Dingbat Kabuki and other structural market hacks

When I first started puppetmaster trading, one of my dearest friends, a Yale-educated economist and professor of same, asked me an important question.  He asked:

In the markets, there are always ‘insiders’ who have the ability to trade on knowledge that you can’t know or with an advantage that you can’t have.  How are you going to compete with these players?

I provided a variety of answers, but at the time my conception of the universe of people with both inside knowledge and the ability to trade on it was limited to cases like that of Mr Rajaratnam.  I believed that cases like these were constrained by clear laws that were duly surveilled and prosecuted by the appropriate authorities.  The problem seemed like a very real one, but constrained in size and not essential to my enterprise.  I still hope that my belief of the time was true, but since then I’ve certainly understood that there’s more than one way to hack the market.

For some, a market hack might consist of some kind of simple (or complex) algorithm(s) applied to some set of markets.  But this really isn’t a hack so much as it’s a trading strategy – like many that have long existed – only that it’s now implemented in software where originally it would have been implemented in wetware.  While implementing trading strategies in software does open up new vistas in terms of the kinds of strategies that you can look to implement – computers are faster than people by a noteworthy amount in many tasks – but, for the most part, you’re really still just trading and when you take on positions, you are still bearing risk.  You might be ‘hacking’ but it’s really not a market hack as I’ve come to appreciate.

hack the market structure

Another area where my perspective has changed substantively since those halcyon days of ‘05 is my appreciation for market (micro) structure.  In futures, market structure is pretty plain as most contracts are effectively monopolies run by their listing exchanges.  There are a few cases of instruments which are tradable across markets, but a rich market microstructure is just not a core identifying characteristic for futures like it is in the fragmented and incredibly dynamic and quickly developing world of equities.  So, while there are some dozens of futures exchanges scattered about the globe, as a futures trader, routing algorithms just don’t enter the picture except in limited and relatively simple cases.

If I have a view on or a hedging need for interest rates that I see effectively expressed through futures, then I go to e.g. the cme and I don’t need to worry my pretty head about getting a great execution because the exchange is in one place and it’s all lit up and filled to the brim with liquidity.  Easy peasy.  But if I have a view on, say, General Electric that I want to express with an equity position and I’m trading in sufficient size or sufficiently close to the market that I really want to ensure best execution, then I might find the need to look around some dozens of lit exchanges and maybe even ping about in a dark pool or twelve.  This is decidedly not easy peasy and is one of the reasons wall st has an insatiable hunger for propeller heads with advanced degrees in seemingly unrelated fields.

Last summer’s brouhaha about ‘flash’ orders first illuminated for many a rich ground for genuine market hacks: the incredibly dynamic terrain of equity market micro structure which changes almost daily with the emergence of new exchanges, ATSes, order types, rebates and pricing structures and all of the many other critical minutia that differentiate the many venues.  Some of these undoubtedly provide meaningful and important services; contrary to populist inclination, dark pools are largely a defense against frothy HF trading strategies.

But the concern (if perhaps not all of the attention) is merited.   Equity microstructural ‘rules’ change so quickly that even independent and upright regulators could hardly be expected to keep up.  This is clearly fertile ground for genuine – if perhaps fleeting – market hacks.

steganography and hacking the market

What characteristics make equity market structure a fertile ground for these kinds of genuine market hacks which I’m describing?  I think the main answer is to be found in the ancient art of steganography – hiding in plain site.  Everything about equity market microstructure is public.  All of the rules for each of the venues are available to the people who might make use of them.  Unraveling what they imply about where you should be executing for any given order is the tricky bit which is hardly revealed through a simple reading of all of the various rules.

Where else do we see this phenomenon?  The US Tax code comes to mind (sort of like the iPhone: “there’s a loophole for that”).  The 2,000 page health care bill comes to mind.  Everybody seems to care about health care, but who’s actually read that bill?  Who could?

Totally public yet it may as well be encrypted.  Steganography.

Elizabeth Warren has also made this observation in the context of contracts made between banks and their retail clientele.  Noted scholar Scott Adams dubbed it a ‘confusopoly.’

a group of companies with similar products who intentionally confuse customers instead of competing on price

So, could people hack the tax code?  Hank and I think so.  So do my friends in the lobbying business.  How about all those recently converted bank holding companies – hack much?  In my last post we read one insider’s view that Madoff had effectively hacked the SEC… perhaps regulatory organizations themselves are also hackable instruments!  How about that health care bill?  …

misdirecting the hack

A lot of attention has focused recently on exchange traded markets and people are up in arms about HF traders and proprietary trading.  I’ve argued before that this appears to be a great ploy to take attention away from the real issues at hand; in the worst case, HFT improprieties might account for no more than 1% of the money disappeared in the last few years as part of the so-called ‘credit crisis’.  It’s easy for non-finance-professionals not to understand that the big bad wolves of the credit crisis essentially all happened off market in essentially unregulated multi-trillion dollar otc markets of ingeniously engineered structured products. These are the real market hackers.  Exchange traded instruments had effectively nothing to do with our current circumstances but remain a convenient scapegoat.

Some argue persuasively that there are fundamental, structural market hacks at the very foundations of our financial system.  I wouldn’t know.  But it is the kind of thing one might think about while watching the highly stylized performance of our leaders last night.

dingbat kabuki and the transparent market hack

To my knowledge, Cal’s (go bears!) Professor Brad DeLong coined the term ‘dingbat kabuki’ back in 2005 in shrill response to a Washington Post article.  He reprised the term this week in response to the latest bit of macroeconomic genius out of washington.  What an inspired phrase.  Yesterday at 2:30 and last night at 9pm the markets voiced their applause and cheered on the performance.

Indeed, it is masterful.

–

A technical note about this post.  While writing it, I seem to have accidentally published it at some point and then realized the error and ‘unpublished’ it.  I apologize if this had any untoward effects on you or your RSS reader.

But some are revealing and one in particular is 100% required reading for anyone interested in electronic markets.

The writer introduces himself thusly:

I am Steve Wunsch, the principal inventor of two SEC‐regulated stock exchanges, the Arizona Stock Exchange “AZX” (originally called Wunsch Auction Systems, Inc. “WASI”) and the ISE Stock Exchange, both of which include dark pools. In fact, both of them, like all modern stock exchanges, have both lit and dark components and, thus, have provided me with potentially useful perspective on the dark pool question and on transparency in general. I will focus heavily on the latter, for it is impossible to understand the dark pool issues raised without understanding the value of transparency or, if improperly applied, the lack thereof. The AZX experience was, I believe, particularly instructive in this regard. Its highly transparent call market structure, combined with its unique regulatory status as a “low volume exempt”exchange, enabled me to see transparency and the role of regulation in promoting it from a perspective that I don’t believe anyone else has.

He deftly mixes snark and a historical perspective on regulation with an opinionated and informed view on the forces driving current equity markets’ microstructure arguing that the worst issues are due to regulatory failures.  He concludes, logically enough, that the SEC should be disbanded.  Perhaps his most inflammatory bit is his claim that the “SEC made Madoff.”  For effect, the section is entitled “An American Oligarchy”:

AN AMERICAN OLIGARCHY

It is not in the Commission’s interest to admit failures of policy, such as the ones I have described in this letter, and I have never seen it done. It was not in the Commission’s interest to admit that Bernie Madoff was the SEC’s most trusted and intimate confidante in formulating and selling transparency, electronic trading and
the whole NMS concept to Wall Street, the public and Congress. His legitimate business was the epitome of the kind of transparent electronic competition that NMS’s leveling policies were trying to create, and he occupied the most favored place of all industry advisors on policy and rules as NMS was being created. In a very real and literal sense, Madoff’s legitimate business and NMS were made for each other. NMS cleared a path for the application of continuous transparency by new electronic competitors, very visibly led by Madoff, enabling him to become at one time the third largest market in the United States, even though he wasn’t officially registered as anything but a broker‐dealer.

Had the SEC not emasculated the rules by which the NYSE controlled its members, Madoff would never have happened. In the time before NMS, when the exchange had Rule 390 or the stronger Rule 394 before it, diverting orders away from the floor or selling them to Madoff would have been banned. But on antitrust principles, the SEC wanted to foster NYSE‐busting competition in NMS, and Madoff became its PosterBoy for such competition. In order to make way for him, the SEC opened up a variety of loopholes that allowed orders to be diverted from NYSE to Madoff and printed on regionals like Cincinnati. Rules 19c‐1, 19c‐2 and 19c‐3 were in this vein. There were perennial attempts by the NYSE to plug the loopholes and rein in the membership, but the SEC batted them all away, enabling Madoff to continually grow his business. Eventually, the NMS environment forced the NYSE to abandon Rule 394, then Rule 390 and ultimately its membership organization altogether when it demutualized. This was all very good for Madoff. And Madoff was very good for NMS, giving it industry cred far in excess of what this poorly articulated socialist leveling theory could have had without his support.

In spite of a 457‐page SEC investigation into Madoff and how his Ponzi scheme was missed, the most obvious reasons were not considered, namely, that Madoff played a central role in helping the Commission design and sell NMS, and that NMS made him rich long before the Ponzi scheme. Most importantly, the credibility that theCommission’s collaboration with Madoff on NMS conferred on him was the principal factor enabling him to bring in money for the Ponzi scheme. Although the investigation’s report notes his credibility in the industry, it is mentioned as if itwere just a fact of life and was already there. Not mentioned is that his superior access to the SEC and apparent influence over the Commission, both of which were implicitly proved by his ability to get rich on NMS, are the most important reasons that he had such extraordinary credibility in the industry. The truth is that the SEC made Madoff. He could not have existed as a threat to investors without the Commission’s active and dedicated support over several decades.

Although, in typical blogger fashion, I’ve highlighted his spiciest claim, the rest of the letter is more technical and informative while just as entertaining.  I encourage you to read it and then engage in a thought experiment in which You are the designer of an electronic exchange and must balance the needs of a very heterogeneous set of users and stakeholders while ensuring transparency, liquidity, profitability, “fairness”, performance (he references an exchange targeting 100M executions per second) and utterly fail-safe transactional integrity…

I have embedded the full letter below the break…

messages per second across "all" feeds

I came across this compelling site which uses a hardware-based ticker plant (Exegy) in a colo environment to measure peak bandwidth across scads of NA feeds and then, every minute, updates a chart like the above to capture the average messages/sec across all of them.  Pretty swank.

While the uninformed may rail against colocation rather than focus on less intriguing issues like banana-variety corruption, they miss the basic point that colo can be done by anyone with the checkbook and the wish to do so.

unfair advantage?

It’s sort of like that boat in Forrest Gump.  Forrest wanted to be a shrimper.  So he invested in a boat.  With his initial capital, hard work, perseverance and a bit of luck, Forrest made a go of it.  He might easily have not made it. Colo is like that.  You can shrimp without a boat if you have a mask and fins, but it’s likely not a sustainable model… either way, it’s hard to see the harm in Gump’s boat.  Or colocation.

Hat-tip to Rodrick’s Web Log !! for spotting the market data peaks site.

lemon-law arbitrage?

Derivatives pricing has always been a notoriously complex, computationally expensive and potentially breathtakingly remunerative undertaking.  This is true enough for relatively vanilla, exchange-traded options, but once one goes off-market and starts applying creative financial engineering, it can get much more complicated.  Products like CDOs, CDSs, CDO^2s and their ilk have exploded in recent years creating opaque markets of trillions of notional dollars and accounting complexities we’re still only beginning to understand.

A recent paper, Computational Complexity and Information Asymmetry in Financial Products, by Arora, Barak, Brunnermeier and Ge take things a step or two further as they illustrate using information theory that it may be far worse than imagined as totally undetectable fraud can be engineered into these products.  They show that fraud with these products can be undetectable in the sense that the pricing process is a formally intractable problem when the informational asymmetry inherent in the development of these products is taken into consideration. In this context, “informational asymmetry” is a polite way of saying “fraud.”

The authors, from the Department of Computer Science and Center for Computational Intractability at Princeton (man, I want one of their business cards!), demonstrate that if the designer of, say, a CDO wants to cherry-pick amongst bundled assets to maximize their own return, they can do so in a way such that it would be impossible for a buyer of the derivative to know they were being stiffed.  The problem can be so hard that if you got the NSA’s mythic clusters humming on a pricing model, they might chug away until the sun falls from the sky before they accurately price it…  Co-author Rong Ge provides a FAQ to the paper here and I must hat-tip Andrew Appel for his informative post on the paper.

The “perfect crime” is a puzzle that has occupied the (criminal and otherwise) mind of many a bright and motivated soul from time immemorial.  While some may indulge towards the vulgar or base through violence or vice and others might ponder the perfect crime of passion, the cerebral Queen of Crime is surely some form of regulatory arbitrage: committing the crime for which the law has yet to be written or creatively engineering a legal loophole for a crime one has perpetrated or is about to perpetrate.  The developers of CDOs are to be lauded as it appears they have materially upped the state-of-the-art of the perfect crime.

hmmm… Is there a Nobel for that?

the good news: in the US, we don't stigmatize failure...

Meritocracy is a system of a government or other organization wherein appointments are made and responsibilities assigned based on demonstrated talent and ability (merit)[1], rather than by wealth (plutocracy), family connections (nepotism), class (oligarchy), friendship (cronyism), seniority (gerontocracy), popularity (democracy) or other historical determinants of social position and political power. In a meritocracy, society rewards (by wealth, position, and social status) those who show talent and competence as demonstrated by past actions or by competition.

Steal a little and they call you “thief”… Steal a lot and they call you “King” – Bob Dylan

I try to avoid the news during the trading day.  I never trade manually and as I’ve mentioned before, I’ve never yet had much success trading the news and none of our models presently use news feeds for decision-making.  So I really try to avoid keeping excessively abreast of the news as it’s just a distraction from real work.

would-be king

That said, this morning I noted a pretty good jump in our pre-market p&l and wanted to see what splendid news had prompted the spike.  So I scanned some headlines.

On Bloomberg I saw:

•U.S. Payroll Cuts Slow, Jobless Rate Unexpectedly Falls as Recession Eases

•AIG Reports First Profit in Seven Quarters After Investment Losses Shrink

•Dollar Advances as U.S. Employers Cut Fewer Jobs Than Economists Estimated

Unemployment down?  AIG profitable?  Dollar rumbling to strength?  Splendid, splendid and splendid.

I also saw the bit about Hank Greenberg paying the SEC $15M as he “thought it would be good to get it behind us.”  Indeed, good thinking.

And anyone looking at the news this week knows that regulators are likely going to put the kabosh on flash orders and that Goldman trades profitably.  (And they improve!)

my kind of fat tail

Within a few moments, I’d identified the likely causes for our spike in p&l: optimism.  Thank you, optimists!

My immediate question was answered, but the news about Mr Greenberg stuck with me for a moment.  After all, one of the positions we made some money on this morning was AIG, a firm perhaps as central to our current financial crisis as any could possibly be.  A *personal* $15M fine over accounting um irregularities.  Ouch, that’s gotta hurt.  Could you imagine paying a $15M fine?  “Without admitting wrong-doing.”  Remarkable.  I’d own-up to a fair amount of wrong-doing if it meant saving me $15M.  Of course, if the average American got hit by a $15M fine they’d be bankrupt.  What’s it do to Mr Greenberg?

Last I could find him on the Forbes list of “World’s Richest People” was 2005 when he was ranked #79, weighing-in with a fortune of ~$3.2B.  Of course, it’s been a tough few years and he’s probably taken it on the chin.  How much?  No idea, but for the sake of argument, let’s say he’s down to a lightened but still respectable fortune of ~$1B.

The average American instead has a “fortune” of somewhere between $0 and $1M, according to the FED’s most recent Survey of Consumer Finances.

Hank wins

For the sake of our back-of-the-envelope calculation, we’ll say that the average American family is worth $1M, though this is surely fanciful.  This means that Hank is only about 1000 times richer than our fanciful American family who’s equivalent fine would be $15K.

Now, $15K will get you a beer and more, so I’ll never be the one to spit on $15K, but for a $1M family it is something that will look a lot like an ordinary item on their taxes.  Not fun, but a lot of people would rather part with $15K than pass a kidney stone.  Actually, when you pass a kidney stone in the US you also typically have to cough up something like $15K, but that’s another story altogether..

It’s just not the kind of fine you’d think would be very effective at getting people to not ruin the global economy so they can pocket a few quick billions, thank you very much.  If I know I stand to make billions at the cost of being fined in the millions, I just might spin the wheel.  Not much deterrent there.

So, Hank really didn’t do so badly as all that.

Now that that’s out of the way, regulators can address important items like flash orders, short sellers and high-frequency trading.  Meanwhile, an almost manufactured-looking populist backlash suggests darkly that Goldman’s trading gains are ill-gotten.

/pitchfork-mode-on

I don’t personally believe that Goldman is front-running their clients, but I’d prefer to avoid the possibility entirely by disallowing firms with proprietary trading operations from handling client accounts.  In programming, the best way to deal with concurrency issues is to prevent them from happening structurally by employing producer-consumer queues and other such mechanisms.  In just the same way, front-running should be structurally prevented by regulation.  Just make it effectively impossible.  But this eminently sensible model was over-written in the twilight of the Clinton I years by some of the super heroes who brought us all the marvelous financial innovations we’ve enjoyed over the subsequent decade.

more kings, yay!

Back to Goldman.  While I don’t think they’re front-running, everyone ethical/sensible will agree that if they were, it would be bad.  How bad?  Well, 252 trading days times $100M of ill-gotten gains yields something like $25B annually.  Big money by my proletarian standards, but let’s say that Mr Barofsky overcooked his stew by an order of magnitude and this bailout will only cost us ~$2.5T.  That would make the worst case scenario for HFT hijinks something like 1% of our crisis tab.

Worth pursuing, if there’s something there, but probably not the most bang for regulatory buck out there.

What’s an ambitious regulator to do?  Well, faced with symptoms like those evident in today’s US markets, the IMF would recommend breaking-up the finance oligarchy outright:

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform.

As Americans we are participants to a historic transfer of wealth from the US taxpayer to [?].  We don’t know how much, but we know it’s measured in Trillions.  And we really can’t say where it has gone.  Remarkable circumstance.

Some are saying that modern finance is so complex that we can’t hope to understand what just happened.  But I don’t think we need people with sophisticated intuitions about volatility smiles or nuanced appreciation for the creative engineering of structured products to solve these mysteries.

We just need garden-variety, honest and empowered investigators.

The “Untouchables” and other real-life gang-busters come to mind.  The techniques they employed would be effective for identifying and bringing down the people who’ve contributed to this epic transfer of wealth.

Just as they identified the “associates” of their prime suspects and then pieced together their activities by following money trails, our own regulators need to do some straightforward investigation of the people involved in this mysterious money hole.  Some will be innocent, some will have committed crimes.

Start with someone central to the fracas.  AIG has a few candidates with both Greenberg and Cassano likely suitable, but there are any number of lists out there implicating people with our “credit crisis.”  Pick one.  Look closely at his (or her) taxes, offshore holdings, business interests.  Identify 50 of their top social & business contacts.  Again, start with taxes.  Do this for a few cycles and you’ll have unwittingly collected the cream and dregs of international finance.  Investigate them.  Look at their taxes.  Follow the money.

identify the bad guys, follow the money, prosecute

People who committed crimes go to jail.  People who didn’t don’t.  Some new laws will need to be made and probably others will need to be taken off the books.  Minimal math required.

But what few honest and competent regulators we have are not empowered to do anything except kvetch pleasantly on the John Stewart show and perhaps muck about with market microstructure.  They are certainly not empowered to take on the beneficiaries of the crisis we’ll spend a generation paying for.  It’s even difficult to imagine how a regulator could be empowered to take down the architects of this most ambitious of capers.  The arch-villains of Mario Puzo or David Chase’s most feverish moments never approached the sophisticated operations unfolding today.

Focusing on market microstructure in an environment like this is truly missing the forest for the leaves.

I’ve been saving the above image in a stubbed-out blog post I’ve wanted to write since a conversation I’d had in Jerusalem last fall.  The recent attention to high frequency trading and all of its attendant evils has reminded me that the topic is relevant and so I relate various thoughts at the risk of jumping on a cacophonous bandwagon of rumbling misinformation.

First of all, the conversation.  It was with a talented guy who acted as the CFO for a variety of companies including a small startup hedge fund which traded US equities at a high frequency.   Although he was a part-time cfo, he seemed pretty plugged-into their trading operations and noted that they use an agency-only brokerage service for automated traders I’m familiar with and that they were “looking at full data for many” hundred stocks concurrently. He remarked that their trading was going well but that their hit rate was something like 4% and dropping.  By hit rate, he meant that they were placing limits frequently and generally pulling the orders if they didn’t get hit immediately.  He didn’t specify, but I imagine that “immediately” might range from milliseconds out to a second or twenty.  If the market is composed of makers and takers, then these guys were definitely makers of liquidity in the strict sense that they were placing limits and making markets.

At the time I thought it was interesting because it seemed that so many people were focused on the very, very short term trade that the frequency was becoming saturated.  It looked like a reminder that trading frequencies populate a spectrum; in this case, this part of the spectrum was becoming so saturated that returns were becoming increasingly difficult to obtain as more players crowded into it.  I’m not sure how this hedge fund has fared, but at the time I remember thinking that they were going to have a tough time competing if they were only geared for high-frequency trading as the space becomes increasingly expensive to play in as the inevitable talent and technology arms race marches on.

Lo and Khandani provide the below image illustrating this phenomenon happening to a class of contrarian strategies Lo & MacKinlay had described in 1990.  The strategies stop working as people squeeze out the alpha.

My conversation in Jerusalem mostly made me think that we were seeing a similar phenomenon amongst HF strategies.

What does it mean for a strategy to be high-frequency?  First of all, it’s a large class of strategies which probably shouldn’t be treated uniformly.  What they have in common is an intention to trade in and out of positions on a frequent basis where frequent will range from sub-seconds out to perhaps several seconds or even minutes in particularly felicitous cases.

Aside from the fact that one can trade at various frequencies, one can mix them and one might even be only peripherally aware of doing so.  A long-only, fundamentally-driven mutual fund (ie, not an algo or high-frequency trader) might call/fax/email/ftp/fix etc their trades into their brokers who might then execute the trades with their in-house or outsourced/white-labeled execution-quality algos.  Those algos might use some very clever close-to-the-market analytics to provide great execution for the client.  Or they might be traded profitably against.  Or both.

In any case, to me it seems clear that there is nothing intrinsically wrong about high-frequency trading itself.  People will always try to react to information as quickly as possible.  Why wouldn’t or shouldn’t they?  They also like to be clever.  Again, why wouldn’t this be expected and good?  I remember Lefevre recounting the use of personal teletypes by big speculators at the turn of the (prior) century.  Not your everyday household item at the time.  I also remember him recounting strategies for moving large positions which involved both buying and selling to hide one’s hand.  Why wouldn’t algos do the same and more?

That the loudest critics have been old-style execution traders “talking their book” to me tells the story here.

One other thing that my conversation evinces is the kinds of biz models being employed by brokers.  Like I said, this little hf hedge fund used an agency-only brokerage that caters to algo/hf traders.  Why is it important to note that it’s “agency only”?  Because, as the Goldman/Aleynikov story illustrates, strategies are organizationally porous in the sense that their value drips away as the human capital behind them moves from organization to organization and understanding of the strat’s internals become understood more broadly outside the organization.  This is likely the dynamic that drove Lo’s example above – more and more traders were employing similar strategies as the knowledge of the strategy leaked further and further from its original source(s).  Likewise, if I see all of your trading activity in sufficient detail, I might be able to reverse-engineer your strategy and work to steal your alpha.

Thus, traders are happy not to advertise their strategies’ behaviors.  So an agency-only broker – a broker who doesn’t engage in prop trading themselves – should inspire trust in a potential client.

Great!  What an honest business model!  But there’s an irony here and it points to the real kinds of problems we should be bugging our regulators to be addressing.  The specific agency-only broker I mention wasn’t self-clearing.  That is, they were using another broker (Goldman in this case) to handle their backoffice duties.  And guess what?  Goldman is anything but agency only.  So, clients who feel warm and fuzzy that they are dealing with an agency-only shop are actually exposing all of their activities with a particularly sophisticated and arguably predatorial prop trader.  It’s like the Guiness ads.

It’s funny to me that while there sits a multi-trillion dollar hole in our fed’s balance sheet which such hippies as fox news and bloomberg (suing to find out) and our US congress (asking politely) can’t seem to tease an explanation for out of the relevant authorities, the blogosphere and regulators seem to focus their invective on short sellers, hedge funds and high-frequency traders.

secret meeting at 85 broad?

as suspected, the seat of evil can be found in NJ

There’s a whole bunch of interesting things about this story of how a programmer has allegedly stolen some of the code at the place he’d worked.  One is the remarkable reverb it’s created amongst bloggers.  The house pictured left is evidently the diabolical mastermind’s home according to the NJ Real Estate Report.  Another is the fact that a programmer stealing some code is news. Funny what becomes news (apparently a fêted pedophile died) and what doesn’t (we are creating millions of refugees in Pakistan).

One angle that I haven’t seen highlighted in all of the commentary is Mr Aleynikov’s choice of weapon.  Seems that he was an erlang guy with an interest in ocaml.  Choosing functional programming for algo trading systems is an interesting but not unique choice.

A few months back I’d seen Jane St’s Yaron Minsky give an interesting talk on OCAML in which he describes the virtues of ocaml as applied to the algo trading domain.  You should watch it as he’s entertaining and clearly a “true believer.”   The key argument he makes is that algo trading requires correctness, agility and performance and that ocaml provides a great set of tools for addressing these needs.  Correctness and agility are supported by the rich type system while performance is just a happy feature of the language.

He describes Jane St’s need for correctness as obsessive – the company’s founders read/review all of the code that goes into production.  Thus, concision and the absence of OO languages’ dynamic dispatching mechanisms are viewed as advantageous.

Mr Minsky admits that there are significant limitations involved in choosing ocaml, including a dearth of external libraries (they write their guis using curses(!)) and a lack of native threading.  The language’s unpopularity turns out to be something of a double-edged sword as it results in the lack of usable libraries but also in a close-knit community of likely above-average developers.

Anyway, it’s an interesting decision for Jane St Capital to have made and it’s compounded by Mr Aleynikov’s use of Erlang/OTP at Goldman.  His linkedin profile describes his recent work as:

• Lead development of a distributed real-time co-located high-frequency trading (HFT) platform. The main objective was to engineer a very low latency (microseconds) event-driven market data processing, strategy, and order submission engine. The system was obtaining multicast market data from Nasdaq, Arca/NYSE, CME and running trading algorithms with low latency requirements responsive to changes in market conditions.
• Implemented a real-time monitoring solution for the distributed trading system using a combination of technologies (SNMP, Erlang/OTP, boost, ACE, TibcoRV, real-time distributed replicated database, etc) to monitor load and health of trading processes in the mother-ship and co-located sites so that trading decisions can be prioritized based on congestion and queuing delays.
• Responsible for development of real-time market feed handlers, order processing engines and trading tools at a Quantitative Equity Trading revenue-making HFT desk.

which makes it sound like they were using Erlang alongside a lot of C++.  I’d also speculate that their use of Erlang was more about concurrency than functional programming.

One of the nice observations made by Mr Minsky is that there’s a magnificent freedom about prop trading: you don’t have clients to please and can thus make genuinely original technology decisions.  It looks to me like the curious case of Serge Aleynikov highlights some of that originality in play in serious algo trading prop shops.

]]> http://www.puppetmastertrading.com/blog/2009/07/08/the-other-interesting-thing-about-the-serge-aleynikov-story/feed/ 4 http://www.puppetmastertrading.com/blog/2009/04/13/playing-by-the-rules/ http://www.puppetmastertrading.com/blog/2009/04/13/playing-by-the-rules/#comments Mon, 13 Apr 2009 13:14:45 +0000 tito http://www.puppetmastertrading.com/blog/?p=449

Competition has forever been fierce and at times may not be entirely fair.  Thus, a student of the market must be ever aware of the trends around them so they can promptly identify growing areas of opportunity which haven’t yet been revealed to the majority.  Mr Madoff made a very good living (while it lasted) offering clients a steady ~10% return on their investment.  Bush league stuff, it turns out.  The real maestros of money are doing rather better.

Accounting and legal researchers at the University of Kansas have identified a bull market in influence-peddling: returns on the order of 22,000% for firms who “invested” in lobbying efforts to favorably modify the tax code.  These people obviously learned that it’s important to play by the rules.

I’ve written some decent strategies and have been blessed with moments of great luck, but I’m ashamed to note that I’ve never gotten remotely close to these kinds of returns.  Can you imagine the sharpe ratio these guys can claim?  And it’s a repeatable process.  Although the Kansas researchers don’t mention it, there are many other cases of such legal arbitrage as pointed out in an AP piece on the subject:

The nonpartisan group recently released a study comparing the amount spent by bailed-out banks on political contributions and lobbying with the amount of money they got from the Wall Street rescue fund, known as the Troubled Asset Relief Program. The results produced eye-popping rates of return, an overall 258,449 percent for the $114 million they spent on campaign donations and lobbying.

Now this number – ~260,000% ROI – is clearly a bit inflated as $114M barely covers what Citi paid out to Mr Rubin for his services over the relevant period, but we’re probably in the ballpark.  Perhaps the banks only made 100,000% on their investment, but we can still see why they’re “the pros.”

I’m wracking my brains trying to figure out how to shoe-horn this marvelous alpha-generator into my trading algorithms.  I confess that I haven’t yet figured it out.  But I take solace in the knowledge that, as an American, I have the best government money can buy!

one view on the important stuff

There seem to be two kinds of economists in today’s world.

Keynesians and Austrians?  Freshwater and saltwater? Macros and micros? Voodoos and uh well-adjusted?

No.  These may be valid distinctions ordinarily, but in today’s debate on how to solve the great self-inflicted wound known as the credit crisis the only two that matter are those who’ve worked for prop trading outfits (or perhaps more broadly, those who would someday like to once their time of public service is up) and those who just practice economics, typically academically.

Among the former, the solution is uniformly, as Mish so memorably put it, “to patch the busted dam with water” and to do it now or the consequences could be incomprehensibly bad.

Among the latter, the views are many and divergent, but they at least agree that throwing trillions of dollars about is a serious bit of work and should be undertaken with deliberation, transparency and a long view.

I’m not qualified to opine on which type of economist has a better chance of saving us from ourselves.  But I can observe that the only kind sitting at the decision-making side of our president, pre- or post- January 20th 2009, is the prop trader.

Reminds me of a song I once knew…