Latency arbitrage, exploitation of electronic stocks, and high-frequency trading are the financial jargon that have been regularly discussed over the past month. People claim the US stock market is fixed; by high frequency traders, investment banks and private exchanges. But what does all this mean?
Public and private stock exchanges contain high-performance computers programmed to trade financial vehicles at the speed of light. Any computer trades large chunks of stocks in fractions of a second while also receiving information about the same stocks, milliseconds before ordinary investors get the data. The high-frequency trading firms only collect data milliseconds in advance, so what’s the problem?
Surrounding the concept of latency arbitrage is the idea that people receive market data at different times; the time difference is tiny. Latency arbitrage occurs when high-frequency trading algorithms trade ahead of a competing trader a split second, and then pass the shares on for a small profit moments later. While profits per trade are small, total earnings from HFT make up a significant portion of assets traded on the US exchange. Essentially, latency arbitrage is the main theme of HFT – algorithmic trading, which specifically uses sophisticated technological tools and computer algorithms to trade securities quickly.
Today we find private exchanges paying large sums to run high-speed fiber optic cables from trading venues directly to their servers, shaving milliseconds off the time they receive market data.
Here is an illustration of how high frequency trading firms exploit time frames of multiple stocks in a single trade: You buy 20 shares of Bank of America at $17.80147. You place the order through your online brokerage. The agent buys 5 shares from an investor in Chicago, 5 from a Los Angeles firm, and 10 from a Denver firm. The broker then sends your order to parties in Denver, Chicago, and Los Angeles via high-speed fiber optic cable. Once your order reaches Denver, firms that have cables direct to that exchange will see your potential order, and within 4 milliseconds of you buying 10 shares of Denver and 5 shares of Chicago, high-speed trading firms are selling Bank of America stock at one priced at $17.80689 and an even higher price when your order reaches Los Angeles. Companies use various manipulations such as those widely used for investors and companies across the country.
Companies like the Royal Bank of Canada have developed software that staggers a trade so all parties involved can get the information immediately. This means (in the context above) that your order to buy Bank of America reaches Chicago, Denver and Los Angeles simultaneously, giving high-frequency traders not a nanosecond to advance your order. Other trading companies like Fidelity have laid 50 miles of spools of fiber optic cable between themselves and other traders. The coil serves to delay the trades going in and out of the firm. When high-frequency traders submit their trades to Fidelity, their data travels a full 80 kilometers through fiber optic cables, reaching the trader at the same time as all other trades.
Essentially, this is what companies that have the financial resources to leap to the forefront of trading do. These firms are ambivalent about what they trade; They trade because they know they are guaranteed a profit. High frequency traders don’t play the market, they play the players. HFT has always been the domain of mathematicians and physicists. Just the simple notion that physicists have their own niche in stock market trading should raise eyebrows. These traders don’t actually invest capital; They essentially collect a tax on every share of equity traded. Unfortunately, it’s legal… and interestingly, big banks don’t argue about it. Put simply, all they have to do is put themselves on the same footing as the high-frequency traders, which contain either trading algorithms that stagger each trade, or spools of high-speed fiber optic cables that limit the rate at which all parties are receiving data , fight physically .
Ultimately, the latency arbitrage form of high-frequency trading is legal, but certainly not victimless anymore. All investors who do not have the same trading opportunities as high-frequency traders have to pay a slightly higher price. On the one hand, the companies that operate HFT paid large sums of money to do so – which does justice to the notion that this is every company’s prerogative. 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 fundamental aspect of our economy and the stock market plays a central role in the growth of industries. Investing in the stock market is one of the few true financial win-win activities for individuals (minus the inevitable introduction of capital gains tax). Complexities like HFT in the marketplace seem daunting to an exchange fueled by the invisible hand in which our economy’s platform exists. I believe that once deterrent is allowed beyond taxation, total participation [in the market] sinks. All investors should act on the same level – the investment assessment does not include safety analysis, quantitative and qualitative analysis and location of high-speed fiber. Once algorithmic trading is no longer unilateral (e.g. merger arbitrage), it must be regulated by an appropriate government agency. Ironically, the way to preserve the fundamentals of laissez-faire economics is to use the considerable powers of legal action through the promotion of regulation.
Beginning April 13, the Securities and Exchange Commission is preparing to remove a number of high-frequency trading firms. Additionally, the SEC intends to campaign for new rules and trading practices that would limit latency arbitrage.
Finally, a few food for thought – the practice of high-frequency trading [at its current level] was developed by Bernie Madoff.