High Frequency Trading: Sneak Peek and Cut the Line

Latent arbitrage, electronic stock leverage and high frequency trading are the financial jargon that has been discussed regularly over the past month. People argue that the US stock market is fixed; from high-frequency traders, investment banks and private stock exchanges. But what does it all mean?

Public and private exchanges contain high-performance computers that are programmed to trade financial instruments at the speed of light. Each computer trades large swaths of stock in fractions of a second, while simultaneously receiving information about the same stock milliseconds before ordinary investors receive the data. High-frequency trading firms only collect data milliseconds in advance, so what’s the problem?

The concept of latent arbitrage is surrounded by the idea that people receive market data at different times; the time difference is minimal. Latency arbitrage occurs when high-frequency trading algorithms enter trades fractions of a second before a competing trader and then pass on the stock moments later for a small profit. Although the profits per trade are small, the aggregate revenue from HFT is a significant portion of the wealth traded in the United States stock market. In essence, latent arbitrage is the main problem of HFT – algorithmic trading, specifically using sophisticated technological tools and computer algorithms to quickly trade securities.

Today, we find private exchanges paying large sums of money to lay high-speed fiber optic cables from trading venues directly to their servers, taking milliseconds off the time they receive market data.

Here’s an illustration of how high-frequency trading firms use the time frames of multiple stocks in one trade: You buy 20 shares of Bank of America for $17.80147. You place the order through your online intermediary. The brokerage firm buys 5 shares from an investor in Chicago, 5 from a firm in Los Angeles, and 10 from one in Denver. The brokerage then sends your order via high-speed fiber optic cables to countries in Denver, Chicago, and Los Angeles. As soon as your order reaches Denver, the firms that have wires going directly to that exchange will see your future order, and within 4 milliseconds, when you buy 10 shares from Denver and 5 shares from Chicago, the fast trading firms sell the shares of Bank of America for you at $17.80689 and even higher by the time your order reaches Los Angeles. Firms use various manipulations, such as those on a large scale to investors and businesses across the country.

Companies such as the Royal Bank of Canada have developed software that distributes trades to allow each party involved to receive the information immediately. This means (in the context above) that your order to buy Bank of America will reach Chicago, Denver, and Los Angeles at the same time, leaving not a nanosecond for high-frequency traders to execute your order. Other trading firms such as Fidelity have installed 80km coils of fiber optic cables between them and other traders. The coil serves to slow down transactions entering and exiting the firm. When high-frequency traders submit their trades to Fidelity, their data travels over 50 miles of fiber optic cables and reaches the trader at the same time as all other trades.

Essentially, companies that have the financial means to jump to the front of the queue to trade do so. These firms are ambivalent about what they trade; they trade because they know they have a guaranteed profit. High frequency traders don’t play the market, they play the players. Since its inception, HFT has been the domain of mathematicians and physicists. The simple idea that physicists have their own niche in stock market trading should raise eyebrows. These traders do not actually invest capital; they collect what is essentially a tax on each share of equity that is traded. Unfortunately, it’s legal… and the interesting thing is that the big banks aren’t up for it. Simply put, all they have to do is put themselves on the same level as high-frequency traders, which will involve either trading algorithms that move every trade, or coils of high-speed fiber optic cables that physically struggle with the speed at which all parties receive data.

After all, the latent arbitrage form of high-frequency trading is legal, but it is certainly no longer victimless. All investors who do not have the same trading facilities as high-frequency traders are forced to pay a marginally higher price. For one thing, HFT firms do pay large sums to do so – lending credence to the notion that it is the prerogative of each firm. Additionally, arbitrage has been a concept used by traders since the inception of the New York Stock Exchange. On the other hand, investing in the market is a major aspect of our economy and the stock market plays a major role in the growth of industries accordingly. Investing in the stock market is one of the few truly profitable financial activities for the individual (without the inevitable application of capital gains tax). Complexities like HFT in the market hold back the exchange that is governed by the invisible hand in which the platform of our economy exists. I believe that once deterrence beyond taxation is allowed, the total participation [in the market] decreases. All investors must trade on the same level – investment evaluation does not include security analysis, quantitative and qualitative analysis and high-speed fiber optic location. As soon as algorithmic trading is no longer one-sided (such as merger arbitrage), it must be regulated by an appropriate government agency. Ironically, the way to preserve the vestiges of laissez-faire economics is to use the considerable powers of legal action by promoting regulation.

As of April 13, the Securities and Exchange Commission is preparing to delist a number of high-frequency trading firms. In addition, the SEC is seeking to use a campaign of new rules and trading practices that would limit latent arbitrage.

Finally, some food for thought – the practice of high frequency trading [at its current level] was created by Bernie Madoff.

Source by Cassidy Chalhoub