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Market Microstructure and High-Frequency Trading: Part 1

Sun, 08 Jul 2012 20:37:36 GMT


I just finished reading "Dark Pools" by Scott Patterson. The book documents the foundation of the major electronic exchanges (from Island through BATS) and high-frequency trading firms, along with the related regulations. Ironically, the book says virtually nothing about actual dark pools (such as Goldman's Sigma X). Patterson makes this clear in the first note:

The title of this book doesn't entirely refer to what is technically known in the financial industry as a "dark pool". Narrowly defined, dark pool refers to a trading venue that masks buy and sell orders from the public market. Rather, I argue in this book that the entire United States stock market has become one vast dark pool. Orders are hidden in every part of the market. And the complex algorithm AI-based trading systems that control the ebb and flow of the market are cloaked in secrecy. Investors -- and our esteemed regulators -- are entirely in the dark because the market is dark. ("Dark Pools" 339)

"Narrowly defined"? This decision to immediately simply ignore the meaning of a well-defined type of trading venue provides a good analogy for the book overall: it provides a very juicy story about the world of high-frequency finance while gently stepping around real accuracy. An example is the common theme of the book of the dominance of AI-based models. This phrasing seems to demonstrate a clear lack of understanding for how most firms actually run their models; to the best of my knowledge, there is very little actual AI employed.


Patterson also wrote "The Quants" about the origins of the major quantitative hedge funds such as Renaissance Technologies and Citadel. In both books, Patterson tries to make a case for how Quants can be destructive forces in the markets. In "The Quants", Patterson actually makes the case that the quantitative funds such as Citadel were responsible for the crash of 2008, and almost brought the global markets to collapse. This book also suffers from needless sensationalism (presumably with the intention of selling more books), which is unfortunate given the otherwise great amount of excellent journalism.

All that said, I personally highly recommend both books to anyone interested in a popular, entertaining story about quantitative trading. I'm unaware of a more readable history of electronic exchanges, high-frequency trading, or quantitative hedge funds. And while these are certainly not balanced accounts, they're far more balanced than most in the popular press. Patterson does a reasonably good job at wearing his biases on his sleeve.

Market Microstructure

Given the popular attention now given to high-frequency trading, I thought that it would be worthwhile to given a general introduction to the field of "market microstructure". The goal will be to give an unbiased account of how the markets function at a micro level.

I will give a brief treatment to the major topics as covered in the canonical texts on the subject:

The next set of posts will give a brief overview of the functioning of exchanges, introduce the standard sequential trade and strategic trade models, and provide a short lit review of some of the latest academic ideas on high-frequency quoting and trading (e.g. Easley, Lopez de Prado, and O'Hara et. al. on "Flow Toxicity and Liquidity in a High Frequency World").

This will partly follow along with some of the material from Joel Hasbrouck's two courses at NYU on "The Structure and Dynamics of Financial Markets" and "Market Microstructure", and Dale Rosenthal's course at UIC on "Market Microstructure and
Electronic Trading"
. I will also try to include R code along with the respective models so that interested readers can explore ideas further.

As always, let me know if there are specific topics that you would like to see covered!

[I should also point out that Quantivity had an excellent blog series on "How to Learn Algorithmic Trading" which is related (although more general in scope).]

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