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DAVID KRUSE

By Staff | Apr 18, 2014

My experience of knowing that something was not right from watching market quotes was probably not that dissimilar from how Brad Katsuyama explained things in the new book, “Flash Boys,” by Michel Lewis.

Katsuyama, who worked for the Royal Canadian Bank, could not figure out how his orders to accept offers for stock posted on quotes systems always seemed to chase the posted prices away, resulting in higher prices for his fills.

He was curious enough to dig into the system deep enough to ferret out the reasons.

In my instance, I was tired of watching the commodity quote screen flash in reaction to USDA reports before the information in them was posted on our newswire.

The answer to both of these things is that someone is in the middle of the information flow and able to act on it faster that we could.

Our cases were different in that I was not impacting the market with my orders. In my case it was simply a matter of speed of wire service reception and the ability to respond instantly with orders.

I believe that there is high frequency trading in commodities, as well as in the stock market. The issue is “front running,” which is taking advantage of the knowledge of the order flow to place orders ahead of customers or other traders.

It is illegal in both commodities and the stock market if done by people. If your stockbroker does it he can go to jail, but the irony is that it is not illegal if done by computers, a loophole which an entire industry is now exploiting to the point where it is estimated that high frequency traders skim as much as $160 million a day from the Wall Street order flow.

This was not a secret, but has been kept quiet, hidden by intended complexity, because so many were profiting from it.

The exchanges work with the HFT selling them close-terminal access to enter orders nearest to their computers which gives them their milliseconds trade advantage.

The exchanges benefit from the volume of contracts that HFT generate. I was surprised in listening to the squawk after a “60 Minutes” story broke how the financial news networks jumped to defend HFT.

The financial network commentators made the argument that HFT provides market liquidity. I don’t think this kind of liquidity was lacking.

When there was an offer posted to sell a stock you wanted to buy, the necessary liquidity was there with no need for an unwarranted entity inserting himself in the transaction to scalp a cent/share out of your pocket making the trade more expensive than it should have been.

The seller didn’t benefit because all he got was his offer price and the buyer didn’t benefit because he paid more than he should have.

Only the scalper benefited by taxing the buyer by inserting himself into the trade, like getting paid for taking the stock hostage until paid a higher price. He had no risk and provided no capital benefit.

His computer acted on information it should have never had access to in order to front-run your trade.

As to commodities, I expect HFT is occurring as somebody gets to trade USDA reports before the public.

Two members of our company were in Chicago recently touring the exchange floor and reported to me that the official on the tour (arrogantly) defended the release of USDA reports during trading hours because everyone got the news at the same time “just like in the stock market.”

I don’t know that I would use them as a good example.

My argument is that we do not all get the news at the same time, nor are all our computers located next to the exchange terminal so orders reach it first, nor are they programmed to react to the order flow.

The HFT doesn’t care what the report said, instead have sophisticated computer algorithms issuing orders off the order flow reacting to it.

They are gaming the system, not all that different than the trading pit in the movie “Trading Places.”

I used to say that movie was inaccurate depicting the release of USDA reports while the pit was open, but they since changed things so that now they do.

I don’t think the public does get the information at the same time, nor has equal access to it so that a trade suspension is warranted during major USDA reports to help level the playing field.

What HFT is doing may not be ethical, but it is not illegal. Regulators were aware of it.

Both the FBI and Justice Department are initiating investigations, but it is likely this is an instance of technology advancing ahead of regulation that needs to update.

Someone needs to issue an opinion on whether computer front running is really any different than when done by human decision.

Humans wrote the algorithms. Those now making enormous sums of money from this scheme will fight all regulatory change to adapt to technology to sustain the system as it is, because of the advantage they now have from it.

The other risk is that regulators will over-regulate in response, as they did to Peregrine and MF Global, costing us more than HFT is stealing.

David Kruse is president of CommStock Investments Inc., author and producer of The CommStock Report, an ag commentary and market analysis available daily by radio and by subscription on DTN/FarmDayta and the Internet.

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