Interview with Peter Green

In this first in our series of High Frequency Trading Interviews, we talk to Peter Green, Founding Partner and CEO of The Kyte Group, a leading independent clearer, broker & trader of financial derivatives.  The firm was established on the LIFFE exchange in the mid-1980’s and has grown to become a significant participant in the world’s major futures exchanges.

As well as being Chief Executive Officer of The Kyte Group, Peter serves as a trustee for the Nightingale House charity.

High Frequency Trading Review: Peter, welcome to the High Frequency Trading Review. What’s your own definition of high frequency trading?

Peter Green: My definition of high frequency trading would entail a large amount of relatively small orders, in and out of the market, where round trip times are measured in milliseconds if not microseconds, where the trading model is taking advantage of the “noise” in the market, to a degree providing liquidity to the market. But holding a position for more than a minute would be unusual for a high frequency trader.

HFTR: Ok, so HFTs generally hold a position for less than a minute?

PG: Yes and in many cases for a few seconds only, although there may be times when they hold the position for five minutes or more. One other qualification that is usually the case with high frequency traders is that they are flat at the end of the day, they do not take long term directional views. That’s an incredibly important factor when we come to talk about the systemic risk that HFTs provide to the market.

HFTR: One of the of big areas of confusion in the marketplace is regarding terminology, or the distinction between high frequency trading, flash trading andalgorithmic trading, which are all terms that seem to be interspersed but they do mean different things. Can you help us draw a distinction between those three different terms?

PG: Yes of course. Algorithmic trading, or algo trading, is a generic term that effectively describes a style of trading where algorithms are used to generate the orders. Effectively, it means there is some kind of computer model rather than human interaction in terms of artificial intelligence or some kind of sophisticated matrix that will generate trading signals. You could have a system that is algorithmic that generates signals without necessarily generating a trade and it doesn’t have to be a high frequency trade or a high frequency signal. Certainly groups like AHL, which is part of Man Group’s portfolio of trading hedge funds, is regarded as one of the worlds largest algo trading systems but it is not considered high frequency. It’s a trend following system; it’s made up of thousands of different computer programs. The people behind AHL (Adam, Harding and Lueck) were engineering graduates and geniuses in their fields, regarded as world leaders. So although that is algorithmic trading, their typical time frame could be two weeks to three months when they are holding a position.

You could have an algorithm that generates the signals, you can have a separate algorithm that would actually execute the orders and send them into the market. People will talk about things like VWAP when they are trading shares, which is a Volume-Weighted Average Price, itself an algorithmic application.

If you look at the exchanges, the LIFFE exchange for example has a process where in certain products, they judge your order on the time angle in terms of “did I put my bid into the market before you?”. They also have a pro-rata share-out where it depends on the size of my bid compared to yours. That in itself is referred to as an algorithm. It is the exchange’s algorithm of how they will deal with orders coming into the exchange and how they will share out whatever transaction is being processed at any one time.

So the term algorithm is quite generic. You must be aware that people talk about “algo” traders but there is a lot of crossover between the use of the term algo trader and the use of high frequency trader. By definition, a high frequency trader is an algorithmic trader but not the reverse.

As far as “flash” trading goes, flash trading by definition is a form of high frequency trading. But the controversy about this particular type of trading (and this is peculiar to the US stock markets, and not all of the stock exchanges in the US) is where the exchanges effectively created a club of favored high frequency traders who were getting to see orders in a very short period of time – but still a period of time – before the rest of the market (who weren’t members of that club) would get to see them. And because high frequency traders have algorithms that can make a thousand different decisions in a split second, by giving them even a fraction of a second to see an order before the rest of the market could see them, it gives them an unfair advantage. And so flash trading is the one that really got the goat of the politicians and the media in the States because this type of trading is not on a level playing field.

For example, if you wanted to go and buy Vodafone shares and you knew that every time there was a seller in the market, I could have a look 10 seconds before you see it and decide whether I wanted to buy that offer and you would be given the leftovers, you would be pretty upset. However, if both of us are allowed to see that offer in the Vodafone share at exactly the same time, but I’ve paid £10,000 for my computer and you’ve bought something from PC World for 500 quid, you have less right to be upset if I am getting that order executed a fraction of a second before you every time. You are allowed to go and spend £10,000 on the same piece of hardware as me to get your orders in quicker, you’ve just chosen not to.

As long as the market is managed as a level playing field, we should have the same fairness, the same rules, the same access and then it’s down to each individual as to how clever they are in designing their own algorithms and how much resource they want to throw at the system. For some of our traders here at Kyte, they don’t need to be split seconds ahead to do their trading, they are very happy to be not the first in the queue or not the fastest because sometimes the style of trading doesn’t require nanosecond technology.

HFTR: Can you elaborate a little on how high frequency trading is actually used at Kyte Group?

PG: There are a number of different legs to our business but the one that is relevant for this conversation is our clearing business where we provide exchange connectivity, DMA or Direct Market Access. Our clients connect to the exchanges through our pipes and through our exchange servers. We’ve got two very high tech state-of-the-art data centers here as well as having co-located servers in the Frankfurt data center for Eurex, in Chicago for the CME and we will be in Basildon when LIFFE moves their data center out to Essex in the coming months.

Our client base is made up exclusively of professional traders. We don’t have retail business here but the professional traders are split into three distinctive groups. We have high frequency traders that account for about a third of our activity. We have market makers, particularly option market markers, that account for about a third of our activity and then we have more traditional, what we refer to as “point and clickers” or screen traders.

These three constituents have all been able to survive and make money during quiet markets, busy markets and so on and there are times when certain market conditions suit some of them better than others. But the first constituency, the high frequency traders, are very focused on receiving market data as quickly as possible, getting their orders sent into the market in the lowest round trip time as possible and typically having flat positions at the end of every day.

The option market makers have very long term positions in terms of their underlying options portfolio. However it is very common that market makers in options will be quoting maybe 50 different prices in different products at any one time and as the underlying market on which they are quoting option prices start moving, it changes all of their prices on the 50 different options strikes they are quoting. They will be waiting until the underlying price moves by the smallest increment possible and suddenly all of the option prices get updated because that is how the process works. So for them, the speed of the price information coming to them from the exchange and their ability to requote the market every split second is as important as it would be for the high frequency guys. So even though they’ve got a very different style of trading their requirements for lightening fast access are exactly the same.

Then you come on to the 3rd group, the screen traders. No screen trader wants to believe that he is slower than the rest of the market but if you think that it takes half a second for a human to blink and the high frequency guys are doing hundreds of transactions per second, it gives you some ideas of the differences that you are dealing with here. Some screen traders will use what is known as “auto spreaders”. For example, you may have a screen trader who is pointing & clicking away but part of his strategy would be to buy the FTSE and sell the EuroStoxx index against it, as a packaged trade. The FTSE trades on LIFFE and the EuroStoxx trades on Eurex, so he is buying one market selling another. He knows what differential price he wants to trade them at and he wants to execute that trade as a package, all at one go. So he might use an auto spreader that employs an algorithm that will look at the price of FTSE on LIFFE, compare it to the price of EuroStoxx on Eurex and execute an order automatically for him. In that instance he will need to have very fast connectivity and round trip times otherwise he will always be second to the trade. But once he’s got that trade on, he might sit with it for a couple of days before he unwinds it.

HFTR: In terms of the access that you provide to these three types of trader, can we talk about that? There is a lot of controversy at the moment about sponsored access, naked access, direct market access and so on, with calls for greater pre-trade risk management across the board.

How does that work at Kyte Group? If you are providing access to these traders, what do you provide (and what is it necessary to provide) in the way of pre-trade risk management before any “fat finger” type problems can occur?

PG: Again there is certain confusion in the market place with terminology. People will mix up DMA with sponsored access or “naked” access and not everyone uses the right term.

As far as Kyte is concerned we only provide DMA. We will not provide sponsored access or naked access because of the reasons you mentioned. It is essential to us that we can monitor every trader’s position. It is essential to us that we can block a trader if they are losing too much money, it is essential to us that we can prevent the “fat finger” error or in the case of algorithmic trading the risk of a computer model getting stuck in a loop where it just keeps buying and buying and it’s a while before the operator or the trader behind the algorithm realizes that something has malfunctioned in his software. So from our perspective, we will only allow DMA and as far as we are concerned DMA means that you will have to pass your orders through a risk management system here. Of course for high frequency guys, their concern is that by introducing that extra risk management filter it will slow them down and when you are competing in milliseconds and microseconds, that kind of filter and slowdown can be crucial to you. It’s possible that Kyte has missed out on business opportunities because we would not allow traders to enter the market without passing through a risk filter, but that’s a commercial choice, it’s not yet a regulatory requirement.

HFTR: And by having that filter in place you are making sure you are not open to massive losses through some kind of rogue algorithm or fat finger error.

PG: Yes exactly.

HFTR: OK, moving on. Co-location is another area that has been somewhat controversial because there are critics who say that the fact that exchanges provide co-location services to high frequency traders is not a level playing field, because it gives unfair speed advantages. What would be your response to that? You mentioned earlier that you do use co-location for certain exchanges.

PG: Absolutely, we do provide co-location facilities but it’s a cost issue. There is a level playing field as far as what is available and on offer, it’s just a matter of price. The exchanges have seen that providing co-location facilities is a source of potential income for them. If you see the facility that LIFFE has created in Basildon it will blow you away in terms of the specification and the quality of the place and that doesn’t come cheaply! They’ve built what adds up to something like eight football pitch sized halls that are bomb proof, fire proof, tamper proof, they’ve gone to absolutely every length to provide the very latest technology available. If you want to have your trading machine based in that data center, you can do it, I can do it or JP Morgan can do it. It’s just a case of paying for it. And if you aren’t focused on the speed of execution, then you can put your trading machine in either in Kyte’s own data center in Islington or run it from your home office.

It’s your prerogative, it’s your choice. It’s all dependent on the style of trading that you take. If you are a retail investor (and, correctly, so much of the regulators’ focus is to look after retail clients), it’s unlikely that you will be bothered whether you get your order into the market in a millisecond or a micro second. You just want to know that you’ve bought those Vodafone shares or those FTSE futures and you will sit with them for either an hour or a day or a week. As an investor, you are at no disadvantage but if you are a short term day trader, you might want to pay the extra price to be co-located.

I believe that high frequency traders actually add liquidity to the market and allow the retail investor to get his order filled more quickly than he might have done a few years ago before HFTs were even present in the market.

HFTR: Regarding the wider controversy that’s out there about high frequency trading, do you think that is purely due to a lack of understanding on the part of the public and sensationalism on the part of the media, or are there real concerns and valid issues that need to be addressed?

PG: There are certainly valid concerns and issues that need to be addressed. The controversy around high frequency trading is misplaced in many cases but not in all cases. I think it’s a mistake on the part of the exchanges if they focus too much on any particular group. Two or three years ago the exchanges were getting excited as the largest growth area they were seeing was coming from the high frequency traders. They made a few changes in the marketplace to suit this sector of the client base. For example, one major exchange halved the tick size in a core product to suit the high frequency traders to the detriment of options market makers and screen traders.

HFTR: Well I guess it can mean lower spreads.

PG: Lower spreads between bid and offer, which is good for HFTs but not always ideal for other trader types because the cost of trading versus making a tick was doubled. Whereas for the high frequency traders it was positive because they wanted smaller spreads for getting in and out in smaller size. For some banks, they felt that it was actually bad for liquidity because they felt that if you were trading at a price of five and a half, you might be able to get 100 contracts away but if you were trading at five, you might be able to get 300 contracts away. For a lot of bank traders, they prefer to execute large orders at one price.

The point I am trying to make here is that if every exchange were to accept they have a broad church of client types and/or trading strategies and that they shouldn’t be favoring one type over another, then I think that’s a healthy approach. If you find yourself in a situation where those US stock exchanges did start favoring one group with flash trading, you start getting yourself into a mess with unlevel playing fields. And that’s when the politicians and the regulators start stepping in and with good reason.

So the area of high frequency trading is not controversy-free but I do think that there is a huge amount of misinformation; people get scared of things that they don’t understand.

Going back two or three years, the term algorithmic trader or algorithm made people nervous because they didn’t understand what it meant; some people couldn’t even spell it properly! It’s taken a while for people to understand the issues within our industry. So what about people outside the industry? They just assume that they are being terribly disadvantaged by secretive “black box” trading systems that are destroying the fabric of the financial system. This is simply not the case.

It is worth noting that the major exchanges believe that as much as two thirds of the activity on all their markets is now generated in an automatic fashion by computers.

HFTR: Do you think that is what is making the public and the retail investors uneasy?

PG: Yes, because they think that they must be at a disadvantage if they are in the minority. But really it’s just progress. Think of any other industry. If the trading industry hadn’t modernized and used technology to improve speed of execution, would it be better to go back to Victorian days where you did one trade a day over a cup of tea on the stock exchange floor and where we discuss how your family was before we completed the deal?

You’ve got to be realistic about technological progress. The big change I think started happening from around August 2004 when we started seeing a surge in the automated trading systems that were entering in the market. Technology had moved on and hardware had improved and bandwidth was increasing rapidly. We have moved from standard 126k bandwidth 10 years ago to Gigabit now and every year the bandwidth of connections seems to double again. It’s the same thing as your internet connection from home. You’ve probably got something like 8Mb broadband at the moment, whereas five years ago that was unthinkable.

So one needs to keep things in that kind of context before you get too upset about these developments.

HFTR: In conclusion, there are calls from various quarters for greater regulation and the SEC had their round table discussions last week. So first of all, do you think that any greater regulation is needed and if so, which are the areas that do need to be looked at most closely, in both the US and in Europe?

PG: I would say risk management is certainly a key factor. In terms of systemic risk, I don’t believe that HFTs are a systemic risk generally speaking and certainly the “flash crash” of May the 6th has not been attributed to any kind of high frequency trader. The regulators are still looking into the case and it might be sensible for the exchanges to introduce tighter circuit breakers.

I think that it would be bad for the market if high frequency traders were given naked access where software bugs could lead to some kind of anomalous trade that could be very costly. I think there’s a low risk of that but I think it needs to be addressed. But if you think about the style of most high frequency traders, it’s very rare that they retain open exposure to the market for any period of time, typically no more than a minute or so. And so you are not looking at a Lehman’s type disaster, you couldn’t be further from it.

I would suggest that the two key issues the regulators should focus on are front-office risk control (ensuring that computer malfunctions don’t cause some spurious type of trading activity) and that there is a level playing field for all market participants where exchanges ensure that everyone has the same right of access and that there is no club of exclusivity. If it is purely a cost differential of “can I afford to have the latest equipment?”, that is acceptable. Anything else is not.

HFTR: And do you see the UK and the European regulators as being on top of this as much as the SEC and the CFTC?

PG: No, but the US has the tightest regulated market of anywhere in the world. Could European regulators pick up some of the positive aspects of what the US regulators are doing? Absolutely yes but in my view, the regulators are focused on some other things at the moment such as market abuse, bankers’ bonuses or the separation of the investment bank from the retail bank. Those are much bigger issues at the moment. But what tends to happen is whenever those bigger issues get dealt with and go quiet, the high frequency story comes back up and you see a lot of the media regurgitating stories they put out a year before.

If you attend any of the trade shows like the upcoming IDX, it’s unlikely that there will be any new information presented regarding high frequency trading. The big story at the moment is to do with global regulation rather than high frequency trading.

HFTR: Ok, well on that note, I’d like to thank you for sharing your thoughts with us today Peter.