Quant Trading:
The Ever Changing Market

Terms:

Q Trading: Quant Trading. The Use Of Mathematical Algorithms To Form And Identify Successful Investment Strategies.

HFT: High Frequency Trading: The Use Of Computers To Provide Trading Execution At Many Times Per Second.

OTC: The Over The Counter Market. An Unregulated Decentralized Market That Mainly Operates Between Big International Banks And Other Financial Institutions.

VaR: Value Adjusted Risk. Risk Of An Instrument Adjusted For Reward Probability.

MTF’s: Multi-Lateral Trading Facilities Set Up Between Banks And Financial Trading Houses. Theses Platforms Use Similar Software That Allows Interoperability.

MiFid: Markets In Financial Instruments Directive (European Union).

CTA: Consolidated Tape Association. This Association Oversees The Dissemination Of Real-Time Trade And Quote Information In The New York Stock Exchange And The American Stock Exchange.

ETF: Exchange Traded Fund.

Flash Trading: The Allowance Of Specific Traders To View Orders From Other Traders In Fractions Of A Second Before The General Market.

Dark Liquidity: Funds Available For Trading Large Blocks Of Instruments Between Institutions Unregulated And Unreported To The Public. The Blocks Are Normally Broken Up To Mitigate Unwanted Intelligence As To Source.,Volume And Price.

Alpha: Investment Performance In Percentage Above Or Below What Would Have Been Predicted By Its Risk.

Beta: Measure Of Stock Volatility.

The markets in mainland Europe are going through something of a revolution particularly since the MiFID directive in 2007 from the European Commission. The purpose of this initiative was to promote competition in the financial markets throughout the Euro zone. As a result all European exchange venues are promoting themselves as the battle for market share heats up. As these exchanges reinvent themselves the installation of new technology and new relationships has led to many unanticipated developments. One such outcome is the diminishment of the “classic” exchange in preference for MTF’s and the OTC market. It addition, increasingly traditional forms of trading are being replaced by the Flash, Quant and Dark Pool variety. Any trader who does not understand the implications of these developments is (not to put the issue too finely) “living in the dark ages.”

The growth in size and complexity of OTC trades means that this market now dwarfs the main public markets and in effect the regulated stock exchanges are now nothing but a “bench mark” for the main action. As Nathan Tiefenbrun, chief executive of multi-lateral trading facility, Turquoise Europe recently said in “Global Markets”:

“The evidence is that when the primary market stops trading everybody stops trading. They are the source of official calculations and when you arbitrage a share across different venues, you need to have that link back to what is happening on the main exchange.”

This situation amounts to a revolution in financial affairs. The major banks and financial houses are no longer “investing “ to buy and hold but are now only interested in “trading” on their own account. This institutional trading is in the main quant programmed trading looking to find VaR, Beta and Alpha through algorithmic analysis. The target trades are then executed through HFT to get an edge. It is important to note that the funds from these institutions that would have entered the New York stock exchange and bid up prices and values are now on the side lines betting on short term price action in dark pools. For those who understand the importance of technical information it must dawn on them that you cannot have true analysis of volume and price activity that is unpublished and unreported to the CTA.

As I wrote a few months ago:

“Dark Pools, what are they?” Dark pools of liquidity” are crossing networks that provide liquidity that is not displayed on order books. This situation is highly advantageous for institutions that wish to trade very large numbers of shares without showing their hand. Dark liquidity pools thus offer institutions many of the efficiencies associated with trading on the exchanges’ public limit order books but without showing their actions to other parties. This is achieved because neither the price nor the identity of the trading entity needs to be displayed. Many of the OTC “exchanges “used by the dark pools use high frequency trading programmes to minimize order size and maximize order execution. Now you may think that this manner of doing business on the “stock market” is carried out by minor unknown entities but this is not the case. Below I list the Independent dark pools, the broker-dealer dark pools and exchange-owned dark pools that we currently know about.

Independent dark pools: Instinet, Smartpool, Posit, Liquidnet, Nyfix, Pulse Trading, RiverCross and Pipeline Trading.

Broker-dealer dark pools: BNP Paribas, Bank of New York Mellon, Citi, Credit Suisse, Fidelity, Goldman Sachs, Knight Capital, Deutsch Bank, Merrill Lynch, Morgan Stanley, USB, Ballista ATS, BlocSec and Bloomberg.

Exchange-owned dark pools: International Securities Exchange, NYSE Euronext, BATS Trading and Direct Edge.

When you understand that all the big players in banking and finance are using the OTC system and have a turnover 12 times that of the “public” markets you get to wonder why there is stiff regulation on the public New York Stock Exchange and the American Exchange, yet no such mandate exists in the OTC market. Surely the SEC is failing in its regulatory duty here.”

At the moment the platforms, systems and strategies being used by OTC traders are experiencing explosive growth. This growth is sucking liquidity and stability from the main markets. The small time investor and trader who tries to “time” the market through traditional “day trading” strategies does not stand achanceagainst computers that flash trade many times per second based on “unseen” technical and dark bid/ask price data. In fact any trader who does not take the new market reality (indicated in particular by the flash crash of May 6th.) into consideration is going to lose and lose big. The fact that he/she is losing to the major institutions is indicated by the fact that HFT operators made 21 Billion dollars last year. This figure is set to grow but to the detriment of the traditional market players. Thus, to state it clearly, I finally quote my favorite Irish poet:

“All changed, changed utterly. A terrible beauty has been born.”

Easter 1916
William Butler Yeats

www.wealthbuilder.ie October 2010