The High Frequency Game Changer

The financial industry's leading independent research firm's forward-looking assessment into high frequency trading

Once regarded as a United States-focused trend, today, high frequency trading is gaining momentum around the world. Yet, while high frequency trading continues to be one of the hottest trends in the markets, due to the highly proprietary nature of the computer transactions, financial firms and institutions have made very little available in terms of information or "how-to" techniques. That's all changed with The High Frequency Game Changer: How Automated Trading Strategies Have Revolutionized the Markets. In the book, Zubulake and Lee present an overview of how high frequency trading is changing the face of the market. The book

• Explains how we got here and what it means to traders and investors
• Details how to build a high frequency trading firm, including the relevant tools, strategies, and trading talent
• Defines key components common to HFT such as algorithms, low latency trading infrastructure, collocation etc.

The High Frequency Game Changer takes a highly controversial and extremely complicated subject and makes it accessible to anyone with an interest or stake in financial markets.

Introduction xi

Acknowledgments xiii

Chapter 1 Birth of High Frequency Trading: Equity Markets Go Electronic 1

Defining High Frequency Trading 2

Who are the High Frequency Traders? 6

Impact of High Frequency Trading 9

Building a High Frequency Trading Team 13

Chapter 2 Market Structure 15

Order Handling Rules of 1997 16

Growth of Electronic Communication Networks 17

Regulation National Market System 22

Market Fragmentation versus Competition 28

Dark Pools 32

Chapter 3 Trading Infrastructure 47

Rise of High Performance Technology Vendors 49

Key Components of High Performance Infrastructure 52

Feed Handlers 52

Ticker Plant 54

Messaging Middleware 55

Storage 58

Networking 59

Colocation 60

Sponsored Access 61

Chapter 4 Liquidity 71

HFT as Liquidity Providers 71

Flash Crash 72

Chapter 5 Trading Strategies 75

Examples of Algorithms 77

Order Types 78

Flash Orders 79

High Frequency Trading and Predatory Strategies 79

Chapter 6 Expansion in High Frequency Trading 81

Futures 81

Fixed Income 84

Foreign Exchange Market 85

Equity Options 92

Over the Counter Derivatives 94

Expansion into Global Markets 94

Chapter 7 Positives and Possibilities 105

Commoditizing High Frequency Trading 106

Trading Technology Demands and Preferences 108

Internal Focus 109

Choosing Vendors 110

Finding the Next Opportunity 111

Issues and Risks 114

Order Routing Gets Smart 115

Smart Order Routing’s Future 118

Is Artificial Intelligence Next? 121

Economic Indicators 121

News 122

Securities and Exchange Commission Filings 123

The Pseudo-Semantic Web 125

Going Global 128

The Next Wave 129

Chapter 8 Credit Crisis of 2008: The Blame Game 131

U.S. Federal Reserve 131

Regulatory Agencies 132

Credit Agencies 132

Politicians 132

End-Users of Derivative Products 133

Recent Regulatory History 134

Financial Modernization Act of 1999 134

Commodity Futures Modernization Act of 2000 134

Dodd Frank Wall Street Reform Act of 2010 135

Ending Too Big to Fail Bailouts 136

Creating Transparency and Accountability for Derivatives 137

Hedge Funds 137

Credit Rating Agencies 138

Executive Compensation and Corporate Governance 138

Impact of Potential Regulations and Rule

Changes—Securities and Exchange Commission

Concept Release 139

Chapter 9 Conclusion 141

Glossary 143

About the Authors 149

Index 151

PAUL ZUBULAKE is a senior analyst at Aite Group, LLC, specializing in financial, energy and commodities futures, and options markets. His expertise includes how the application of technology, such as algorithmic trading and FIX protocol, is playing an ever-increasing role in futures and options trading.

SANG LEE is a cofounder of Aite Group, LLC and currently serves as the managing partner. Mr. Lee's expertise lies in the securities and investments vertical and has advised many global financial institutions, software/hardware vendors, and professional services firms in sell-side and buy-side electronic trading technology and market structure.

Lee and Zubulake have both been quoted extensively in the media, including in the Wall Street Journal, New York Times, the Washington Post, Financial Times, Business Week, Reuters, the Chicago Tribune, and other publications.

The transformation from a human based trading model to an electronic model has been one of the most important technological advances of modern investing. But this transformation has not come without controversy. Instead of calling in your orders to a broker who then would execute it via a floor exchange, the order now is instantly transmitted to the various market venues. The market has a new player, but it is not a person, it is a machine that can replicate the role of a liquidity provider but at a much higher rate of speed and efficiency. Sometimes controversial and most times misunderstood, the role of the automated trader is one of major importance in today's ever-changing marketplace.

The High-Frequency Game Changer offers a forward looking overview of the high-frequency trading trend—including the movement into other asset classes, global domination, and retail traders getting into the game. The book examines who "high-frequency traders" are and analyzes the impact of high-frequency trading on the rest of the marketplace—in particular how it affects liquidity and trading strategies. The authors detail the far-reaching effects, both positive and negative, of this trend, looking at its effect on futures markets, global markets, quantitative trading, future regulatory changes, and more.

The high-frequency trader story is one of how the shift of power in a profitable business can create a firestorm of misunderstanding. The High-Frequency Game Changer cuts through the confusion and shows how you can make the most of a fundamental change in the markets that is here to stay.