Haim Bodek is the CEO of Decimus Capital Markets LLC based in Stamford Connecticut. He is a globally recognized expert in High Frequency Trading and the market structure upon which it is executed. His 2013 book The Problem of HFT exposed the problems with that structure and the ‘special’ order types that allow well-connected insiders access advantages that equate into unfair advantages for those so affiliated.
He was the founder of Trading Machines LLC, a high frequency options trading firm that executed upwards of a half percent of the U.S. options market.His discovery of inconsistencies in market structure was the subject of Dark Pools, a book published by Scott Patterson in 2012 He was formerly head of Electronic Volatility Trading at UBS and was the lead electronic trading strategies at Hull Trading which was acquired by Goldman Sachs in 1999.
[four_fifth_last padding=”0 0 0 20px”]Listen to the interview with Haim Bodek:
Full Transcript of Interview:
James West: Haim, thanks for joining us today.
Haim Bodek: Yeah, thank you.
James West: Haim, since the publication of your book, The Problem of HFT, in 2013, do you feel that the more pernicious grievances you discussed have been remedied at all, or are they more present?
Haim Bodek: Well, that’s kind of a loaded question. The way what we call the order-type controversy, which is the problem of HFT, my book, was highlighting a systematic asymmetry in order types that would basically create environments where sophisticated traders could get an edge on institutional investors. That controversy has basically steered its way through to a point where it is nearly resolved at this point. And that was done over a period of four years, and had intense SCC SEC investigations.
And so, what is the remedy? You may not be happy with it, but most of the practices that I kind of exposed were basically approved by the regulators. And the solution or the remedy for those asymmetries was basically disclosure.
James West: Okay. So now, anybody who envisions himself as a participant in a high-frequency trading environment has uniform access to the order types offered by the various exchanges?
Haim Bodek: Well, in some cases, the order types are only available to certain participants. On the NYSE, we have have to decode the D-Quote order type which is only permitted for certain types of members, but that is disclosed information.
Now, most of the order types that I kind of exposed, were available to most participants, but their brokers did not implement the functionality, which is why most people thought they couldn’t get access to it. Basically, the brokers didn’t even know about the order types.
Another thing to point out is, one of the most important order types is what we call the inter-market sweep order, ISO. And that order type, which can be used to get to the top of the queue, to get ahead of people, to trade at prices that other order types can’t get, and that causes a lack of – these order types basically give the trader access to more liquidity, so those order types are incredibly important. Everyone should be using them across the board. But, there is significant compliance and technology investment that you have to do, by regulation, to use them. So brokers that aren’t willing to invest in that, can’t really provide those order types to their customers.
James West: Okay. Just for the edification of the audience who might not be that sophisticated in HFT: what exactly do you mean by that ISO order? What exactly does it do that’s different from, say, just the normal bombardment of the system with orders designed to extract a fractional, I guess, fee, in the make-or-take environment, or else, say, somehow exploit in a spread?
Haim Bodek: When we talk about the properties of order types, you really go down the wormhole. The inter-market sweep order has many, many different uses, but I could highlight one that our readers might be able to kind of latch onto as a concept: during the flash crash, the New York Stock Exchange posted prices that were significantly delayed. And they were actually fined $5 million for this negligent violation, but the impact of those stale prices on institutional investors’ fill rates – and let me explain to you how it works:
When you send in an order to sell, the exchanges are required to check where the best price is, and they’re not permitted, except in certain circumstances, but they’re typically, by default, not permitted to execute an order when there is a better price available.
So what NYSE did during the flash crash is, they were disseminating prices that, as the market was falling, they had bids that were basically non-tradeable. You couldn’t trade, it had phantom bids, but the exchanges were not allowed to execute investor orders because they had to honour the NYSE price. So what they typically do is, there’s two things they’ll typically do when they’re not permitted to execute an order: 1), they’ll route the order to the NYSE. Well, you know what happened there, is your order gets stuck in la-la land trying to trade against a price that doesn’t exist, right? And the other thing that they do is, these are basically settings the brokers have to choose, but they’ll basically reject the order and they’ll say ‘regulatory restriction’.
Now, regulatory restrictions, during the flash crash, probably were off the charts, right, because of this – if you read the order against NYSE, implicit in that order is their impact on the market. So what I’m basically saying is, institutional investors, if they’re using the wrong broker, are selling, and they think that they’re missing the prices. They’re not, they’re just being prohibited from trading, period. They’re frozen all the way down that crash.
So whether ISOs, I don’t have to go into details, but ISOs are a way that you can tell the exchange hey! Don’t block me.
James West: Okay. That’s interesting.
Haim Bodek: Okay? I don’t go into details there, but you got it, right?
James West: Right. And that sort of brings me to sort of my next point: is it the complexity itself that represents the advantage that high-frequency traders exploit at the expense of institutions and other investors?
Haim Bodek: Yeah. I’ve said over and over that speed is a red herring. The example I like to give is that I was investing at my old firm, I was investing in significant technology. Our system was basically distributed over five different co-location sites, we used all the fast price feeds, and the more and more I invested in that technology to get faster, the more slippage I started seeing in my orders.
I’m supposed to get better executions, not worse ones, as I get faster! And what was happening is, I was kind of falling into an order-type abuse with greater and greater frequency. Because I was so fast. I was the first one to jump into the snake pit.
James West: Right. And multiple more times than anybody else could, by the sounds of it.
Haim Bodek: Yeah. So that’s how I discovered the problems that eventually led to certain people in the industry kind of inviting me into what was happening. And that information… I’ll stand by this: that information about those snake pits was not available if you were at a major investment bank. That’s kind of where I came from, through quite an elite unit of an investment bank. I’m thinking to myself, if they don’t know about this, how am I supposed to have, without that information, how was I supposed to have any chance at all?
That information asymmetry is the fundamental issue. We call market structure, or knowledge of market micro-structure is what we often call it, but it really is that we know the loopholes. The high-frequency traders know the loopholes, and they are masters of that gray line between permissible activity and activity that’s prohibited by regulation.
James West: Right. So my attraction initially and fascination ultimately with the whole idea of high-frequency trading is, you know, I’m based in Canada, and our Canadian markets have been essentially taking a beating for over five years, and at various meetings and round tables, people who strike me as not particularly knowledgeable because they’re not particularly involved in high-frequency trading, stand up and point the finger at high-frequency trading as one of the primary causes of the deterioration in our markets. And it just never held water for me. So that’s what started me on my path.
So I read, I first heard about you through the book called Dark Pools by Scott Patterson, and he opens that book with a description of you at trading machines becoming increasingly frustrated with something that you couldn’t see, costing you money. So I mean, I guess, at the end of the day, markets are always about whoever’s got the best information first is going to trade better than the next guy in line.
Haim Bodek: Yeah. The thing to understand, you know, I’m kind of sympathetic. I don’t blame high-frequency trading, which gets often confused with electronic market-making or electronic trading. HFTs are, in my book, specific firms, and I kind of divide them into, you know, good ones and bad ones. And the bad ones tend to be associated with these back-doors that are now, finally, they’re disclosed, but from my perspective, they’re still back doors.
So these bad firms are, at the height, yeah: they were, I don’t want to say the numbers, but a huge part of the US equity market, but those volumes actually decreased definitely since I went public, and they’ve become less of a problem. So the reason I’m sympathetic to institutional investors is, especially, let’s say, a buy side trader, is, just like me, if you’re sitting there and you are executing on the markets over a period of years, and that’s your bread and butter, and then things change. That’s what happened to me in May 2009, right? It changed, dramatically.
The trader may not know what changed. In my case, I didn’t know; it turned out an exchange rolled out order types with very, pernicious features, which I was on the losing end of. But that trader smells the rat, but he can’t point at it, right? And the people who are defending the industry tend to deny the existence of the rat. And I mean we can go case after case, but there has been in the US, a number of cases recently. ITG was running a secret trading desk that was trading against their customers in an undisclosed manner. That firm in particular was seen as, the entire brand was built around trust. We have major investigations that look like they’re going to be moving to record settlements. It was reported recently that the two actions against Barclay’s and Credit Suisse with regard to activity in their ‘dark pools’ is going to total $150 million.
If those types of settlements are, call it an example, of activity that was happening, we don’t know the whole story yet, but there’s activity that it appears warrant that level of fine. And that is what these investors that complain to you, are sensing. They know they’re on the losing end; they just don’t know the mechanisms.
James West: Sure. Okay, so let me ask you, then: in your opinion, through a process of observing market phenomenon that professional traders recognize as irregular, you finally come to this understanding of these special back doors and special order types and you disclose them, and you essentially pursue a fair trading environment for all. So what’s to say that, at this point, there are other back doors and other specialized accesses that have been evolved by those at the centre of the universe, the plumbers themselves, to replace the ones which are now common knowledge? Is that a risk?
Haim Bodek: Well, you know, that’s what, when I started this, people, I’m still considered in the HFT Insider I heard recently that they think of me as one of them who’s gone astray.
James West: I see.
Haim Bodek: So the argument is that whatever you turn in, there’s always another way, another scheme or angle. My view was, the order type issue was an issue I was going to try to bring to closure as best I could, and that it’s fine, let them find other, when I say ‘them’, you know, the bad apples of the market, let them find other holes in the system; let them exploit other inequities or asymmetries. The thing to understand here is that asymmetries associated with the golden age of HFT – you know, basically, came to dominate US equity trading overall. They’re not going to find another honeypot like that for awhile.
James West: Right. Okay. So I guess you would say that the problems that you’ve identified in your progress from not knowing what’s going on, to being fully aware of how what was happening is happening, have been more or less addressed. You’re not sure that there’s not something else that somebody else is exploiting. So in your current incarnation as Decimus Capital, are you still essentially involved in high-frequency trading?
Haim Bodek: Yeah, in many ways, you know, that role has kind of evolved to assisting other firms in eliminating this information asymmetry. The problem is, since most of the complex order types have been approved and disclosed, basically there is now an obligation to use them effectively, because the ways that I had slippage, the ways that I lost money, now we’re talking six years ago, well, those are now basically blessed. So you’re either going to be on the losing end of those practices or on the winning end. So you have to basically execute more like a high-frequency trader now, and I advise firms on that. I’ve got some other things going that are more call it ‘stealth’ oriented, but you know, I have done quite a bit of work assisting other firms.
Interestingly, you’d think that the firms that I end up working with would be the kind of traditional buy side or pensions, mutual funds. It’s actually firms in the quantitative trading space who are on the losing end of this, but have been the most aggressive in working with me in those competencies. And many of those firms didn’t find out about me by reading Dark Pools, they read my book The Problem of HFT and realized I was right.
It’s kind of strange to me that the last four years has really seemed to me like an insider versus insider, you know, kind of battle. The institutional investors, the major investment banks, have not addressed the problem, and if you think about some of the major equity venues, these dark pools having record fines – these execution electronic trading desks at the major investment banks are right now battling potential litigation. That doesn’t give them a lot of time to adapt their technology to become the kind of service that I believe should be generally prevalent, which would be, HFT for the buy side. It still does not exist.
James West: I see. So there’s an opportunity there, by the sounds of it?
Haim Bodek: Yeah. I think IEX has done a great job in kind of moving into that space; I think it may not be clear to people that this dark pool will soon be an exchange,IEX; they just have an order routing service that, my assessment, is better capabilities than most of the banks. It’s just fascinating.
James West: Right. Okay, and I asked you about a specific company and you mentioned that it wasn’t really an area that you – it wasn’t company-specific, the whole idea of HFT, and you just indicated that it’s more or less a transaction tax for anybody who’s in the market. And so for the retail investor, which is primarily my audience, is that just a reality that we’re going to have to live with? I mean, entities like yours and like some of the bigger ones, it’s just a transaction tax that we have to deal with?
Haim Bodek: Well, that’s the way I think of it, because the mechanics of especially the strategies and the order-type abuses that I’ve turned in, in many cases, it operates like a tax, in that two counter parties were going to trade anyway, and somehow, the HFT through these specialized features, was able to intermediate between those two traders.
So I think of that as a tax, but I think of that as a tax that’s really aimed at the institutional investor. Retail traders in the US are primarily routed to, what we call, wholesale market makers, who are allowed to trade against those retail traders without any competition at all. Those trades are not available to your traditional high-frequency trader, and that’s part of the reason why HFTs – and I guess I’m a little bit sympathetic to this – HFTs basically requested these order types, and you can look, the regulators have confirmed that these have been, these order types were basically requested by the HFTs. And they requested them because they were at such a disadvantage against institutional investors. They don’t think about – retail to them, that’s occurring off-exchange, that’s a whole world that they don’t have access to, and they’re on the exchange trying to trade with these toxic, large institutions and pensions, and they’re like, we need more of an advantage to do it.
So that’s one of the things that’s kind of broken in the US,because the what we call neutral trades, the mom and pop trades, because those aren’t really sent to the exchanges, it’s made the exchanges a very toxic place to trade.
James West: So you know, we’ve got this exchange that’s started in Canada called the Aqueatas NEO Exchange, and their whole value proposition to companies and to institutional investors is that they are going to bar certain HFT practices from even being possible on their exchange.
Haim Bodek: Yeah, I’m familiar with them, and by the way, I did actually do a review of Canadian market structure and did a private market structure event with RBC, so I got the opportunity to look at the difference there that you’re talking about. What’s interesting to me is that because of the dual listings, you’re still tied to all these practices here, even if you didn’t have them in Canada. And the latency, arbitrage, basically, a lot of these practices are oriented around instantaneous arbitrage between markets. So you’re – Canadian markets are, even if they get very, very friendly, you still are going to have this contamination from this dual listing.
James West: If people want to find out more about your particular area of expertise in the HFT world, where can they find that information?
Haim Bodek: On Amazon, I have one book, The Problem with HFT. That’s been very well received, basically, across the industry; it’s been cited by the SEC, and it was actually used, by one of the major class action lawsuits. So I definitely recommend picking that up if you want to get into this HFT wormhole.
We have another book coming out on November 1st, called The Market Structure Crisis. It is mainly oriented for people who are trying to get a big-picture view of what the major risks are, and when I say risks, I mean, if you are a broker or, let’s say, if you’re a mutual fund and you’re using a broker who is under investigation or dark pools, this kind of book would assist you in understanding what risks you have. If you’re investing in the exchange space, the lawsuits against the major exchanges should be very interesting and important to you. I do think the book is a little bit more academic, but we do give a broad review of the whole space in US equities. And then we also give some forecasts for some developments in the future. So The Market Structure Crisis is coming out November 1st, and lastly, if you want to learn more about me and my firm, just go to haimbodek.com. I also have a portal that you can get to from my main site, which contains a lot of my free research and videos.
James West: Great, Haim. I appreciate your time so much. Thank you for joining us today.
Haim Bodek: Okay. Thanks.
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