April 14, 2010

Quant Trading at the Hudson

Spring finally tossed its verdant cape over the Denver Front Range. We saw it firsthand on our bikes from Sedalia to Palmer Lake last weekend, our first 40-plus miler of the year. It’s been too cold! We know you Californians among us are already past the early and midseason allergens.

Meanwhile in Manhattan, down on Old Slip between Water and South streets there hums and whizzes a sharp shop of folks whose cares are far removed from the seasons. And apparently geography too, for Hudson River Trading sits just off the East River.

Hudson River Trading (HRT) is a quantitative proprietary trader. What’s that mean, in IR terms? That they use their own money to buy and sell securities with sophisticated mathematical calculations. HRT says it “develops automated trading algorithms using advanced mathematical and statistical modeling techniques and an extremely high-performance computing environment.” In a quick turn of phrase, it claims to have “successfully positioned itself at the intersection of technology and finance.”

Founded in 2002 by a Harvard computer science whiz, a Harvard math star, and the old guy of the group, an MIT math grad from the class of ’97, HRT calls its traders “algorithm developers.” According to job posts, they offer starting salaries around $175,000 plus incentives. They cater in breakfast and lunch. They wear jeans and t-shirts. You can bet these young, brilliant guns work hard.

One of HRT’s bright founders, Suhas Daftuar, has been appointed an interim member director for the new Direct Edge exchanges that will replace the former EDGA and EDGX tapes for active and passive mathematical trade executions. In a 2004 comment letter to the SEC on proposed rule changes emanating from Regulation National Market System, Mr. Daftuar explained that Hudson was a high-volume automated trader providing liquidity.

HRT is a high-frequency trader, not a broker-dealer. It doesn’t work order for clients. It instead does as other liquidity providers do and moves small amounts of liquidity from place to place at lightning speed to fill orders, committing little capital and modulating risk exposure with statistical analysis.

HRT makes money from doing the same thing over and over rapidly in places where it commands a competitive speed or market-structure advantage, and from “rebates,” or payment from exchanges for furnishing shares that attract other buyers and sellers. We’ve explained rebates before.

Key point: there is absolutely nothing wrong with this sort of trading. They are but modern-day specialists meeting the liquidity needs of a transient, complex trading market.

On the other hand, the growth of intermediaries like Hudson River, which facilitates interaction, signals to the observant that markets are commoditized. When intermediaries set prices and determine whether orders meet and fill, there is a fundamental structural problem. Look at health care, where the same problem exists. Intermediaries, not consumers and providers of services, set prices.

We want IR folks to understand that the great majority of trading activity reflects the actions of intermediaries reacting to small amounts of underlying real stuff. Intermediaries don’t determine outcomes, generally. Intermediaries point to changes in market structure. You can’t often fool the fleetest feet in the marketplace.

But intermediaries aren’t here to help you. And intermediaries have shaped the rule structure to which everyone else is now subject. We have equity markets ideally suited to the Hudson Rivers of the world, and they should be congratulated for outstanding entrepreneurial achievement. We in the IR industry might take a cue from them and start offering our own comments on market structure. It’s our marketplace too, after all.

Speaking of which, we at ModernIR have drafted a market structure comment letter for the SEC (the comment period is closing next week). If you’d like a copy, drop me a note. Perhaps you might encourage your management teams to use parts of it and offer comment letters themselves. Rarely do public companies speak up about the equity markets so crucial to capital formation.

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