LONDON (Reuters) - It’s a debate that has raged in other parts of the financial universe for years.
But it’s only this year that the issue of high-frequency trading (HFT) has burst into acrimonious bloom in the closeted world that is the London Metal Exchange (LME).
Mike Farmer, titular Lord and legendary lord of the copper market, pulled no punches when he addressed the great and the good of the metals market at the LME’s annual black-tie dinner last month.
High-frequency trading, “appears to have no other purpose than to make money from the trading of other participants by jumping ahead of them.”
It might even, Farmer said, “be described as front running.”
Whoa! That’s illegal, isn’t it? How could the LME tolerate that?
And what is high-frequency trading anyway and how come it’s become such a hot topic in the mundane old world of industrial metals trading?
To understand HFT means seeing the market through robotic rather than human eyes.
Take copper as an example.
This is how we humans tend to see the market, expressed as daily price action: tmsnrt.rs/2gRe1kP
We can add moving averages and draw trend lines to help us “see” better. We don’t physically have to calculate the averages or actually “draw” our explanatory lines any more. A machine, ironically, does that for us with a few strokes of our computer keyboards.
Now put on your robot glasses and look again. This is the copper market broken down into one second intervals over a 15-minute period: tmsnrt.rs/2hEErmK
Looks very different doesn’t it?
But you’re still not seeing fast enough.
Try this snapshot of copper trades taken on Nov. 28 at 07:58 in the London morning over a 5-second period:
See the 13 lots (325 tonnes) traded within 10 milliseconds between 7:58:04:945 and 7:58:04:955? And the 9 lots (225 tonnes) traded within a single millisecond at 7:58:05:026?
You’re still not quite fast enough since the ticker machine only provides a three-decimal breakdown and you’re only seeing the outcome of an even faster interplay of bids and offers.
But you’re getting there.
Those last two graphics were taken from the LME’s electronic Select trading feed.
Remember that the LME still also trades over the phone and, outlandishly in this day and age, via open outcry.
And since no-one has, yet at least, fielded an android to participate in the ring sessions, the human element of trading is still far stronger in this particular market than in others.
The LME doesn’t provide figures for what percentage of trading is conducted by high-frequency traders but it does for the ratio of volume traded electronically. Select accounted for an average of 40.8 percent of copper trading over the May-November period and only a subset of that would have been machine trading, let alone pure HFT.
Other markets have higher robotic participation. “Automated trading” on the CME’s copper contract, for example, represented 49.2 percent of volume over the Nov 2012-Oct 2014 period, according to a study by the CFTC. (“Automated trading in future markets,” March 13, 2015).
The LME, moreover, has refused to join the arms race for ever faster speed. Unlike other exchanges, it doesn’t make money from co-hosting, which means charging participants for putting their servers right next to an exchange’s matching engine.
You can put your server in the same Interxion data center in Shoreditch in London but for a high-frequency trader such “proximity hosting” represents a physical speed cap on signal times.
And you can’t go warp speed in terms of making bids and offers either. The LME has a 50-to-1 limit on order-to-trade volumes for machine quoters, defined as those submitting over 50,000 “order actions” in a trading day.
OK, there’s still a lot of machine trading going on. But what are the robots actually up to?
All sorts of things, it turns out.
They can be arbitraging other markets, such as CME, foreign exchange, the VIX or any other financial instrument they’re programmed to track.
They can be trading momentum signals generated by other machines. They can now even be trading news headlines.
Everything a human can do, just at much faster speeds with their robot eyes.
Much of their work, though, is simply executing orders against other market-making programs.
And it’s these last ones that really annoy the humans.
The machines, to quote Lord Farmer, “have a nano-second advantage over other users and can jump in front of incoming orders in the market” with the effect that “the orders behind them buy at higher prices or sell at lower prices than would have otherwise been the case.”
This, to human eyes, looks like front-running.
But it’s not.
Front-running, and there was no shortage of egregious examples in the pre-machine days, means a broker trading in front of his customer, particularly if that customer has a large order to place. In other words, the broker has information that only he knows and uses that edge to make some money for himself to the disadvantage of his own customer.
HFT doesn’t work like that. An algorithm doesn’t know anything until it “sees” a bid or an offer in the market. Its edge is first and foremost its speed of reaction time.
At the heart of this moral maze is the simple fact that the customer always wants to get the best bid or ask from a market-maker who also has to make money from the trade.
That’s always been the case.
In the old days, traders such as Lord Farmer would have used subterfuge to disguise their intentions in the market.
Had a trader announced to the LME ring that he was a buyer of 5,000 tonnes of copper, he would surely not have been surprised to find all offers to sell mysteriously evaporate. So he didn‘t.
Electronic trading is no different.
All that has changed is the way machines play poker with other machines.
The tools are not just speed but also intelligence with both sides of the liquidity battle-ground evolving ever more sophisticated algos to read the other side’s intention.
But you need robotic eyes to see the game.
Machine trading came to the LME metals world as soon as the exchange turned on its Select system back at the turn of the century.
And short of uninventing computers or prohibiting any sort of non-manual trading, it’s going to be around until further notice.
As one LME broker summed it up, complaining about automated trading is like the man using the telegraph complaining that the man with the telephone gets his market information faster. “Just buy a phone!”
Of course developing your own machines and, even more critically, the knowledge to program them, comes at a price.
There again, if the metals men don’t want to pay that price, they could always pick up the phone and call a broker to place their order.
The LME still works like that.
It’s just you won’t get the same fractional bid-ask spread from a human as you would a robot.
Trading’s like that. It’s not free. And it never has been.
(The opinions expressed here are those of the author, a columnist for Reuters.)
Editing by David Evans