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Dark Pools and High Frequency Trading For Dummies with Jay Vaananen

Thu, 18 Dec 2014 08:33:00 GMT

The Bankers UmbrellaJay Vaananen talks about his first book Dark Pools and High Frequency Trading For Dummies which is published in January 2015 by Wiley. Order your copy direct from Wiley and enter our promo code MON30 to receive 30% off this title.

Jacob Bettany: Could you begin by introducing yourself and telling us a bit about your book?

Jay Vaananen: My background is as a private banker. I have a degree in Finance and Risk Management and I went into Private Banking pretty much straight out of university. Before that I worked on analysing non-listed companies. I was based in Luxembourg for a long time managing a rather large portfolio of private client assets and during the job while I was executing trades for the clients, my colleagues and I started noticing some funny instances where the price would slip. We thought maybe this was just some kind of bad luck, but then we started to think no, there is something going on here. That got me interested in finding out about dark pools and high frequency trading which was behind all the funny things that were going on, like orders not showing up in the exchange and this kind of thing.

JB: How long ago was that?

JV: It’s going back quite a while – first it was happening in the US markets in 2005/6, around that time, and then you started seeing similar things happening in the European markets. In 2013 I set up The Banker’s Umbrella blog, a blog about private banking which I had wanted to do for a while. It really took off like a rocket and gained a cult following quite quickly. Then later that year I was asked by Wiley to see if I would be interested in writing a book about dark pools which I thought was a wonderful chance as it was a subject I was particularly interested in, so it was very easy for me to say “but of course”!

JB: Why did you choose the format you did for this book?

JV: Wiley suggested the For Dummies format and I thought that would be wonderful, as I had a few Dummies books myself, I think everyone does, and I like the fact that they are conversational and easy to understand. Also it is a globally recognised brand, go into any bookshop in the UK and you will see a shelf full of them. From a banker’s perspective I thought: this will sell, the message needs to be out there anyway because there’s not really much out there on dark pools and high frequency trading and what there is is quite academic and complex. The book is understandable and accessible to pretty much anyone – if you watch the financial news and you are literate you will get something out of this. So I was really pleased to write a For Dummies book, I think the market really needs one like that. If someone wants to learn a new subject they will maybe go out and buy two books and chances are one of them will be a For Dummies book. It will be read by a lot of people because the brand is so well known.

JB: I’m sure that’s true. Did you find it constraining to write in that format or were you free to develop it in the way you wanted to?

JV: Yes and no; it is a global brand so it has to be done in a certain way. If I compare for instance The Banker’s Umbrella blog which I write, that’s a certain kind of brand which is very easy for me. I can sit down and pump out a thousand words no problem. So although having to write for another brand was difficult Wiley were very open about bringing my expertise into the book and from that perspective it wasn’t constraining. I actually found it rather positive because the brand has been around for a long time, they know what they’re doing, how to package the text and make it accessible to the reader. I felt very well taken care of in that sense. The book was made better because of the skills and experience of the people behind the brand.

"The book is understandable and accessible to pretty much anyone – if you watch the financial news and you are literate you will get something out of this."

JB: What challenges did you encounter in writing the book?

JV: The biggest thing was that the goalposts kept getting moved by the world at large. It’s a subject that has been very much in the news while I’ve been writing in 2013/14. The headlines haven’t just been on the business pages, it’s been on mainstream media as well. I’d find that I’d write something and then it would be old news or things would have changed a month later, then I had to go back to it and change it totally.

JB: Dark pools and high frequency trading are both fairly weighty subjects and I presume you could have written a single book about each – why did you choose to combine them?

JV: Well, dark pools was the idea for the book originally and then as we discussed it we came to the conclusion that high frequency trading had to be included in it, so much so that it had to be part of the title itself. You have to remember that dark pools were set up as a place to get away from the high frequency traders, and now as high frequency trading has evolved it has – depending on your point of view – either infiltrated or penetrated the dark pools themselves. So I don’t think you can write about one without the other, you really need to have a good understanding of both. Okay you can do high frequency trading strategies and so forth, but dark pools are such a big part of that. The point of the book is that if you understand the modern market microstructure then you need to know about both. And for that I’m very pleased that we have both in the book and I think that it’ll help the reader immensely.

JB: How is the book structured?

JV: The book is structured in the same way as all the other For Dummies books, which are modular. The term modular means that even if you have expertise in a subject or know something about it, you can pick up the book, look at the table of contents and go “oh, hang on – I know that, I don’t need to concentrate on that”. And then you can go anywhere in the book and pick and choose parts that are interesting to you, so you don’t have to go from cover to cover. Actually writing a book like that is a challenge, being able to write things that can stand alone.

When we were beginning the project I read through several Dummies books to get myself immersed in the whole brand style and there are quite a few finance books. One of them was Currencies for Dummies. Currencies were an integral part of my daily work so I would like to say I’m an expert in currencies and my clients would like to hope I am an expert in currencies! Yet in that book there were several things that I found which were very useful and I wasn’t aware of.

The book covers the basic of what dark pools and high frequency trading are so you can understand what’s going on in the markets especially now there is a lot going on that you can’t see because it happens so quickly. There’s a huge amount of things happening in the fractions of a second between placing an order, it going to the market and being executed, and confirmation being received.

As for what it doesn’t cover; it’s not a “how to build your own high frequency trading business”.

JB: So the book is aimed at people with a general interest in the field.

JV: Yes. It’s particularly important for professionals in the finance business who still don’t know what is going on or have any kind of idea how dark pools work – Chief Investment Officers and fund managers, private bankers, investment advisers and of course private investors. If you invest directly in stocks or equities then you need to be aware of what is going on in the market at the moment. You need to understand dark pools and high frequency trading.

JB: You need to understand the context?

JV: Yes, so you can understand context - do you have the right broker, are you being taken care of properly, are you getting the best execution? There are certain things that perhaps you can do to try to mitigate the negative effects of high frequency trading on you and that is important. If you don’t understand the marketplace you shouldn’t be in the marketplace. Otherwise you are the one that’s going to be taken advantage of. You’d be surprised at the lack of knowledge of market microstructure. When we talk about microstructure we talk about specifically the stuff that happens when you send your order to the exchange or dark pool or wherever – you’d be surprised how little many senior Finance people know about that. These people are handling everybody’s pensions, and that’s a problem.


JB: Could you describe those microstructure transactions a little?

JV: Well we can take as an example that you want to buy 100 shares in Microsoft. You sit at your computer with web or digital access to your brokerage account. When you find the shares you want and press that enter button, that’s when the interesting things start happening. Where does it go from there? It might not go directly to the exchange. It might go to your broker who tries to internalise it. If it doesn’t get matched there it might get routed to a dark pool first and if it’s not matched there it may go to another dark pool – all in fractions of a second. If it’s still not matched then it might go to the exchange. There could be information leakage along the way – what algorithms or machines see that order? All that can affect the price you get for the trade.

JB: So this book was necessary as it’s really important for everyone in the market to know this information.

JV: Yes, there are so many different kinds of strategies in HFT and that is different again to automated trading. You have the dark pool operators, the exchanges – in the US there are several exchanges – so all parties concentrate on their specific capabilities. That means if you’re listening to an HFT trader on the news, we will see him as an expert on HFT in general when he won’t be, he will be speaking only about his area of expertise. The area is so complex he is only talking about one thing and probably has absolutely no idea of a how a certain dark pool will work. Getting some perspective on the market as a whole is very difficult. He will be an expert on his own strategy in his own way. He will view the market only from that perspective. Yet all of these people are operating in the same marketplace.

"If you invest directly in stocks or equities then you need to be aware of what is going on in the market at the moment. You need to understand dark pools and high frequency trading."

Another example is two traders with different strategies. One is based on a news flow algorithm which draws in information from Twitter. There’s nothing bad about that, they’re not manipulating the market. The other trader is a brokerage firm who goes to a dark pool or they go to a stock exchange and say “look, let’s do a payment for order flow meaning all your orders that come in to you, you send them to us, we’ll pay you for it, and we can trade against that and provide liquidity”.

So one group is a fair way to trade with great technology that can do trades in fractions of a second. Good luck to them. Then you have the second group who is actually paying so that when you send your order it goes to them and all the other orders that come into the exchange go to them first. So they have knowledge of all the order flow for a stock or basket of stocks – that’s not fair. If I place an order I should at least know if it is going to somebody that is using payment for order flow. It’s like a bottleneck, they can deduce from the order flow if there is a big uptake in buying, buy it and then sell it quickly. With an algorithm it happens in a fraction of a second.

Another example is maker-taker fees. Exchanges will pay high frequency traders or market makers to trade on their exchange. So if you make an at market order to buy at whatever price and there is someone on the other end of that trade who has a maker taker fee – in this case it would be maker fee, they ‘make the market’ – they post limit orders in the book and it looks like it is an active market.  The exchange will give them a share of the exchange’s fee just for posting that order. Now, another market might have a taker fee meaning someone who ‘takes’ at market orders and buys (sells) from their book, they (the exchange) will pay them. If you look especially in the US where they will have tens of exchanges, why not have maker fees in one exchange and taker fees in another – even if you’re trading at the same price or a small loss you might be making a profit because you’re making the maker or the taker fee.

JB: So that adds a layer of complexity.

JV: Yes, if you go back to the HFT firm that does things based on what Twitter says and then you interview him and ask if HFT is bad, he’ll say “no, of course it’s not!” and he’s speaking hand on heart and actually being honest. He doesn’t know about the other strategies someone else is operating. Maker-taker fees and payment for order flow are big problems. I’m not so much against them but investors deserve to know if their trades are subject to them.

I would love to see some academic research on this, it is quite complex and multi-faceted. Generally, the cost of trading has gone down, without a doubt. When I went into this business you’d be charged 1% to execute a stock trade. Nowadays it can be a fraction of that and it seems a lot cheaper. I would want to see some study done into adverse selection. Prices often slip while the order is being executed and then I have my fee on top of that. So are we really as private investors trading cheaper than we did before? I can’t answer that. If I was a student I’d be wanting to write my thesis on it!

So, getting a clear overview is actually quite difficult and I don’t think anyone has tried to grapple with that. That is what we tried to achieve with this book.

JB: These techniques are all sat upon fast-evolving technology so in a sense everyone is playing catch-up.

JV: Absolutely.

JB: Both these topics are controversial at the moment and to some extent misunderstood. To what extent does the book address the controversy around these topics?

JV: That’s another reason I think the book needed to be written. Some people will think that it’s the most evil thing ever (dark pools and HFT) while some will say that you’re getting better prices than ever before for the services because of these (dark pools and HFT) and they will never agree. The book doesn’t pull any punches and tackles the controversies. One of the challenges of the book was how to cover them because you will get a fight about HFT very quickly. Go on social media and try to talk about HFT and there will be a fight between finance people within 30 seconds! The book is neither pro nor anti dark pools or HFT. Regarding the Flash Crash, I think that’s a really important event and there is a whole chapter on that. First of all, it’s famous and there are many different theories of how it happened – there is the official version and there is a very popular one by a company called Nanex and then there are many conspiracy theories too. The Flash Crash is a good example because then you can see what happens when things go wrong with technology and HFT and dark pools and how they actually work. The chapter splits it up into microseconds and you can read at your own pace and see how it could have happened – because there is still no clear 100% certainty of how it happened.

JB: The events on Twitter seemed to be driven by those using sentiment analysis.

JV: That event doesn’t get its own chapter but it does get a mention in the book as it was important too. If you look at the Flash Crash that could be compared to an aircraft disaster which 99% of the time turns out to be due to a combination of things rather than just one. The Flash Crash was a combination of many things coming together overwhelming the system. But with the Twitter example when somebody hacked the AP’s Twitter account and then that sent the market crashing, that shows you how vulnerable the market is that one single event like this can really send things completely off kilter and that is a huge worry. It does worry me because it shows you that the market can be manipulated with serious consequences.

JB: To what extent has there been a rebranding or changes to HFT as a result of the controversies?

JV: Well, the golden age of HFT is over and the proof is in the pudding. In a study by Purdue University the profits of high frequency trading – they are only estimates – in 2009 were around 5 billion dollars and in 2012/13 it was around 1 billion. The profits have decreased because the spreads are tight, margins have decreased, and more players have come in chasing those returns.

JB: I’ve heard it described as a very expensive race to a draw. I guess as technology develops and arbitrage opportunities are identified, exploited and closed there is inevitably a slowing down in the market.

JV: Absolutely and a good example of that is to be found in the news flow strategy, when economic data is released for instance. Say it’s released in Washington DC at 2pm and can have repercussions on the market. You have financial centres in New York and Chicago. New York City is closer to Washington DC than Chicago so just basic laws of physics mean the information will get to New York first. There was an instance where this was studied by Nanex where there was a piece of information released in Washington and before it could reach Chicago it had already been traded on (in Chicago). The information is released to news services before with a quarantine period in which to write up and release a report. It’s a race to be first now and those who could act first would have taken pretty much the whole profit in that trade.

"...if you’re listening to an HFT trader on the news, we will see him as an expert on HFT in general when he won’t be, he will be speaking only about his area of expertise. The area is so complex he is only talking about one thing and probably has absolutely no idea of a how a certain dark pool will work. Getting some perspective on the market as a whole is very difficult."

Anyone who follows The Bankers Umbrella on Twitter will know I’m a big boxing fan and although in my 40s I still box quite actively. Of course I had those kind of comparisons. If you look at the Olympics final in boxing, the guy who gets the silver medal still got his butt kicked! It’s very similar, there can be only one winner and even if you’re in the medals you are still a loser.

JB: So for you personally what do you find most interesting about HFT?

JV: The way that it’s completely changed the market and how little understanding of it there still is. I’ve always been fascinated by these kinds of things which are not common knowledge and we don’t fully understand.

JB: What are the arguments for and against dark pool trading? If it was developed as a way to avoid HFT, does it also have uses within HFT?

JV: For positives, there are two main benefits for institutions or individuals with a large volume of trading. The first is that large orders can be executed without price impact. A very large order usually sends a signal to the market and it will move the price. The second main positive is a better price than other people in the market because in general in a dark pool you execute at the mid-price of the spread. You have a bid, and you have an offer that’s sometimes called an ask. The bid is what someone is willing to buy at and the offer is what someone is willing to sell at. If it’s an illiquid share there can be quite a big spread. In a dark pool there’s a general rule that the trade is executed at the mid-price of the lit market, the stock exchange. So both buyer and seller are happy as they both get a better price and that is a great thing about dark pools when they work well.

As to the negative side, it’s lack of transparency. Is it fair that you can make big trades without price impact? Shouldn’t the market know that there is a bigger player there?

for dummies cover imageJB: Presumably there are more and more dark pools appearing all the time, is it an area of trading which is growing?

JV: If I was a brokerage or a bank I would hope that it’s growing, I would want to do my trades in-house in my own dark pool because it’s cheaper, you don’t have to pay the exchange fees.

Then you come to the problem at the centre of the issues with dark pools – how do you get the liquidity? It’s okay if I have three institutions with massive amounts of shares to buy and sell but if there’s no one there to trade against them or with them you don’t have a market.

High frequency traders are important because they are only interested in trading, getting in and out as quickly as possible. That’s their business. So, if I’m running a dark pool the easiest place for me to get liquidity is someone who wants to trade. Dark pools are sold to clients as a safe place but then HFTs are involved.

JB: In a particular dark pool, clients were told there were no HFTs in it but there were, is that correct?

JV: Yes, and I wrote a couple of articles for International Business Times analysing this case. There is a lawsuit by the New York Attorney General against them. I’m sure the fine print didn’t say “there are no HFTs” but let’s be very clear the idea given to their clients was this is a place where you are safe from predatory trading. And then, what turns out to be the case? There were high frequency traders in the dark pool.

JB: How can the industry mitigate against that happening?

JV: Regulation is the only answer I have. Finance has a credibility problem without a doubt. Some people want to believe there is nothing nefarious going on in the banking sector and we have done nothing wrong – we’ve got Libor, Forex… what so far haven’t we been fined for? A reality of the market is that we have a credibility problem. Even if we did fix it I don’t think anyone would believe us. So it needs to be regulation to build trust back in the whole industry. Would we watch the football World Cup if there were no referees there? If people were breaking the rules all the time it would turn into mayhem. You need rules and regulations, it doesn’t work otherwise.

JB: Is it even possible to regulate the industry when it changes so fast and banks have much higher budgets than regulators?

JV: I think it is, yes although you are right they haven’t had the necessary budget. More importantly I think they (regulators) haven’t had the expertise. They don’t have the understanding because it’s still relatively new. We’re talking about something that’s been around for over a decade, depending on how you class it. To build expertise in-house in a regulatory environment is not really that easy but they are getting there. If you look at regulation in Europe MiFID the Markets in Financial Instruments Directive II just now coming into force only barely mentions high frequency trading. We are still behind but all of this media interest has helped in moving things forward and having regulators look into it. We are talking about somebody buying and selling and coming to an agreement on price. That is what’s happening. It shouldn’t be that complicated. Okay it’s fast but slowing down and seeing how things have happened after the fact should be pretty easy to do.

JB: What’s next for HFT?

JV: It’s inevitably going to go to the OTC market, through bonds and such and then to emerging markets with exchanges that don’t have the regulatory framework that would be considered restraining for HFTs. As for stock markets and dark pools I am a little bit worried if we can’t return some kind of credibility to the market. A lot of trading and liquidity in the market has been phantom, these are just machines trading against each other. We need to have private institutions, we need investors, and we need people behind it to make a market. That doesn’t mean they don’t use the automated tools. For private investors I’m sure we’re going to be seeing an increase in tools that you can use from your laptop to have more control over your trade. The technology will be used for people other than just HFT traders. Those with access to the money will have the best technology.

"Behind all the computers and algorithms and automated trading, we do need people to make a market and I fear that the market is actually getting smaller because of a distrust of it."

As an example, I was on holiday a little while ago and I thought I would get a prepaid phone as it would be cheaper, I was there for a week. I went into a newsagent and bought one for 19 Euros with five Euros time on it. It blew my mind – it’s a phone! Going back ten or fifteen years, how much would a phone cost? This is how technology works.

Behind all the computers and algorithms and automated trading, we do need people to make a market and I fear that the market is actually getting smaller because of a distrust of it.

Related to this for instance is the ETF market, the exchange-traded funds. More and more people now are saying the only smart way to invest is through ETFs because all actively managed funds lose money and the fees are too high, which is pretty much true. But, let’s flip it on its head. What if all the people who aren’t rocket scientists or physicists or mathematicians only buy ETFs. You don’t then have a working market. You still need people trading against each other. The attractiveness of the stock market as a place to trade is under threat, I think.

JB: Returning to the book, does it come with any supplementary materials?

JV: There will be a website for the book and I have written several articles for it which are complimentary to the book on how you can protect yourself from predatory trading and so forth, so there’s a lot of online stuff that will be available around the time the book comes out in January.

There is a great guide in the book to people and websites and sources that you should follow who are active in the areas of dark pools and high frequency trading. There will be changes and regulatory changes and there are certain people who I think are very, very important who you should be following and listening to.

JB: Finally, what’s next for you?

JV: I’ve enjoyed writing the book so much I would like to continue writing. I was a private banker for a long time and that whole business has changed so much. I had the opportunity to jump out and concentrate on the writing side of finance, and I enjoyed it so much that I don’t have a desire to go back into private banking. Possibly at some point there will be a second edition of this book and I have some ideas for that, I would like to collaborate with some people on that. Probably as the market evolves a few years down the line there probably would be demand for a second edition.

Dark Pools and High Frequency Trading For Dummies is published in January 2015 by Wiley. Order your copy direct from Wiley and enter our promo code MON30 to receive 30% off this title.

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