Haim Bodek, the quant trader who was featured in the book “The Dark Pools” has written a book on what he thinks is the main problem with HFT. This content is more like a collection of articles and blog posts packaged as a book. Despite such a structure, the author focuses on ONE issue through out,i.e., “Special order types”,  that he claims as the single most important demon behind HFT dominance.

Let me summarize the main points of various essays.

I – The Problem of HFT

The first essay talks about a fundamental problem with HFT. It was a game created by the exchanges and HFT players at the expense of institutional and retail investors. It was like everyone was using checker pieces to play checkers, while the game has been changed to chess and the HFTs were using the queens, rooks, bishops. Traditional investors in order to make alpha were actually playing checkers at a faster speed. But when the game itself had changed, it was a pointless effort.

The HFT business strategy was to work with the exchanges to align the features of the exchange with the features of the algorithmic strategies themselves. The exchanges facing margin pressure and intense competition from other ECNs found that pleasing HFT players and providing “guaranteed economics” was one way to bring trading volumes. Why were exchanges facing crisis? Firstly, the growing practice of internalizing retail order flow off exchange lead to shrinking volumes on the lit markets and secondly the rise of dark pools. Subsequent to these “exchange mis-innovations”, HFT strategies became much more prevalent in the market in 2005-2006 and the top HFTs were able to achieve results comparable to mid-tier market makers. However there was something else that made them rake massive money in the last 5-7 years. What were they? Special order types and corresponding order matching engine features (through artificial and anti-competitive means). Post REG NMS, there were a lot of abusive features introduced in the exchange structure, under the pretext of complying with the regulation. So, instead of creating a fair place, exchanges and HFT players manipulated rules in REG NMS environment. Slowly HFTs became a dominant form of trading and soon enough it became the only game worth playing.

The problem with HFT is not that its basic strategies are illegal or even unethical. The problem with HFT is that these strategies shouldn’t work at their current scale and volume, and have only come to dominate the market through the carefully crafted advantages provided by the electronic exchanges for these specific HFT strategies – advantages such as special order types and preferred order matching engine practices. The problem with HFT is that it amounts to little more than opportunistic skimming that is only possible because HFTs have been accommodated with unfair and discriminatory advantages that assist them in getting an artificial and anti-competitive edge over public customers.

The author suggests an easy solution to this prevailing discrimination amongst various players. If the features that unjustly enrich HFT profitability are eliminated from electronic exchanges, either by regulators or by industry pressure, the adverse impact of HFT activity in the market will rapidly dissipate. HFT strategies will still exist, but their role will once again be limited by their natural scale and volume.

The essay also makes an interesting point that the media, politicians, HFT critics etc. are focusing on wrong issue, “speed”. The actual problem lies in “special order types” and “order handling treatment” that are keeping HFT players in the game. Unless something is done about this, the HFT problem will persist. Currently the bulk of modern HFT volumes are executed with HFT-oriented special order types, accounting for a significant proportion of the total US market volume. Actually the rise of dark pools is a natural consequence of a prolonged neglect of this issue. When the institutional investors lost confidence in the lit markets, they gradually moved to dark pools which are currently about 40 in number.

The crux of the essay is this:

The alpha of HFTs is in the “order type”, and overwhelms the alpha in many quantitative signals and strategies. The sad part is that alpha is not even talked about much in the media in the last 5-7 years. Everyone is focusing on the wrong issue, “speed”. Speed doesn’t help if your order will kicked to the back of the queue because you are not using the abusive special order types.


II – HFT Scalping Strategies

In this essay, the author talks about HFT scalping strategy that is the basis for many strategies in the market place. To understand this strategy, the essay talks about three aspects, i.e. the intentions, the key properties and observable effects. I am adding a fourth aspect in the context of this discussion, i.e. what are the factors that are driving the adoption of this strategy?


  • Its core intent is, on every round trip trade, to step ahead of supply-and-demand imbalances evident in market depth, and to capture a micro-spread by closing on the other side for a tick or to scratch out by closing on the same side, both of which are favorably subsidized by rebate in the maker-taker market model that is currently prevalent in US equities.
  • Manage sweep risk / a large informed swing trade.
  • Capture rebates and minimize losses from scratch trades

Key Properties

  • High Frequency Turnover – passive scalping of a micro-spread
  • Queue Position – a dependence on order rank and order book depth
  • Low Latency – precise and timely reaction to market microstructure events. It is default for any electronic strategy in today’s world.
  • Exchange Microstructure – usage of special order types and order matching engine features
  • Rebate Capture – subsidized costs through “post only” orders and tiered rebates
  • Low Risk Tolerance – avoidance of risk and usage of market book depth to reduce risk
  • Superior cancellation latency

What’s in Favor of this strategy?

  • unfair order handling practices that permit HFTs to step ahead of investor orders in violation of price-time priority
  • unfair rebooking and repositioning of investor orders that permit HFTs to flip out of toxic trades
  • unfair conversion of investor orders eligible for maker rebates into unfavorable executions incurring taker fees
  • unfair insertion of HFT intermediaries in between legitimate customer-to-customer matching
  • unfair and discriminatory order handling of investor orders during sudden price movements

Observable effects

  • Lot of IOC orders, High order cancellation rates
  • Toxic trades that are merely used as sniffers of big trades or sweep trades
  • Mere algo trading strategies don’t work as HFT players employ hybrid strategies, i.e. use algo strategies and special order types
  • Sudden and dramatic withdrawal of liquidity
  • Price fluctuations – Quote pulling by major HFT players can create a cascade as other players also pull out of the market
  • Market disruptions way beyond what the initial sweep trade might have created
  • Popular techniques to limit market impact, such as order slicing and various weighted averaging strategies, can backfire when they interact with HFT scalping strategies employing special order types and market microstructure features.

III – Why HFTs have an advantage?

The author gives the following reasons

  • “Spam and Cancel” orders: Rule 610 of REG NMS banned locked markets. This means a bid of $X in one exchange cannot be displayed if there is an ask quote at $X at another exchange. The implementation of REG NMS changed the mechanism for achieving queue position in a price-time priority market. The ban on locked markets created a massive number of strategies that were “spam and cancel” type. What exactly are they? If an order entered an exchange that could potentially lock the market, the exchange had a mechanism to slide the order. Immediately HFT guys sniff this situation, cancel their order and retry with a different order so as to get to the top of the order book. The result obviously is that large institutional orders get pushed back and the “spam and cancel” jockey for the top-of-the-book status.
  • “Hide and Light” orders: Since exchanges were inundated with “spam and cancel” kind of orders, they created special order types like “Hide and Light” orders which clearly was “guaranteed economics” to the HFT player. He could be hidden at the NBBO and as soon market is unlocked, he gets to be at the top of the queue rather than the guy whose order was price-slided.
  • ISO (Intermark Sweep Orders ) like IOC orders
  • The DAY ISO

The chapter goes in to pretty elaborate description of these order types and the reasons they provide HFT traders with a massive advantage against the institutional and other traders.

HFT – A systemic issue

This essay is more positive about the recent developments that have happened in the second half of 2012 and hopes that the HFT volumes on the exchanges would go back to something like 20% of the total volume. The developments listed are

  • Some exchanges, not all, have been quietly cleaning up since October 2011.
  • Some of the more egregious HFT-oriented features appear to have been neutralized through order matching engine modifications.
  • Certain HFTs and exchanges are admitting that they no longer have the cozy relationships they once had – this was certainly the case by second quarter 2012 when regulatory scrutiny was heating up.
  • Certain electronic exchanges are on the path to becoming more open, transparent, better documented, and less exclusive. NASDAQ’s recent move to provide order type documentation certainly attests to this fact.
  • The concept of SRO status of for-profit exchanges appears to be under scrutiny. At the bare minimum, exchanges are certain to be subjected to a higher level of regulatory oversight going forward.
  • There appears to be some degree of industry consensus and perhaps regulatory consensus that HFT-oriented electronic exchanges went too far and full market reform is likely untenable

The author makes a few predictions for various market entities in the times to come

  • Regulators – We will see regulators strengthen the regulatory oversight of self-regulating
  • Exchanges – We will see exchanges eliminate discriminatory practices and enhance their level of disclosure.
  • HFTs – We will see HFTs lose advantages and a new emphasis by such firms on market making status and order flow relationships.
  • Sell Side – We will see electronic trading desks utilize sophisticated features of exchanges appropriately.
  • Buy Side – We will see institutional investors take more responsibility for their execution performance.

The book also contains a paper that talks about Electronic Liquidity Strategy that aims to level the playing field between institutional investors that need to source liquidity and short-term liquidity providers that operate in an opportunistic and discriminatory manner.

REG NMS gave the HFT player a complex jungle of rules that they could exploit. In one of the essays, the author suggests ways to improve this jungle, i.e. National Market system to make the field a level playing one. The book ends with excerpts of Haim Bodek’s interview with various media outfits.

imageTakeaway :

The book is about 100 pages long and describes the core problem of HFT, i.e. “special order types-order handling treatment”. This has created a complex and fragmented market structure where the only game worth playing is the HFT game. If nothing is done to address this aspect, the author predicts that dark pools will become even more important and investors will lose all the confidence in the lit markets.