Days after the so-called flash crash on May 6, veteran high-frequency trader and exchange entrepreneur Dave Cummings sat down with Traders Magazine to discuss a bevy of issues facing the equities markets. Cummings started the pioneering high-frequency trading firm Tradebot Systems out of a spare bedroom in his house 11 years ago. He remains its owner and chairman. In 2005, Cummings launched the electronic communications network BATS Trading. Today it’s the third-largest equities exchange. Here is part one of the interview.
Traders Magazine: So, does a prop trading firm ever have a day when it loses in the HFT game?
Dave Cummings: It depends on what your models are and how they work. Our goal is to create a very large number of very small trades, and to get statistical significance in a short window by being spread out. That’s our way of doing it. Other people would take much more directional bets than we would. We’re trading typically close to 3,000 stocks every day. And so, on any given stock we may make or lose money. But when you look at the whole basket, the good ones and the bad ones tend to average out. Most days we make money.
TM: They say that if you’re right 55 percent of the time in trading, you can make money?
DC: I don’t know what the exact number is, but yes. Do you have the edge, or not? I teach my traders: trade pretty small until you have your profit/loss chart going in the right direction. And when you like the shape of that, you start trading bigger. And when you get nervous, you start trading smaller. It’s really varying the trade size according to whether you think you’ve got the edge, or not. And I mean the statistical edge (not the edge on every given trade).
TM: So, whatever formula you have and how the market reacts to the way you’re reading it …
DC: Yes, there are a lot of different models out there. And certain days, our models seem to be doing well (so we should be a major player in that stock). And then there are days when you struggle with a stock, and you’ll need to back off a little bit. And some other algorithm is there to fill that gap. That’s what makes a robust market: having thousands of different people playing for all kinds of different reasons and all kinds of different time frames and all kinds of different correlations and models. Markets are all about transferring risk. And the more people you can pass that risk around to, the more value is created by the whole system. And that sounds like markets 101, but people forget that. It’s more than just a big poker game.
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I think it’s unproductive to label kinds of trades as morally better or worse than others. All investors and traders are in the market to make money. Some people do that in seconds and others do it in decades. But you set up a destructive process when you try to start to characterize trades; there are all these different nuances of why people do what they do. As long as they’re making legal trades, I don’t think you should try to second-guess the motives of a certain group of traders.
TM: Do you think that’s going on right now?
DC: There’s clearly a witch hunt. It’s driven by the political process.
I think if you’re talking about the events of [May 6], the market definitely needs better circuit breakers. There’s a thoughtful discussion underway to get to better circuit breakers. I’ve always believed that any time you break trades that’s really, really bad. It’s bad for the markets and the public’s confidence in the markets. The answer is not to go back and break the trades that somebody after the fact on some committee (without any transparency) decided these must be errors and these must be good. The answer is to build logic into the matching engines that don’t let errant trades happen in the first place–limits, collars, whatever you call it (that are thoughtful, transparent, known by participants up front) rather than having messes like we had last Thursday.
TM: What about a unified market surveillance system. Is that necessary? The recent move by NYSE Reg to hand the rest of its regulatory abilities to FINRA, do you think there should be just one person watching the markets?
DC: The markets need good regulation. Sometimes, some competition among regulators gives more efficient solutions, too. Any time you have one system, it never seems to catch the one thing that the bad guys are doing, because they’ve designed what they’re doing to circumvent the one system out there.
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TM: You’re saying that we need better, unified rules, where if everything is run properly we won’t have these shifts …
DC: Exactly, and so all you need to verify is … it’s similar to the business continuity rules. Exchanges have business continuity plans. The regulators test that they work, and they kick in when they need to. It’s the same thing with circuit breaker-type things.
We don’t need to be collecting millions of data points that we don’t know what to do with. You’ve got real issues of intellectual property leakage if you let different regulators or others start snooping through everybody’s trading styles. There are questions about what they are doing with that information, or what controls are there with that information.
TM: It sounds like you’re talking about the large-trader tagging thing.
DC: As an industry, we just have to think about things very, very carefully. There’s clearly a revolving door between regulators in the industry. So you have to ask yourself: is it fair to have a regulator look at a bunch of trades and then go take a job with a competitor? I want to make sure that whatever system is in place, there are information barriers that don’t let that happen.
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There is very stiff competition among the top players.
TM: Describe that process.
DC: A lot of people are out there with very complex strategies. Those strategies interact to form a pretty efficient market.
TM: Is that your arms race: dealing with these huge firms that are investing lots of money in algos?
DC: You clearly have to innovate in this business. You use technology and innovate. I’ve been in this business for 11 years, and every year the markets get more efficient, the spreads get tighter, the liquidity gets deeper. There’s no doubt, especially if you’re looking at it really close, that it may not be obvious. But if you look back a decade, the spread on stocks was 25 cents between the bid and offer. Now, we think of that as a huge move. Before, that was just the difference between a tick on the bid and a tick on the offer. And so, absolutely, the players that want to be on the lead lap have to invest in technology. That’s a good thing. We have computers and technology affecting every other segment of our lives. We need to make sure we’ve got a robust environment.
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But we have to have a robust environment that doesn’t let crazy things happen because of one bad program. So, it really falls on the exchanges and other market centers to build collars and circuit breakers. It goes back to defining what is a reasonable trade, and allowing trades within that range, and then trades in that range stand, and preventing–not cleaning up–trades from outside of that range. And as long as those boundaries are well known, let everybody play to the best of their ability and those competitive forces will make a better and better market. The long-term investor has never had a better deal than what they have today. You can buy and sell huge quantities of stock and pay your broker something like $8.95. A lot of the time, the bid-offer spread is less than a penny.
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The long-term investor is getting a great deal by these markets. The public, their confidence gets shaken by big plunges and volatility, especially like [May 6], when it got exaggerated. Overall, the public is fairly happy with the structure that you see electronically. They like pushing a button and getting a fill in a second. They don’t like having to route an order to a human being with a fill that comes back two minutes later. That was not popular.
TM: The exchanges, the SEC, there are a couple of initiatives out concerned about off-board trading. Some high-frequency traders like you that are supplying liquidity to exchanges are pleased with the way things are going with "trade at." The exchanges are also talking about introducing subpenny to low-priced stocks to increase price discovery …
DC: I’m generally not a fan of subpennies. It lessens the public understanding of the market, and that’s the primary concern.
TM: Is that because people can’t conceive of prices going below a penny?
DC: We’re conditioned to buy everything in the mall. It’s very natural to go into the stock market and see prices in dollars and cents. If you’re talking a five-cent stock, then maybe it makes sense to have prices in fractions, but I just don’t think there’s the public outcry there.
TM: How about the outcry from Tradebot? Would it help you guys out more? It’s a competition issue there.
DC: Whatever the rules are, we will compete. But ultimately, I want what’s good for the markets. If the markets instill public confidence, that’s the best long-term thing. I don’t want to ask for a bad market structure to benefit myself.
