Submitted by Tyler Durden: Courtesy of the author, we present to our readers the following excerpt from Dark Pools: High-Speed Traders, AI Bandits, and the Threat to the Global Financial System, by Scott Patterson, author of The Quants.
In early December 2009, Haim Bodek finally solved the riddle of the
stock-trading problem that was killing Trading Machines, the
high-frequency firm he’d help launch in 2007. The former Goldman Sachs
and UBS trader was attending a party in New York City sponsored by a
computer-driven trading venue. He’d been complaining for months to the
venue about all the bad trades—the runaway prices, the fees—that were
bleeding his firm dry. But he’d gotten little help.
At the bar, he cornered a representative of the firm and pushed for
answers. The rep asked Bodek what order types he’d been using to buy and
sell stocks. Bodek told him Trading Machines used limit orders.
The rep smirked and took a sip of his drink. “You can’t use those,” he told Bodek.
“Why not?”
“You have to use other orders. Those limit orders are going to get run over.”
“But that’s what everyone uses,” Bodek said, incredulous. “That’s what Schwab uses.”
“I know. You shouldn’t.”
As the rep started to explain undocumented features about how limit
orders were treated inside the venue’s matching engine, Bodek started to
scribble an order on a napkin, detailing how it worked. “You’re fucked
in that case?” he said, shoving the napkin at the guy.
“Yeah.”
He scribbled another. “You’re fucked in that case?” “Yeah.”
“Are you telling me you’re fucked in every case?” “Yeah.”
“Why are you telling me this?”
“We want you to turn us back on again,” the rep replied. “You see, you don’t have a bug.”
Bodek’s jaw dropped. He’d suspected something was going on in- side
the market that was killing his trades, that it wasn’t a bug, but it had
been only a vague suspicion with little proof.
“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.
The special order types that gave Bodek the most trouble—the kind the
trading-venue rep told him about—allowed high-frequency traders to post
orders that remained hidden at a specific price point at the front of
the trading queue when the market was moving, while at the same time
pushing other traders back. Even as the market ticked up and down, the
order wouldn’t move. It was locked and hidden. It was dark. This got
around the problem of reshuffling and rerouting. The sitting-duck limit
orders, meanwhile, lost their priority in the queue when the market
shifted, even as the special orders maintained their priority.
Why would the high-speed firms wish to do this? Maker-taker fees that
generate billions in revenue for the speed Bots every year. By staying
at the front of the queue and hidden as the market shifted, the firm
could place orders that, time and again, were paid the fee. Other
traders had no way of knowing that the orders were there. Over and over
again, their orders stepped on the hidden trades, which acted
effectively as an invisible trap that made other firms pay the “take”
fee.
It was fiendishly complex. The order types were pinned to a specific
price, such as $20.05, and were hidden from the rest of the market until
the stock hit that price. As the orders shifted around in the queue,
the trap was set and the orders pounced. In ways, the venue had created a
dark pool inside the lit pool.
“You’re totally screwed unless you do that,” the rep at the bar said.
Bodek was astonished—and outraged. He’d been complaining for months
about the bad executions he’d been getting, and had been told nothing
about the hidden properties of the order types until he’d punished the
it by reducing the flow he send to it. He was certain they’d known the
answer all along. But they couldn’t tell everyone—because if everyone
started using the abusive order types, no one would use limit orders,
the food the new order types fed on.
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.
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