadvantage. Their supporters have said they increase liquidity in securities and reduce volatility.

Accused? Obviously the author of this story has never actually, what's the word, traded, submitted a VWAP or any other market-based order.

There is a reason the NY Fed works with HFT-giant Citadel: it is precisely to facilitate what HFT is "accused" of doing. But one can't go and expose all the manipulated secrets that have sent this fake market to even faker all time highs.

Authorities are exploring potential holes in the system, including new algorithms referred to as “news aggregation” which search the internet, news sites and social media for selected keywords, and fire off orders in milliseconds. The trades are so quick, often before the information is widely disseminated, that authorities are debating whether they violate insider trading rules, the people familiar with the matter said.

 

Authorities are also monitoring alpha capture systems, platforms where sell-side firms share information with buyside professionals, for potential front running or insider trading. Also on their radar is artificial intelligence trading, an algorithm that predicts market reactions based on history.

One can see it already: "it was all Twitter's fault."

Nonetheless, there is at least a trace reason to be hopeful:

One government official said market structure could be the next big area for cases, although it was not clear whether any of the strategies violated criminal laws. To prove a criminal case the FBI would need to show that the trader intended to manipulate the stock, which could prove more difficult for strategies that are triggered by computers.

The hope is not from the SEC or FBI actually putting someone behind bars, as this proves...

The SEC has brought a handful of cases involving these strategies and other investigations are under way. No criminal case is on the horizon, one of the people said.

... But at least neither the Feds nor the SEC will be able to plead ignorance when confronted with the same knowledge that our readers had back in 2009.

Then again, by the time the two agencies catch up to what anyone with half a frontal love and an interest in the stock market knows already, the Dow will be either at 36,000 or 0, or in other words, too late.

While most of the US was in deep REM sleep, the Germany stock index, the DAX, had a flashback to May 2010: starting at 3:44 am EDT, in the span of 6 minutes or much faster than the gradual drop that led to the US flash crash from three years ago, the DAX went from well and solidly-bid to having zero liquidity... and dumping nearly 200 points in the process. Whether it was rumors of a (subsequently validated) rating agency downgrade, or just an algo testing its quote stuffing ability, the moves showed vividly that when the current rosy paradigm shifts abruptly and violently, all those hoping to be the first out of the door and hit the sell button, simply won't be able to do so. Because sadly there is no such thing as a free "4 year long zero volume levitation" - one must always pay the piper in the end.

Charts below from Nanex:

1. June 2013 DAX Futures Depth of Book.

Shouldn't demand increase as prices drop? Only if it is demand for physical gold it seems.

2. June 2013 eMini Futures Depth of Book.

eMini basically shrugs it off, DAX influence weak.

The major compression in VIX into the close combined with a complete lack of JPY-based carry-driver for the equity market comeback today has many asking just what happened? Though the mechanism for quote-stuffing or momentum ignition in this case is unclear - one thing is absolutely crystal clear - today's total and utter explosion in the quote volume for SPY options provides more than a little concern for just what this market has become. As Nanex notes, over 1.1 billion quotes for SPY Options were posted today as 'quote spam' seems to be serving as some kind of parasitic momentum spark. The point here is that just as the market's flash-crash occurred on a day in which quote-stuffing in cash stocks hit a record; so today we got the inverse flash-smash higher in stocks from a surge in quotes on the far-more levered options market. Just look at these charts!!

Simply put - this spamming in the levered options market explains how the S&P 500 can leviate 25 points on low volume amid every other risk-asset's almost total nonchalence...

Via Nanex,

Obviously, no one at the SEC is paying attention. There should be an immediate review of recently proposed or added (10 share contracts) option contract types. In addition, a moratorium on new option's exchanges until this alarming explosion of unwanted quote spam is addressed. 

1. SPY Options Quotes - Daily Counts. Note, the scale is in millions.
Over 1.1 billion option quotes in a day for just one equity symbol.

3. SPY Options Trades - Daily Counts. Note the scale in the chart above (quotes) is in Millions.
Where are the trades? Maybe it's harder to execute trades in a sea of quotes.

3. SPY Options Quote/Trade Ratio.
The number of quotes for every trade is accelerating at an alarming rate.

It has been almost 2 years since FINRA started to get 'serious' about thinking about looking into an investigation of (get our point) high-frequency trading and dark pools but it seems, as the WSJ reports, this time they are more specific. In Sept 2011 FINRA noted "there's something that's troubling us in the marketplace," and it seems now that FINRA has spent the time since understanding the jargon they have some questions,  "who is responsible for the automatic shut off or kill switch," asking firms how they avoid "quote bursts and stuffing" that create confusion for other investors and potentially distort the market, and approving a plan to force dark pools (15% of all stock trading)  to disclose and detail trading activity on their platforms.  Of course, we've seen this kind of bluster before and they did nothing then but hope springs eternal.

Via WSJ,

Regulators are ratcheting up their focus on the complex computer systems deployed by high-frequency trading firms, with an eye on whether the systems have adequate safeguards against chaotic trading that can destabilize markets and harm investor confidence.

 

...

 

The Financial Industry Regulatory Authority is conducting a probe of high-speed firms' trading algorithms - the computer formulas that juggle the firms' rapid-fire trades - and the controls surrounding their trading technology, according to an examination letter sent to about 10 firms this week and reviewed by The Wall Street Journal.

 

...

 

The widening look at high-speed algorithms was sparked by Finra's recent investigations of high-speed trading mishaps,

 

...

 

Finra is asking questions about how firms handle malfunctions, including whether they use so-called kill switches that automatically stop trading as well as "who is responsible for the automatic shut off or kill switch." It is also asking for instances of algorithm malfunctions "which had a material impact to the Firm or any instances in which the algorithm's malfunction caused a market disruption."

 

Another focus is on malfunctioning algorithms, known as "algos gone wild," that can jam exchanges with multiple buy and sell orders. This so-called "quote stuffing" can create confusion for other investors and potentially distort the market. Finra asks about what type of risk controls are built into algorithms designed to prevent "quote stuffing and quote bursts."

 

...

 

Finra is also increasing its scrutiny of "dark pools," private trading venues, frequently operated by sophisticated computer systems that don't disclose investors' buy and sell orders. Last week, the regulator approved a plan to require dark pools to disclose and detail trading activity on their platforms, a move that would give it the clearest view yet into the private markets that account for about 15% of all stock trading, triple the total five years ago

However, in light of ever-decreasing volumes of real traders, ever-increasing dependence of Fed liquidity and asset price divergence from any fundamental reality, perhaps it is the unintended consequence of a regulator getting serious that removes one of the only legs left in the bull market's stool - the low-volume momentum ignition-driven algo-based melt-up.

From Nanex

Compare The Time-stamps Already!

For the first time, the SEC's new multi-million dollar market data analysis tool, "Midas", allows the regulator to measure a stock exchange's compliance with a core rule that lies at the heart of regulations governing how our stock markets work. We are referring to rule 603(a)(2), which basically states that exchanges cannot send stock quotes faster to special groups than to the public quote (consolidated feed, more here). This is the same rule the NYSE broke and was fined $5 million for in September 2012. It was a data-feed delay analysis from Nanex, sent to the SEC on July 22, 2010, which tipped off the regulator and showed conclusively that a persistent delay existed in the NYSE public quote relative to the direct feed quote and this delay was not from the consolidation process.

Now that Midas gives the SEC the same ability Nanex had in 2010, we strongly urge them to use it to perform the same data-feed delay analysis on recent trading days (these 10 select days of 2013). This is an urgent matter as there is ample evidence that public quote delays continue to exist from several exchanges. These delays not only violate regulations, but they significantly disadvantage the 2.5 million subscribers who collectively pay almost $500 million annually for "real-time" public quotes.

Our method for detecting a data-feed delay is simple, straightforward, and will put Midas to good use. A good programmer with a few years experience should have no trouble coding the necessary logic in one or two days.    

Data-Feed Delay Analysis

In the first and only step, every quote and trade in the consolidated feed, over an entire trading day, is matched to its direct feed counterpart, with the results written to an ASCII text file where each line consists of data for one trade or quote with the following fields: the direct feed time stamp, the consolidated time-stamp, reporting exchange (which direct feed), symbol, price, and size. This output file should be made freely available to the public and universities for statistical analysis.

The regulator may also wish to perform their own statistical analysis to determine when, where, and to what extent the public quote is delayed relative to the direct feed quote. This analysis will determine the level of compliance with a key rule that lies at the heart of Regulation NMS. Its importance cannot be over-emphasized.

Recent speeches from the SEC indicate they plan to use Midas to look at the details behind quote stuffing, excessive order cancellations, the cause of mini flash crashes, and other nefarious activities. While these are all good uses for a market analysis tool (Midas), they pale in comparison to a data-feed delay analysis, because the former are governed by blanket, hard-to-prove manipulation laws, while the latter can be tied directly to a core rule that lies at the heart of Regulation NMS. An improper data-feed delay was the reason for the $5 million fine against an exchange in September 2012. Furthermore, millions of people are directly affected and disadvantaged by illegal data-feed delays. Therefore, it would be a great waste of public resources to not immediately pursue a data-feed delay analysis, because there exists ample evidence that an illegal speed advantage exists in direct feeds over the public quote.

Given all that we know about market data analysis and the state of the industry, we can think of only 2 reasons the SEC would avoid a data-feed delay analysis.

1. Midas is not capable of performing this simple task. If this is the case, then it was a tremendous waste of public resources paying for this tool.
2. The SEC wanted Midas not to detect fraud and abuse by certain participants, but rather to protect special interest groups and bamboozle the public into believing that markets are fair and transparent.

Although reason 2 is difficult for us to accept, we can think of no other explanation. Therefore, we look forward to seeing the results of the SEC's data-feed delay analysis and are ready to offer our years of experience should they need any assistance. If, however, such analysis does not occur in a timely manner, we will have to conclude that either Midas isn't up to the task, or the regulator is unfit to regulate.

To learn how we uncovered the delay in the NYSE public quote, continue reading.

Nanex Discovers the NYSE Public Quote Delay

More that 3 years ago, while analyzing the May 6, 2010 flash crash in detail, we discovered one of the prime causes for the crash, and a serious violation of a regulation that governs how stocks are traded in the United States (Reg. NMS). Specifically, we found that stock quotes from the NYSE were delayed by more than 30 seconds to the public quotation feed (chart 1), relative to Open Book, which is NYSE's expensive direct feed product used mostly by High Frequency Traders (HFT). A crucial sub-ruling in the regulations prohibits exchanges from giving stock quotes to special groups faster than to the public. This sub-rule is of such importance, that without it, the rest of the rules essentially become meaningless.

After we pointed out the severe delay in the NYSE public quote, the exchange immediately denied there was a problem: in spite of probing phone calls from major news media such as The Wall Street Journal (Tom Lauricella and Scott Patterson), The New York Times (Graham Bowley), Reuters (Herb Lash) , Bloomberg (Kambiz Foroohar), and Risk Magazine (Duncan Wood).

To satisfy a curiosity of whether the NYSE public quote delay was unique to May 6, 2010, we ran another quote-by-quote comparison of time-stamps from the public quote and Open Book for a 30 minute trading period in General Electric stock (GE) on July 21, 2010 (see chart 2). We chose this period because there was a noticeable lag in the public quote from the NYSE versus quotes from other exchanges, which rules out the consolidation process as a source of the delay.    

Once again, we detected sizeable delays between time-stamps in the public quote and Open Book. These delays ranged in the hundreds of milliseconds. Though the delay magnitude was far lower than the 10's of seconds discovered during the flash crash, it was still hundreds of times higher than expected.
   
Our first attempt at finding a cause for the delay involved comparing the trading activity in GE stock with the magnitude of the delay. Chart 2 shows the price of GE stock in red, along with the public quote delay in blue. The left price scale shows the delay in milliseconds (thousandths of a second). We couldn't find a correlation between the price and magnitude of the delay, and one does not present itself on the chart.

Next, we looked for a correlation between the number of quotes per second in GE stock and the delay, and again, found none.

We noticed that NYSE's quote was involved in crossed NBBOs (National Best Bid/Offer where bid price is greater than ask price, which is caused by a delayed quote from one exchange), in a large number of stocks. That led us to see if the number of quotes from the NYSE for all stocks in CQS (the public data-feed that transmits GE), was correlated with the delay

It was! More on that in a moment.

First, we had to rule out the possibility of the delay being caused by the consolidation process (which people often erroneously point out). To do this, we looked for examples of the NYSE quote lagging quotes from other exhanges in the public data-feed. This tells us that the delay had to exist before NYSE quotes were processed by the consolidated feed.

The chart on the right is one such example. It shows the quote spread and trades from 2 exchanges in GE. The NYSE quote spread is shown in light blue, and the Nasdaq quote spread in gray. When the two quote spreads overlap, the color is dark blue.

The red area is where the NBBO was crossed - a condition caused by the NYSE quote lagging far behind Nasdaq's, which resulted in NYSE's bid price remaining higher than Nasdaq's ask price. Note where the light gray shade shifts to 14.78 x 14.79 on the left side of the chart (14:13:13.650). The blue shade shifts to this same price almost 450 milliseconds later - which corresponds with the time-stamp difference between Open Book and the public quote.

Note the NYSE trades (blue circles) appearing before the NYSE quote - another indication of a quote delay from the NYSE and not the consolidation process. We coined this phenomenon fantaseconds and published many examples over the years.    

Now, back to the correlation we found which shows up nicely on the two charts below which detail one minute of time on July 21, 2010. The top chart shows the delay in milliseconds between time-stamps on GE quotes in the public data-feed and corresponding quotes in Open Book. The bottom chart shows the number of quotes per millisecond (over 10ms intervals) from the NYSE into CQS (the public data-feed that carries all NYSE, AMEX, and ARCA listed stocks. GE is listed on the NYSE).

Note that whenever the total number of quotes from the NYSE into the public data-feed exceeds about 20 per millisecond (red line on bottom chart), a delay appears in the top chart at the same time. That is, when the stack of blue crosses above the horizontal red line in the bottom chart, a corresponding stack of red appears in the top chart. The longer and further the blue crossed above, the higher the delay.

In other words, a high quote rate from any NYSE stock will cause a corresponding delay in all NYSE public quotes! Anyone with this knowledge can easily cause latency on demand.

Having been the first to warn the world about the perils of high frequency trading nearly 5 years ago, when momentum ignition, layering and quote stuffing were still incomprehensible buzzwords to all but a select few algo traders from Citadel, GETCO and DE Shaw, and warning about such top-down systemic lock ups like flash-crash over a year in advance; as well as the bottom-up impacts of 20 year old math PhDs being in charge of market topology, our crusade from the micro has since shifted to the macro and the primary nemesis of all that is free and fair, the Federal Reserve. In the intervening years, traders such as Haim Bodek opened the HFT kimono even more publicly a few years ago. The following is a must-watch documentary for every investor and trader to comprehend just what it is (and who it is) that drives stock prices day in and day out.

The Dark (Pool) Truth About What Really Goes On In The Stock Market Part 1

“I’ll show you how it works.”

 

The rep told Bodek about the kind of orders he should use - orders that wouldn’t get abused like the plain vanilla limit orders; orders that seemed to Bodek specifically designed to abuse the limit orders by exploiting complex loopholes in the market’s plumbing. The orders Bodek had been using were child’s play, simple declarative sentences sent to exchanges such as “Buy up to $20.” These new order types were compound sentences, with multiple clauses, virtually Faulknerian in their rambling complexity.

 

The end result, however, was simple: Everyday investors and even sophisticated firms like Trading Machines were buying stocks for a slightly higher price than they should, and selling for a slightly lower price and paying billions in “take” fees along the way.

 

Bodek felt sick to his stomach. “How can you do that?” he said.

 

The rep laughed. “If we changed things, the high-frequency traders wouldn’t send us their orders,” he said.

The Dark (Pool) Truth About What Really Goes On In The Stock Market Part 2

The game had changed. Bodek became increasingly convinced that the stock market—the United States stock market—was rigged. Exchanges appeared to be providing mechanisms to favored clients that allowed them to circumvent Reg NMS rules in ways that abused regular investors. It was complicated, a fact that helped hide the abuses, just as giant banks used complex mortgage trades to bilk clients out of billions, in the process triggering a global financial panic in 2008. Bodek wasn’t sure if it was an outright conspiracy or simply an ecosystem that had evolved to protect a single type of organism that had become critical to the survival of the pools themselves.

 

Whatever it was, he thought, it was wrong.

The Wall Street Code

It's just sad now: with every passing day bringing new (and previously unseen) cases of high frequency trading algo-generated market halts or crashes, that none of the regulators are willing to take a stand against this market scourge that we have written about for nearly 5 years now, is a clear indication that the HFT lobby is firmly in control of what were once "capital markets" and that the retail investor is once again, the sacrificial lamb. But while it was one thing for the high freak thugs to control marginal price action through momentum ignition, quote stuffing, hide not slide, flash trades, and all the other well-known manipulative techniques which seemingly are too complicated for the SEC to figure out, in equities where things get really bad is when HFTs start crashing, or at least halting, the bond market at key market inflection points such as during the most important monthly data release, the payrolls release. This is precisely what happened on Friday, when as Nanex clearly shows, a momentum ignition algo sent the ZF (5 Year T-Note future) soaring and resulting in a 5 second - an eternity in today's nanosecond age - trading halt during the actual release of the BLS report.

How this kind of manipulation continues without penalty, and how this same party can keep getting away with this  - recall from June, "Here Is Today's 482 Millisecond NFP Leak, The Subsequent Gold Slam And Trading Halts In Treasurys And ES" - is just too mind-numbing to consider any more.

Here is the criminal action from Friday, in pretty charts, courtesy of Nanex:

On January 10, 2013, about 8/10ths of a second before the Labor Department released the widely anticipated Employment Situation Report, trading activity exploded in Treasury futures, sending the prices much higher in less than 1/10th of a second. The buying activity overwhelmed the 5-Year T-Note market causing a stop logic circuit breaker to trip and shut down trading for 5 seconds. During the halt in 5-Year T-Note futures, the news was officially released in Washington, D.C. - meaning that anyone wanting to trade on that news, would have to wait until the halt was lifted almost 4 seconds later (4,000,000 microseconds in high frequency trading lingo).

This isn't the first time that Treasury futures have been halted (see also 08-Nov-2013 and 07-Jun-2013); however, before June 2013, this was an extremely rare event.

2. All Futures Trades - showing that trading activity before news release was higher than after news release!

3. March 2014 5-Year T-Note (ZF) Futures. Zoom of Chart 1.

4. March 2014 T-Bond (ZB) Futures.

5. March 2014 10-Year T-Notes (ZN) Futures.

6. March 2014 2-Year T-Note (ZT) Futures.

7. March 2014 2-Year Minus 5-Year T-Note (TUF) Futures. This contract also halted for 5 seconds (due to the halt in the 5-Year leg).

8. March 2014 Ultra T-Bond (UB) Futures.

Update: within minutes of publishing this article news hit that the FBI is launching a probe into HFT. QED

For all the talk about how High Frequency Trading has rigged markets, most seem to be ignoring the two most obvious questions: why now and what happens next?

After all, Zero Hedge may have been ahead of the curve in exposing the parasitism of HFT (anyone who still doesn't get it should read the following primer in two parts from Credit Suisse), but we were hardly alone and over the years many others joined along to expose what is clear market manipulation aided and abeted by not only the exchanges but by the regulators themselves who passed Reg NMS - the regulation that ushered in today's fragmented and broken market - with much fanfare nearly a decade ago. And yet, it took over five years before our heretical view would become mainstream canon.

One logical explanation is the dramatic and sudden about face by none other than Goldman Sachs, which from one of the biggest proponents of quant trading strategies including algo trading, and which used to make a killing courtesy of HFT (who can possibly forget Goldman's charges against Sergey Aleynikov's code theft which alleged "there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways"), has in recent weeks unleashed a de facto war on HFT, first with the Gary Cohn HFT-bashing op-ed, and then with the implicit backing of the IEX pseudo dark pool exchange, whose employee just mysteriously also is the protagonist of the Michael Lewis book that has raised the issue of HFT to a fever pitch.

So does Goldman know something the rest of us don't that it is now ready to give up on the HFT goldmine which lost money on just one day in 1238? Why of course it does. And one would imagine that judging by the dramatic turnaround exhibited by Goldman that said something is very adverse to the ongoing future profitability of the HFT industry. The amusement factor only rises by several notches when one considers that Goldman also happens to be lead underwriter on the Virtu IPO offering: one wonders what they uncovered and/or what they know about the industry that nobody else does, and just how the VRTU IPO will fare now that Goldman is so openly against HFT.

But what does all of that mean for the big picture? We hinted at it yesterday, on twitter when we had the following exchange.

@LongOnlyTrader Only until market crashes. Then HFT will be the torches and pitchforks scapegoat. Not the Fed.

— zerohedge (@zerohedge) March 31, 2014

Could it indeed be that the only reason why HFT - which has constantly been in the background of broken market structure culprits but never really taken such a prominent role until last night, is because the market is being primed for a crash, and just like with the May 2010 "Flash Crash" it will all be the algos' fault?

This is precisely the angle that Rick Santelli took earlier today, during his earlier monolog asking "Why is HFT tolerated." We show it below, but here is Rick's punchline:

Are regulators stupid when it comes to high frequency trade? Well, i think that there was a time where they were a bit slow to the party. But i don't think it's stupidity or ignorance or not paying attention. So let's wipe that off. So the question i'm asking is, why do they let it continue?

 

Why is it that anybody would want HFT to be unchallenged or at least not challenge it now? My reason, this is just my reason, when i look at the stock market it's basically at historic highs. When i look at what the federal reserve is doing, it's mostly to put stocks on all-time highs. When i look at all the debt and all the programs that don't seem to be making a difference except for putting stocks on all-time highs, i see that you have this tower of power with regard to the stock market. And nobody wants to challenge or alter hft because it is good to go that many days without having a loss. So my guess is when the stock market eventually deals with reality and pricing, which will come at a time when there's not a zero interest rate policy and we're long past QE, I think they'll address it.

Rick's full clip:

Precisely: when reality reasserts itself - a reality which Rick accurately points out has been suspended due to 5 years and counting of Fed central-planning - HFT will be "addressed." How? As the scapegoat of course. Because since virtually nobody really understands what HFT does, it can just as easily be flipped from innocent market bystander which "provides liquidity" to the root of all evil.

In other words: the high freaks are about to become the most convenient, and "misunderstood" scapegoat, for when the market finally does crash. Which means that those HFT-associated terms which very few recognize now, especially those on either side of the pro/anti-HFT debate who have very strong opinions but zero factual grasp of the matter, such as the following...

• Frontrunning: needs no explanation
• Subpennying: providing a "better" bid or offer in a fraction of penny to force the underlying order to move up or down.
• Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
• Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
• Order Book Fade: lightning-fast reactions to news and order book pressure lead to disappearing liquidity
• Momentum ignition: an HFT trader detects a large order targeting a percentage of volume, and front-runs it.

... will become part of the daily jargon as the anti-HFT wave sweeps through the land.

Why? Well to redirect anger from the real culprit for the manipulated market of course: the Federal Reserve. Because while what HFT does is or should be illegal, in performing its daily duties, it actively facilitates and assists the Fed's underlying purpose: to boost asset prices to ever greater record highs in hopes that some of this paper wealth will eventually trickle down, contrary to five years of evidence that the wealth is merely being concentrated making the wealthiest even richer.

Amusingly some get it, such as the former chairman of Morgan Stanley Asia, Stephen Roach, who in the clip below laid it out perfectly in an interview with Bloomberg TV earlier today (he begins 1:30 into the linked clip), and explains precisely why HFT will be the next big Lehman-type fall guy, just after the next market crash happens. To wit: "flash traders are bit players compared to the biggest rigger of all which is the Fed." Because after the next crash, which is only a matter of time, everything will be done to deflect attention from the "biggest rigger of all."

So, dear HFT firms, enjoy your one trading day loss in 1238. Those days are about to come to a very abrupt, and unhappy, end.

First HFTs took over capital markets courtesy of "legal" orderflow frontrunning which is, for the sixth years in a row, confused with "providing liquidity", and which has allowed such pending IPOs as Virtu to boast 1237 profitable trading days out of 1238 while making their owners multi-billionaires. And now, courtesy of Michael Lewis, the high freaks have also taken over the Amazon bestselling books list.

That's right - Americans are now fascinated by issues involving market structure, exchange topology, momentum ignition and quote stuffing.

And just like that, virtually everyone now i) knows the markets are rigged and ii) has an adverse opinion of the collocated "New Normal" vacuum tubes known affectionately as the High Freaks. (Incidentally, just the way the Goldman-supported IEX dark pool and apparently the FBI wanted it).

Perhaps now may be a good time for Virtu to shelve its IPO. Due to "market waking up to HFT criminality conditions."

Submitted by Mark St.Cyr via Mark St.Cyr blog,

Suddenly the world is a buzz with the revelations that High Frequency Trading (HFT) may be doing more than actually harming the markets, it might be destroying the illusion they still are markets.

This past Sunday the world at large was introduced that maybe, just maybe, something was amiss in the financial markets. However, anyone with more than a passing interest in business, finance, and a little common sense could feel in their gut that something just wasn’t copacetic.

Between the Federal Reserve's massive QE experiment amplified by the arms race of algorithmic technologies (aka HFT) to shave off a piece of that pie for themselves, the last few years have been nothing less than breathtaking.

Currently I am staggered as I watch or read many in the so-called “smart crowd” taking to the financial media outlets professing their ire at (wait for it….) Michael Lewis’ assertion that: “the markets are rigged.”  This is where they have an issue? Really? I mean…Really?

Let’s put a few things into its proper perspective. HFT is currently a catch-all phrase or moniker. At one time when it was first introduced it could be (and was) argued it had a legitimate use in making markets more efficient. However that was some 10 years ago. Today’s HFT seems to have been on an evolution of exploitation and adulterated well past the point of resembling the good idea it once was hailed to be.

Efficient markets are when: real buyers, and real sellers meet, agree, and exchange with the least amount of friction to transact. Note the emphasis on real, it’s not there for style, real means an actual buyer or seller. Period. (Just so we’re clear and not falling down the black hole of what “is” is.)

This point is one of the underlying problems in the markets today. It’s not the only one HFT has adulterated, but it just might be the most important to this discussion. For what everyone seems to be missing as they defend HFT as the great market liquidity engine, that so-called “liquidity” more often than not is fake. So I ask: Is fake now acceptable in the financial markets? For if that’s true: Bernie Madoff might be looking for his get out of jail card.

We have laws on the books to protect the markets from people trading on inside information, fraud, and more. People get arrested and perp walked in front of the media as to make examples to show, “This can happen too you!” Yet, if machines are doing the same in an equivalent manner, that’s OK. For this is technology we’re talking here, and we all know without technology, the markets are nothing more than the pits. (pun intended)

Sometimes complicated issues have to be reduced to their smallest form to get an indication on whether or not something is good, bad, or indifferent. And once one reduces this all down to just basic common sense, you don’t need a supercomputer spinning algorithms near the speed of light to come up with the obvious answer of – Duh!

When someone within the financial markets comes across information that is deemed “confidential” then uses that information as to front run said information and profit by it, we throw them in jail for insider trading.

If a machine can detect you placing an order then within nanoseconds execute buy and sell orders throughout the exchanges as to skim a piece or to push markets in a beneficial direction to enrich itself. That’s fine. Are you kidding me?

Since when is it “legal” to insert oneself into a transaction they had no business being involved in? That is not “facilitating” that’s fraudulent skimming, for that “inserted freeloader” was not needed to transact. That’s front running pure and simple. And like I said earlier we perp walk people for that. But an HFT? Nope, that’s now looked upon as “improving liquidity” by the so-called “smart crowd.” Simply jaw dropping in my view.

Add to this the insane notion that these HFT outlets are providing, “deep markets.” Again, I’ll ask, what are we talking about here? Real buyers? Or, the illusion of real buyers? For if anyone remembers, the “Flash Crash” showed everyone just how real and deep the markets were.

All those quotes of illusive bids and ask were anything but illusive: they were illusions. The term “quote stuffing” and its consequences were first highlighted there. Now, it’s as if it never happened or better yet, is defended in an “ancient history” type dismissal.

Ancient history or not, if someone were to set up shop selling land deals at bargain prices touting that the demand was high and pointed to the surrounding landscape pointing out the row upon row of newly constructed facades as proof, you might think or find comfort in the notion, “Well if I need to sell there’s a chance I might find a buyer.”

Then you walked over unbeknownst to find all those freshly constructed home facades were just that – facades resembling a Hollywood movie set. Then what would you think? I know what one should be thinking: “How do I contact the authorities? These people need to be put in jail!”

But if it’s a machine rendering a “virtual reality” showing demands of large bids or asks in any given instrument that’s OK, they’re providing a valuable service to the community showing what it could be like if there were real buyers and sellers I guess. Just don’t think of ever trying to sell or buy one of them, for they disappear faster than a snake-oil salesman can close up shop.

The only good thing that has come out lately on this whole issue of HFT is maybe for the first time in years the cover has been thrown off exposing the parasitic beast that’s been living just beneath the surface passing itself off as a symbiotic entity, rather than the pernicious monster its grown to be.

Now the only question left to ask is: Can they invoke the death penalty for this creature…

Without killing the patient?

On one hand CNBC does its darnedest to refute Michael Lewis' claim that markets are rigged (even if it woefully does so by showcasing the most clueless "defenders" it can afford), and yet on the other "mom and pop's" preferred retail broker Charles Schwab, just came out and slammed HFT as a "growing cancer that needs to be addressed." Hmmm.... who to believe?

From Charles Schwab:

High Frequency Trading (HFT) covers such a broad swathe of 'trading' and financial markets that Mark Cuban (yes, that Mark Cuban), who has been among the leading anti-HFT graft voices in the public realm, decided to put finger-to-keyboard to create an "idiots guide to HFT" as a starting point for broad discussion. With screens full of desperate "stocks aren't rigged" HFT defenders seemingly most confused about what HFT is and does, perhaps instead of 'idiots' a better term would be "practitioners."

Via Blog Maverick,

First, let me say what you read here is going to be wrong in several ways.  HFT covers such a wide path of trading that different parties participate or are impacted in different ways. I wanted to put this out there as a starting point . Hopefully the comments will help further educate us all

1.  Electronic trading is part of HFT, but not all electronic trading is high frequency trading.

Trading equities and other financial instruments has been around for a long time.  it is Electronic Trading that has lead to far smaller spreads and lower actual trading costs from your broker.  Very often HFT companies take credit for reducing spreads. They did not. Electronic trading did.

We all trade electronically now. It’s no big deal

2. Speed is not a problem

People like to look at the speed of trading as the problem. It is not. We have had a need for speed since the first stock quotes were communicated cross country via telegraph. The search for speed has been never ending. While i dont think co location and sub second trading adds value to the market, it does NOT create problems for the market

3. There has always been a delta in speed of trading.

From the days of the aforementioned telegraph to sub milisecond trading not everyone has traded at the same speed.  You may trade stocks on a 100mbs broadband connection that is faster than your neighbors dial up connection. That delta in speed gives you faster information to news, information, research, getting quotes and getting your trades to your broker faster.

The same applies to brokers, banks and HFT. THey compete to get the fastest possible speed. Again the speed is not a problem.

4. So what has changed ? What is the problem

What has changed is this. In the past people used their speed advantages to trade their own portfolios. They knew they had an advantage with faster information or placing of trades and they used it to buy and own stocks. If only for hours. That is acceptable. The market is very darwinian. If you were able to figure out how to leverage the speed to buy and sell stocks that you took ownership of , more power to you. If you day traded  in 1999 because you could see movement in stocks faster than the guy on dial up, and you made money. More power to you.

What changed is that the exchanges both delivered information faster to those who paid for the right AND ALSO gave them the ability via order types where the faster traders were guaranteed the right to jump in front of all those who were slower (Traders feel free to challenge me on this) . Not only that , they were able to use algorithms to see activity and/or directly see quotes from all those who were even milliseconds slower.

With these changes the fastest players were now able to make money simply because they were the fastest traders.  They didn’t care what they traded. They realized they could make money on what is called Latency Arbitrage.  You make money by being the fastest and taking advantage of slower traders.

It didn’t matter what exchanges the trades were on, or if they were across exchanges. If they were faster and were able to see or anticipate the slower trades they could profit from it.

This is where the problems start.

If you have the fastest access to information and the exchanges have given you incentives to jump in front of those users and make trades by paying you for any volume you create (maker/taker), then you can use that combination to make trades that you are pretty much GUARANTEED TO MAKE A PROFIT on.

[ZH:

And here is Nanex with the clearest example of just what the difference between the 'slow' consolidated SIP feed (that BATS CEO lied about using) and fast 'Direct' feed (that BATS actually uses enabling HFT to skim as seen below) means...

The trade time-stamps in the consolidated feed are not the original time-stamps shown in expensive direct feeds used by High Frequency Traders (HFT). The time-stamps are getting replaced right before they are transmitted to subscribers from the SIP (security information processor, which creates the consolidated feed). This means direct feed subscribers are getting more accurate core market data than consolidated subscribers: a direct Reg NMS violation.

 

 

The loss of original time-stamps makes it difficult to reconstruct accurate audit trails or make comparisons to quote data. It also renders any computations based on trade data (e.g. charts, technical analysis) inaccurate.

 

We matched a few seconds of SPY trades on June 3, 2013 from a direct feed (Edge-X) to the same trades from the consolidated feed. In the selection shown in the image on the right, the first trade (163.21 and 400 shares) has a time-stamp of 10:00:00.013 in the direct feed and a time-stamp of 10:00:00.243 in the consolidated feed, a difference of 230 milliseconds!

 

Download the complete list (pdf).

 

See this paper for more charts and data on this event.

Ironic that the two versions of the same reality are "blue" and "red" in this chart... which pill will you swallow?]

So basically, the fastest players, who have spent billions of dollars in aggregate to get the fastest possible access are using that speed to jump to the front of the trading line. They get to see , either directly or algorithmically the trades that are coming in to the market.

When I say algorithmically, it means that firms are using their speed and their brainpower to take as many data points as they can use to predict what trades will happen next.  This isn’t easy to do.  It is very hard. It takes very smart people. If you create winning algorithms that can anticipate/predict what will happen in the next milliseconds in markets/equities, you will make millions of dollars a year. (Note:not all algorithms are bad.  Algorithms are just functions. What matters is what their intent is and how they are used)

These algorithms take any number of data points to direct where and what to buy and sell and they do it as quickly as they can. Speed of processing is also an issue. To the point that there are specialty CPUs being used to process instruction sets.  In simple terms, as fast as we possibly can, if we think this is going to happen, then do that.

The output of the algorithms , the This Then That creates the trade (again this is a simplification, im open to better examples) which creates a profit of  some relatively  small amount. When you do this millions of times a day, that totals up to real money . IMHO, this is the definition of High Frequency Trading.  Taking advantage of an advantage in speed and algorithmic processing to jump in front of trades from slower market participants  to create small guaranteed wins millions of times a day.  A High Frequency of Trades is required to make money.

There in lies the problem. This is where the game is rigged.

If you know that by getting to the front of the line  you are able to see or anticipate some material number of  the trades that are about to happen, you are GUARANTEED to make a profit.  What is the definition of a rigged market ? When you are guaranteed to make a profit. In casino terms, the trader who owns the front of the line is the house. The house always wins.

So when Michael Lewis and others talk about the stock market being rigged, this is what they are talking about.  You can’t say the ENTIRE stock market is rigged, but you can say that for those equities/indexs where HFT plays, the game is rigged so that the fastest,smart players are guaranteed to make money.

6. Is this bad for individual investors ?

If you buy and sell stocks, why should you care if someone takes advantage of their investment in speed to make a few pennies from you  ?  You decide, but here is what you need to know:

a. Billions of dollars has been spent to get to the front of the line.  All of those traders who invested in speed and expensive algorithm writers need to get a return on their investment.  They do so by jumping in front of your trade and scalping just a little bit.  What would happen if they weren’t there ? There is a good chance that whatever profit they made by jumping in front of your trade would go to you or your broker/banker.

b. If you trade in small stocks, this doesn’t impact small stock trades.  HFT doesn’t deal with low volume stocks. By definition they need to do a High Frequency of Trades. If the stocks you buy or sell don’t have volume (i dont know what the minimum amount of volume is), then they aren’t messing with your stocks

c. Is this a problem of ethics to you and other investors ? If you believe that investors will turn away from the market because they feel that it is ethically wrong for any part of the market to offer a select few participants a guaranteed way to make money, then it could create significant out flows of investors cash which could impact your net worth. IMHO, this is why Schwab and other brokers that deal with retail investors are concerned. They could use customers.

7.  Are There Systemic Risks That Result From All of This.

The simple answer is that I personally believe that without question the answer is YES. Why ?

If you know that a game is rigged AND that it is LEGAL to participate in this rigged game, would you do everything possible to participate if you could ?

Of course you would.  But this isn’t a new phenomena.  The battle to capture all of this guaranteed money has been going on for several years now. And what has happened is very darwinian.  The smarter players have risen to the top. They are capturing much of the loot.  It truly is an arms race.  More speed gives you more slots at the front of the lines. So more money is being spent on speed.

Money is also being spent on algorithms.  You need the best and brightest in order to write algorithms that make you money.  You also need to know how to influence markets in order to give your algorithms the best chance to succeed.  There is a problem in the markets known as quote stuffing. This is where HFT create quotes that are supposed to trick other algorithms , traders, investors into believing their is a true order available to be hit. In reality those are not real orders. They are decoys. Rather than letting anyone hit the order, because they are faster than everyone else, they can see your intent to hit the order or your reaction either directly or algorithmically to the quote and take action. And not only that, it creates such a huge volume of information flow that it makes it more expensive for everyone else to process that information, which in turn slows them down and puts them further at a disadvantage.

IMHO, this isn’t fair.  It isn’t a real intent. At it’s heart it is a FRAUD ON THE MARKET.  There was never an intent to execute a trade. It is there merely to deceive.

But Order Stuffing is not the only problem.

Everyone in the HFT business wants to get to the front of the line. THey want that guaranteed money. In order to get there HFT not only uses speed, but they use algorithms and other tools (feel free to provide more info here HFT folks) to try to influence other algorithms.  It takes a certain amount of arrogance to be good at HFT. If you think you can out think other HFT firms you are going to try to trick them into taking actions that cause their algorithms to not trade or to make bad trades. It’s analogous to great poker players vs the rest of us.

What we don’t know is just how far afield HFT firms and their algorithms will go to get to the front of the line.  There is a  moral hazard involved.  Will they take risks knowing that if they fail they may lose their money but the results could also have systemic implications ?.  We saw what happened with the Flash Crash.  Is there any way we can prevent the same thing from happening again ? I don’t think so. Is it possible that something far worse could happen ? I have no idea.  And neither does anyone else

It is this lack of ability to quantify risks that creates a huge cost for all of us.  Warren Buffet called derivatives weapons of mass destruction because he had and has no idea what the potential negative impact of a bad actor could be. The same problem applies with HFT. How do we pay for that risk ? And when ?

When you have HFT algorithms fighting to get to the front of the line to get that guaranteed money , who knows to what extent they will take risks and what they impact will be not only on our US Equities Markets, but also currencies, foreign markets and ? ? ?

What about what HFT players are doing right now outside of US markets ? All markets are correlated at some level.  Problems outside the US could create huge problems for us here.

IMHO, there are real systemic issues at play.

8. So Why are some of the Big Banks and  Funds not screaming bloody murder ? 

To use a black jack analogy , its because they know how to count cards.  They have the resources to figure out how to match the fastest HFT firms in their trading speeds.  They can afford to buy the speed or they can partner with those that can.  They also have the brainpower to figure out generically how the algorithms work and where they are scalping their profits. By knowing this they can avoid it.  And because they have the brain power to figure this out, they can actually use HFT to their advantage from time to time.  Where they can see HFT at work, they can feed them trades which provides some real liquidity as opposed to volume.

The next point of course is that if the big guys can do it , and the little guys can let the big guys manage their money , shouldn’t we all just shut up and work with them ? Of course not.  We shouldn’t have to invest with only the biggest firms to avoid some of the risks of HFT.  We should be able to make our decisions as investors to work with those that give us the best support in making investments. Not those who have the best solution to outsmarting HFT.

But more importantly, even the biggest and smartest of traders , those who can see and anticipate the HFT firms actions can’t account for the actions of bad actors. They can’t keep up with the arms race to get to the front of the line. Its not their core competency.  It is a problem for them, but they also know that by being able to deal with it better than their peers, it gives them a selling advantage. “We can deal with HFT no problem”.  So they aren’t screaming bloody murder.

9. So My Conclusion ? 

IMHO, it’s not worth the risk.   I know why there is HFT. I just don’t see why we let it continue. It adds no value. But if it does continue, then we should require that all ALGORITHMIC players to register their Algorithms.  While I’m not a fan of the SEC, they do have smart players at their market structure group.  (the value of going to SEC Speaks :).  While having copies of the algorithms locked up at the SEC wont prevent a market collapse/meltdown, at least we can reverse engineer it if it happens.

I know this sounds stupid on its face. Reverse engineer a collapse ? But that may be a better solution than expecting the SEC to figure out how to regulate and pre empt a market crash

10…FINAL FINAL THOUGHTS

I wrote this in about 2 hours. Not because i thought it would be definitive or correct. I expect to get ABSOLUTELY CRUSHED on many points here. But there is so little knowledge and understanding of what is going on with HFT, that I believed that someone needed to start the conversation

On Monday, in "High Frequency Trading: Why Now And What Happens Next" we predicted that "the high freaks are about to become the most convenient, and "misunderstood" scapegoat, for when the market finally does crash. Which means that those HFT-associated terms which very few recognize now, especially those on either side of the pro/anti-HFT debate who have very strong opinions but zero factual grasp of the matter, such as the following...

• Frontrunning: needs no explanation
• Subpennying: providing a "better" bid or offer in a fraction of penny to force the underlying order to move up or down.
• Quote Stuffing: the HFT trader sends huge numbers of orders and cancels
• Layering: multiple, large orders are placed passively with the goal of “pushing” the book away
• Order Book Fade: lightning-fast reactions to news and order book pressure lead to disappearing liquidity
• Momentum ignition: an HFT trader detects a large order targeting a percentage of volume, and front-runs it.

... will become part of the daily jargon as the anti-HFT wave sweeps through the land."

Of course, another name for "layering" is "spoofing" which is precisely the term that the SEC used today when it announced that it charged the owner of a New Jersey-based trading firm and several other defendants "in a scheme to manipulate the market through an illegal practice known as "spoofing."

From Reuters:

The Securities and Exchange Commission said that Joseph Dondero, a co-owner of Visionary Trading LLC, as well as several other owners and a New York-based brokerage firm called Lightspeed Trading LLC will collectively pay $3 million to settle the charges.

 

Spoofing involves a trader placing orders without the intention of having them executed, a strategy that tricks people into buying or selling stock at artificial prices.

 

Reuters reported earlier this week that the FBI is also investigating the practice of spoofing more broadly in a probe into high-speed trading.

The SEC was kind enough to step away from the porn for a minute for the following soundbite:

"The fair and efficient functioning of the markets requires that prices of securities reflect genuine supply and demand," said Sanjay Wadhwa, a senior associate director of the SEC's New York regional office.

 

"Traders who pervert these natural forces by engaging in layering or some other form of manipulative trading invite close scrutiny from the SEC."

 

The SEC's case comes just days after the FBI and the Commodity Futures Trading Commission each said they were looking more broadly into the practice of spoofing, as part of a wide-ranging investigation into strategies that may be deployed by high-frequency traders.

One HFTer down, millions of vacuum tubes to go:

Dondero has agreed to settle the charges, pay more than $1.9 million, and be barred from the securities industry.

So is this getting clearer now? Yes: precisely those same "strategies" so pervasively used by HFTs, because Virtu didn't have a 99.9% successful trading history in the past four years from "providing liquidity", and which the SEC had no problems condoning as long as the market was going higher, are suddenly being frowned upon, and HFTs are starting to finally feel the wrath of the regulator. But that will be nothing compared to the wrath of the general public, which just like the CEO of BATS has zero understanding of how HFT actually works, when the upcoming market crash is blamed not on the Fed but on 25 year old math PhDs who "trade" and whose lobbying cash at the SEC no longer works now that almighty Goldman has finally turned its back on the high freaks.

Just as we predicted would happen.

And just as a reference so readers can get a sense of the "valuable services" a company like Lightspeed "Our trading software gives you access to real-time quotes and executions faster than ever before" Trading provide, here is an entry from their blog titled, "Ways to Trade the Twitter IPO."

With the huge popularity and notoriety of the name, it is unlikely that many active traders will get their hands on shares at the offering price, but is there a way to trade this stock once it opens to the public? Some are easy, others aren’t likely to be available to you, but here some potential plays.

 

Stay Long

 

The same thesis for going short also works for going long. Especially if the stock doesn’t make a huge jump at the open and appears to be slowly moving higher, going long for the day or longer could be a lucrative play. Just as the outsized volatility could work in your favor in a short position, it could also work as a long position.

 

No Options Available

 

Each exchange determines how soon options will be available on an IPO. For a stock as large and public as Twitter, it’s likely to be fast – as quick as a week but that doesn’t help you on the opening day.

 

If shorting and options trading aren’t practical strategies, what can you do?

 

Trade Related Names

 

The popularity of Twitter will bring more attention to the social media space and that could cause a short term move higher in those second derivative plays tied to Twitter. $FB, $LNKD, and Chinese media company $SINA are likely to see buying interest. Go long or use options. Don’t blindly throw money at these names, though. Look at the charts and see if they’re due for a bounce.

With sage advice such as this, is it any wonder the firm had to "spoof" in order to immitate Virtu's trading perfection?

As for "tricking people into buying or selling stock at artificial prices", surely Visionary Trading and Lightspeed Trader are the only cockroaches. Surely.

I didn't start out with much interest in the stock market—though, like most people, I enjoy watching it go boom and crash. When it crashed on October 19, 1987, I happened to be hovering around the fortieth floor of One New York Plaza, the stock market trading and sales department of my then employer, Salomon Brothers. That was interesting. If you ever needed proof that even Wall Street insiders have no idea what's going to happen next on Wall Street, there it was. One moment all is well; the next, the value of the entire U.S. stock market has fallen 22.61 percent, and no one knows why. During the crash, some Wall Street brokers, to avoid the orders their customers wanted to place to sell stocks, simply declined to pick up their phones. It wasn't the first time that Wall Street people had discredited themselves, but this time the authorities responded by changing the rules—making it easier for computers to do the jobs done by those imperfect people. The 1987 stock market crash set in motion a process—weak at first, stronger over the years—that has ended with computers entirely replacing the people.

      - Michael Lewis, Flash Boys

While we welcome the recent surge in attention directed toward high frequency trading courtesy of Goldman's endorsement of what we said in 2009 even if with a 5 years delay (at least Michael Lewis got a book deal out of it), perhaps the biggest irony is that attention is once again completely misdirected.

Judging by the escalation in various probes and investigations by the FBI, the DOJ and, amusingly the SEC, the primary issue under focus is that of whether or not the market is "rigged", i.e., whether HFT is legal or not. Well, of course it is legal! After all that was the whole point of redoing Reg NMS in 2005 - so those who would soon become HFT billionaires and the financial backers of the HFT lobby, would get a stamp of approval by the various regulators and legislators, completely clueless about what they would usher into the world of trading, and thus a green light to engage in riskless frontrunning of orderflow. Frontrunning which scalps pennies and subpennies, billions and billions of times.

The red herring was also planted: "we provide liquidity", the 'Flash boys' screamed when we first shone a light on their practices in 2009, and are still screaming now that the entire world is looking at them, adding that only thanks to HFT have trade commissions collapsed to record lows, so it must be wonderful for the retail investors, right.

Wrong. Because not only does HFT not provide liquidity when it merely frontruns big order blocks, and all the other time churns hollow quotes with zero intention to execute but merely gauges how all the other HFT algos in the market operate leading to an unprecedented explosion in quote stuffing, layering and churn which together with the complete inability of HFT to provide real liquidity - or take prop risk with limit orders against the trend when there is no bid block to fruntrun - was also the reason for the May 2010 flash crash when the market literally went bidless for several seconds, but the reason why trading has gotten so cheap is that indicated HFT liquidity is a mirage with zero order book depth: something all the major institutions have realized and have long since moved to dark pools when intending to trade large orders.

In fact, the only reason the bid/ask spread has collapsed as much as it has, is because the retail investor is the last hope of the dying "lit" (and rigged) markets, which have nearly cannibalized themselves out of all profitability if not existence (there is a reason why there has been an unprecedented surge in exchange M&A in the past three years), and exchanges are hoping to make up in volume ("oh look how cheap trading has become") what they will never regain in hefty fees. To be sure, commission-free stock trading is coming next in the last desperate attempt to lure the retail sucker who still hopes to "get rich quick" despite a rigged market. Of course, this simply means that equities will soon join the world of FX and bond traders, where there are no commissions, but simply a bid/ask spread. Perhaps we should look to the certifiably rigged FX market to see what a bang up job HFT has done in "lowering transaction costs" there too?

Which brings us to the topic at hand, because it is not whether or not frontrunning by HFTs is legal - it certainly is based on current laws - but what the trade off is to a market in which, as Michael Lewis correctly observes, computers have entirely replaced the people.

The answer is simple - unprecedented fragmentation and instability: a market that is not only rigged, but far worse: completely broken.

• It is this that should be the focus of regulators, legislators and enforcers, sadly of whom are part of the rigged market spiel. 
• It is this that we explained, showing empirical evidence, in July of 2010 is the basis of why the flash crash of May 2010 occurred, in "Scientific Proof That High Frequency Trading Induces Adverse Changes In Market Microstructure And Dynamics, And Puts Market Fairness Under Question"... An HFT-driven flash crash that we predicted, correctly, would happen in April of 2009.
• But most ironic, is that it was this that none other than Shearson Lehman Hutton warned would happen in January 1988, just months after the Black Monday market crash so deftly described by Michael Lewis' up top. 

Irony points that it was the same Shearson that was making millions with "program trading" when everyone was enjoying the ride up and only saw it fit to "warn" about electronic trading after the event that saw a quarter of the entire market cap wiped out in hours (sorry HFT - you too will be the scapegoat after the next crash, as we laid out previously).

Double irony bonus points that it is this same Shearson Lehman Hutton whose well-known spin off would, some 20 years later, nearly cause the end of western civilization as Hank Paulson's 3-page term sheet knows it.

Triple irony, of course, is reserved for the fact that it is now none other than Goldman Sachs which is stepping into the shoes of Shearson Lehman and warning the world about the dangers that are looming unless market structure isn't promptly overhauled.

h/t @Dvolatility