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High Frequency Trading: Sneaking a Peek and Cutting the Line
Delayed arbitrage, the use of electronic capital and high-frequency trading are all financial jargons that have been discussed regularly in the past month. People argue that the US stock market is stationary; by high-frequency traders, investment banks and private stock exchanges. But what does it all mean?
Public and private exchanges contain high-performance computers programmed to trade financial instruments at the speed of light. Each computer trades large swathes of stocks in fractions of a second, while receiving information about the same stocks milliseconds before ordinary investors receive the data. High-frequency trading firms only collect data milliseconds ahead, so what’s the problem?
The concept of latent arbitrage is surrounded by the idea of people receiving market data at different times; the time difference is negligible. Delayed arbitrage occurs when high-frequency trading algorithms enter trades a fraction of a second before a competing trader, then pass on the stock moments later for a small profit. Although the profit from the trade is small, the aggregate income from HFT represents a significant portion of the wealth traded in the United States stock market. In essence, delay arbitrage is the main problem of HFT – algorithmic trading, particularly the use of sophisticated technological tools and computer algorithms to trade securities quickly.
Today, we find private exchanges paying large sums of money to run high-speed fiber optic cables from trading floors directly to their servers, shaving milliseconds off the time it takes to get market data.
Here’s an illustration of how frequency trading firms use multiple stock time intervals in a single trade: You buy 20 shares of Bank of America at $17.80147. You place an order through your online brokerage. A 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 members in Denver, Chicago and Los Angeles. As soon as your order reaches Denver, the firms that connect the cables directly to that exchange will see your possible order, and within 4 milliseconds, if you buy 10 shares in Denver and 5 shares in Chicago, the high-speed trading firms will sell Bank of America shares to you at $17.80689 and more by the time your order reaches Los Angeles. Companies use various manipulations like this on a large scale for investors and firms across the country.
Companies like the Royal Bank of Canada have developed software that stagger trades so that everyone involved can get immediate information. This means (in the context above) that your Bank of America buy order will reach Chicago, Denver, and Los Angeles at the same time, leaving not a nanosecond for high-frequency traders to get ahead of your order. Other trading firms, such as Fidelity, have installed 80-kilometer coils of fiber optic cables between themselves and other traders. The coil serves to delay transactions entering and exiting the firm. When high-frequency traders send their trade to Fidelity, their data travels through fiber-optic cables for as much as 80 kilometers and reaches the trader at the same time as all other trades.
Essentially, companies that have the financial wherewithal to jump in the trade first do so. These firms are ambiguous 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 been the domain of mathematicians and physicists since its inception. The simple idea of physicists having their own niche in stock market trading should be surprising. These traders do not actually invest capital; they collect what is essentially a tax on every share of equity traded. Unfortunately, it’s legal…and interestingly, the big banks aren’t worried about it. Simply put, all they have to do is put themselves on the same plane as high-frequency traders, which will include either trading algorithms that knock down every trade, or spools of high-speed fiber optic cables that physically compete with speed, with by which all parties receive data.
Ultimately, a form of high-frequency trading with latent arbitrage is legal, but it is certainly not without its victims. All investors who do not have the same trading tools as high-frequency traders are forced to pay a slightly higher price. On the one hand, firms involved in HFT have indeed paid large sums to do so, suggesting that it is the prerogative of each firm. Furthermore, arbitrage has been a concept used by traders since the inception of the New York Stock Exchange. On the other hand, investment in the market is a fundamental aspect of our economy and the stock market accordingly plays a key role in the development of industries. Investing in the stock market is one of the few win-win financial activities for a person (minus the inevitable capital gains tax). Complexities such as HFT in the market hinder the exchange that is guided by the invisible hand in which the platform of our economy exists. I believe that once a deterrent incentive other than taxation is allowed, general participation [in the market] is decreasing. All investors must trade on the same plane – investment evaluation does not include security analysis, quantitative and qualitative analysis and high-speed fiber optic deployment. Once algorithmic trading ceases to be one-sided (such as merger arbitrage), it must be regulated by the appropriate government agency. Ironically, the way to preserve the rudiments of a laissez-faire economy is to use significant powers of legal action through the promotion of 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 plans to implement a series of new rules and trading practices that would limit delayed arbitration.
Finally, food for thought is the practice of high-frequency trading [at its current level] was developed by Bernie Madoff.
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