When a stock gets overheated, some form of
stock-specific circuit breaker is a very effective means for
letting information repopulate in the marketplace,
Limes Wecker told me a few days after the flash crash. He
advocates an initial short-term cooling-off period measured in
seconds or minutes; if a stock suffers a subsequent steep
decline in price, the next halt would be longer.
Like many of the people I have interviewed about high
frequency trading over the past five months, Wecker is
concerned that regulators could try to rein in the practice by
putting limits on technology. After all, his business is built
on speed. The challenge with speed bumps is that you are
slowing down innovation to accommodate the players who have no
interest in investing in innovation, says Wecker, 47, who
spent 11 years at Goldman, Sachs & Co., including six in
its famed quantitative trading group, before eventually moving
to Lehman Brothers to build its electronic trading group. He
left Lehman in April 2008, five months before the investment
bank filed for bankruptcy, and was hired by Lime founder Mark
Gorton that November.
Lime handles hundreds of millions of trade orders a day.
This spring it introduced a product called LimeInside that
enables customers to place an order with Nasdaq, NYSE Arca and
BATS in less than ten microseconds, on average including
real-time pretrade risk checks. Thats blazingly fast,
confirms Tradeworx CEO Narang. It takes his group about 20
microseconds to do a trade from the moment a stock quote enters
its system, triggers a signal, determines an order and passes
through risk controls. Besides Lime, the only firms that are
faster than Tradeworx, Narang says, are Tradebot and Getco.
Trading in the single-digit microseconds would be impossible
for firms like Lime, Tradebot and Getco if they didnt
house their algorithms near the computer matching engines that
power exchanges, ECNs and other electronic marketplaces.
Brokerages, proprietary trading firms, hedge funds and other
asset managers can lease co-location space in exchange-owned
facilities (such as the NYSEs Mahwah data center) or
those owned and operated by third-party providers like
Co-location has been a hot-button issue for critics of high
frequency trading. I wonder, however, how many have actually
visited a co-location facility. In March I got the chance to do
just that at Equinixs 340,000-square-foot NY4 data
center in Secaucus, New Jersey. My host was Brandon
Travan, head of the information technology infrastructure,
co-location and cloud-hosting services divisions for Gravitas
Technology, one of the growing number of companies that provide
turnkey technology solutions for high frequency traders
and one of the first tenants at NY4.
From the outside, the white, two-story, unmarked building,
located 11 miles west of downtown Manhattan in an area known
best for outlet shopping, looks like a suburban medical office
or law firm. (I later learned that it had been an eyeglass
factory.) The lobby is equally nondescript, if not a little odd
theres not much more than a phone, a plain steel
door and a biometric hand scanner. After dialing in a personal
code matched against the geometry of his hand, Travan got us
into an inner lobby, where three security guards sat behind
bulletproof glass and Kevlar-reinforced walls. I gave them my
drivers license (which, I was told, Id get back
when I left), and after two more sets of hand scans and steel
doors, we entered the co-location area.
I was glad that I had decided to wear a light coat over my
suit that day, because Equinix keeps the facility at a cool 65
to 72 degrees Fahrenheit. The design itself is also very cool.
Built on a concrete slab with 45-foot-high ceilings, the
building is organized along a rectangular grid system, with
rows and rows of servers housed in metal cages for as far as
the eye can see. Yellow trays snake above the cages, carrying
all types of cables. Orange innerducts transport
fiber-optic connections within the cages. Giant
air-conditioning units, located outside the co-location area in
case of a water leak, pump air through large green ducts that
come down over the cages, creating a giant convection loop that
sends the heat from the servers and networking equipment up
toward the ceiling and out through the roof.
The facility is kept dark, both to improve its energy
efficiency and to protect the anonymity of Equinixs
tenants. Each cage has lights that come on automatically when
someone enters, I learned when Travan typed in the code to
unlock his cage. Gravitas has about 35 clients operating out of
its space, including one large hedge fund firm that spent more
than $1 million on computer hardware, software and setup costs.
The majority of Gravitass clients, however, are small.
The company provides all of its clients with direct high-speed
connections to all the market data providers and trade
execution networks, including other NY4 tenants, like Direct
Edge and the International Securities Exchange.
We make the electronic trading community of Equinix
available to smaller players by taking advantage of economies
of scale helping them get in with the technology they
need with almost no up-front capital, Travan told me.
If youve got a coder and the next best algo for
trading equities, currencies or other vehicles, instead of
needing a quarter-million dollars to start up, you can simply
install your code on our hosting platform or send us servers to
plug in, and youre ready to go.
Not everybody, however, buys the democratization argument.
James McCaughan, CEO of Principal Global Investors, says
co-location gives high frequency traders an unfair advantage.
Co-location creates an informational asymmetry that is
fundamentally acting against the interests of long-term
investors, McCaughan told me exactly one week after my
visit to the Equinix data center. I have no problem
with people developing algorithms for high frequency trading as
long as theyre doing it with the same information as
McCaughan, whose team manages $215 billion in mostly 401(k)
and other retirement assets for Principal Financial Group,
considers himself to be a pretty savvy investor. His
equity-trading desk has six people at the companys Des
Moines, Iowa, headquarters; two each in London and Singapore;
and one in Tokyo, as well as access to state-of-the-art
trade-execution algorithms offered by all the leading brokerage
firms and third-party vendors. Although theres nothing
stopping Principal from using co-location, McCaughan told me
that for a long-term investor, its probably not worth the
effort. As a large, sophisticated investor, we can
compete, he said. But it is a weaker market if you
have to be that sophisticated to compete.
HIGH FREQUENCY TRADING BURST into the public consciousness
last summer when news broke that a former Goldman Sachs Group
computer programmer had been arrested by Federal Bureau of
Investigation agents at Newark Liberty International Airport
for allegedly stealing software code. According to the FBI, the
programmer, Sergey Aleynikov, transferred thousands of files
related to Goldmans proprietary trading program to his
home computers with the intention of using them to help his new
employer build a high frequency trading platform. It
didnt take long for that employer, Chicago-based Teza
Technologies, to cut its ties with Aleynikov. But Tezas
co-founders soon landed in hot water themselves when just six
days after Aleynikovs arrest, hedge fund firm Citadel
sued them for violating a noncompete agreement and trying to
steal its trade secrets. Last fall Citadel finally got the
injunction against Teza that it was seeking, but by the time
the judgment was rendered, the nine-month noncompete period had
The Citadel-Teza lawsuit provides an illuminating window
into the world of high frequency trading. The person at the
center of the drama is Mikhail Malyshev, a brilliant
Russian émigré with a Ph.D. in plasma physics who
joined Citadels high frequency trading group in
2003. During Malyshevs six years at Citadel, the firm
spent hundreds of millions of dollars researching and
developing high frequency trading models and building out the
IT infrastructure and systems to implement them. Its market
data system, for example, contains roughly 100 times the amount
of information in the Library of Congress. Citadel uses this
historical data to test its models, which attempt to forecast
changes in the prices of securities by analyzing statistical
pricing patterns, supply and demand imbalances and other
factors. The signals, or alphas, that prove to have predictive
power are then translated into computer algorithms, which are
integrated into Citadels master source code and
electronic trading program.
Malyshev oversaw all aspects of Citadels nearly
60-person high frequency business, including the approval of
trading strategies. He resigned on February 16, 2009; the next
day his top lieutenant, Jace Kohlmeier, left too. By April they
had incorporated Teza. Last fall, while I was reporting my
story on Citadel, Kenneth Griffin, the firms billionaire
founder and CEO, told me that before the arrest of Aleynikov,
he had no idea what Malyshev and Kohlmeier were doing at Teza.
After all, he said, the two were still on Citadels
payroll as part of their noncompete agreements.
Like most hedge fund firms, Citadel is secretive about its
investment strategies. The fact that Griffin would pursue a
very public lawsuit with Tezas founders says a lot about
the importance of high frequency trading to the $12
billion-in-assets Citadel. In 2008 its high frequency group
made $1.15 billion, compared with gains of $892 million the
previous year and $75 million in 2005, according to
Malyshevs testimony. The 2008 performance was especially
impressive given how poorly Citadels large multistrategy
funds did that year: Its flagship Kensington and Wellington
funds were each down about 55 percent.