The Front Office: A Hedge Fund Guide for Retail, Day Traders, and Aspiring Quants by Costello Tom

Author:Costello, Tom [Costello, Tom]
Language: eng
Format: epub
Publisher: Limoges Press LLC
Published: 2021-02-25T16:00:00+00:00

If the market maker were to take the event of your order’s arrival in the market and use that to drive its own orders on other exchanges it would be illegal, so it doesn’t. Instead, it uses its own system’s internal event of a generation of a confirmation receipt, to drive all further action within its system. That difference costs them a total of 410 microseconds on every transaction, but it technically eliminates any accusation of front running, lowering the regulatory risk. When they were designing the system they literally imagined an SEC investigator saying “Do you use the arrival of that order to drive any logic in your system pertaining to other orders?” If they’re ever asked that question, they will confidently reply “No”.

They HF market maker has been monitoring the news as well, and since being faster is the singular goal of their systems, their systems are an order of magnitude faster than yours. So, while the analysis of the headline was still being processed by the much slower systems in the various hedge funds (including yours), their system was scanning the prices for DANF in all the less frequently used exchanges and dark pools. In anticipation of an increase in buy volume generated by the news, they placed their own buy orders at the lower effective range of the bid offer spread, wherever those other exchange prices were below the prices at the primary exchange.

Technically, there is no front running occurring. All that’s happening is they’re reacting to the news faster than you are, and being more specific about where their orders are placed. And since their orders are arriving at those remote exchanges first, they’re buying up any of the lower priced shares that are available. By the time the orders on the NYSE are ready to be acted upon, they’ve already accumulated a low-priced inventory of shares to meet the increase in demand that’s only milliseconds away.

They bought their stock in places like Kansas City and Philadelphia, as well as the half dozen dark pools that are run by the money center banks, all of which they have access to. On average, they paid 49.403 per share. So, when their system sells those same shares to you from their inventory at the NYSE a few milliseconds later, they can do so at 49.4144 - below the limit price specified on your order, and still make a tiny profit per share.

Since they specified prices with their orders, all their orders were filled as limit orders, so in addition to a small profit, they will also inevitably collect an additional .6 cent per share rebate from the exchange as well. And thanks to their ability to predict the flow of future orders (their solitary business expertise), after filling your order, they still have a sizable position in DANF left to accommodate all the people who are your direct competition, but run slightly slower systems, and haven’t reacted to the new information as rapidly as you.

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