There has been a lot of press recently about the evils of high frequency trading (HFT), with many commentators saying that HFT may well be the root of the next big financial crisis. The basis for this view is the increasing importance of computerised market-making systems in providing liquidity to markets, and the concern about what happens if these participants stop providing this liquidity in the event of some sort of market panic. Additionally, some commentators maintain that automated market makers are trading in a manner that is to the detriment of other participants.
Rather than attempting to add more commentary to this debate, I'd like to contribute in a practical way by widening the understanding of these systems so that people can decide for themselves. As such, this is going to be the first in a series of articles during which we will build a fully-functional electronic market-making system. It's going to take a little while to develop all the pieces, but since I have the first piece almost ready to go I think it's time I came out with the introductory articles. This series will mostly be aimed at people with some computing background and interest in financial markets but not assume any knowledge of how markets work.
Nothing in these articles is going to constitute any sort of advice as to the merits of investing in a particular product, or making markets using a particular strategy. If you follow the series you will acquire some bits of software which can be used to construct an EMM (Electronic Market-Making) system. I won't make you pay for them, and if you use them, you may lose money. The software may have bugs or unintended features which cause you to lose money. I'm really sorry if that's the case. You need to understand the software and accept the consequences of what it does, because it will be trading on your account. You need to put in place any tests you require to feel happy that it is performing according to your specifications. You also need to understand that in financial markets you are dealing with random processes and as such even well-founded strategies can lead to losses. Additionally, anything you make using this toolkit will need to be able to hold it's own against other market participants who will be aiming to exploit it. In any financial situation you need to do your own research and take responsibility for what happens - this is no different. Obviously you shouldn't put more at risk than you can afford to lose, but it's your money, and you need to decide whether this is right for you.
It would be very cumbersome if every time you wanted to buy something you had to find the person willing to sell exactly that quantity at that time and agree a price, so generally when we buy or sell, a marketmaker actually takes the other side of the trade, hoping to find someone else wanting the opposite bargain later in the day. The marketmaker makes money by charging a small spread (ie they buy for lower than they sell for) in return for assuming the risk of holding the position you have put them into until they are able to unwind it by doing the opposite trade. This risk is a function of the ease of the unwind (how likely they are to be able to find someone to trade with) and the price volatility of the asset. So if you want to trade in a product which has very low price volatility, and very high liquidity, then it would be easy for the marketmaker to find someone to trade out of their position with, and they would not need to worry about the price moving too much while they hold the asset, so you would expect the spread between the bid and ask prices to be very low. Conversely, high volatility and low liquidity assets would normally have high spreads to compensate marketmakers for their higher risk.
In the old days, the position of marketmaker was held only by exchange locals who had to pay for the membership that allowed them to earn this spread, but with the advent of limit order books, anyone can provide liquidity to many markets and expect to be compensated for it. Our goal is to write a computer system which will do this for us. In order to do that, we first need to understand how a limit order book works, and by way of an example I'm going to jump right in and introduce the market we will use as the basis for this whole series.
The market we're going to use for our examples is bullionvault.com, which is in essence a physical gold and silver market, with all the actual metal held in escrow in reserves in New York, London and Zurich, with seperate order books in $, £ and €. If you sign up using that link I will make a small referral fee (at no cost to you) from the commissions you pay to trade your account, and that's I'm going to get for writing these articles. Before you sign up, you should of course, peruse the on-line help so you understand how their system works, and like any other investment, you should think carefully about the risks involved.
If you go to the front page, you can see the current sell and buy prices for gold in the three locations in one currency (USD by default).
Bullionvault USD gold touch prices
These prices are just the top of the order book - the so-called touch prices. You would find more quantity available at different prices to buy or sell further away in the book, but what the prices mean in this example is that if you wanted to buy one troy ounce of gold in NYC it would cost you $1528, but if you wanted to sell you would only get $1524, so the market spread is $4 per TOz or $110 per kg if you live in the modern world. We're going to use metric units for these articles as teaching something as amazing as a modern computer to think in Troy ounces (or any imperial units) is a great evil, like teaching children arithmetic only by using Roman numerals or something.
We're also going to use some real market-making terminology, so we're going to refer to bid and ask or bid and offer prices, rather than sell and buy prices. The easy way to remember which way round these are is to think about the fact that as marketmakers we want to make money and so charge people for what they want to do. If they want to sell, we're going to bid to buy those shares from them at a low price. If they want to sell, we will reluctantly offer to sell to them at a high price. Hence bid is low and offer is high. When these prices are reversed, the orderbook is said to be crossed. This happens in equity markets when they are closed for the night, there is then an auction phase where high bids are matched with low offers until the book is uncrossed and normal trading begins. We wouldn't expect the orderbook to be crossed in a continuous trading market like this unless something was wrong and matching was suspended.
If an order to buy comes in, and it has no limit price, it is matched with the cheapest available sell orders until it is filled. If it has a limit price, it will only be filled up to the limit price on the order. But what happens to the remaining quantity? Under normal circumstances, this quantity stays on the book at the limit price until it can be matched against an incoming sell order within its limit.
We say that an order that provides liquidity by sitting on the book waiting to be filled is passive and that an order which crosses the spread, taking liquidity from the market by crossing off with passive orders is aggressive. We can also refer to the passive touch and aggressive touch. If we have an order to buy, then the passive touch is the bid and the aggressive touch is the offer. This is because if we want to buy passively, we will place our order at the bid or lower, whereas if we want to buy aggressively, we will need to pay the offer or higher. The opposite would be true for a sell order. If we want to sell right now, we will need our limit price to be at, or more aggressive (lower) than, the current bid, whereas if we are prepared to wait, our price can be more passive (ie higher).
In the next article, I will introduce a the software we can use to connect to bullionvault. Please feel free to comment below if anything so far is unclear and I'll try to deal with it in the next article.
permalink Updated: 2011-05-11