Financial jargon has been discussed frequently over the past month. Many claim that the U.S. stock markets are fixed by high frequency traders and investment banks. What does this all mean?
High-performance computers are used to trade financial instruments at lightning speed on both public and private exchanges. Every computer trades large amounts of equities in fractions of seconds and simultaneously receives information about the same equities. Regular investors do not get the data for a few milliseconds. High frequency trading firms receive data milliseconds ahead of regular investors, so what’s the problem?
Latency arbitrage refers to the concept that different people receive market data at different times. The difference in time is minimal. Latency arbitrage is when high-frequency trading algorithms trade a split second before a competitor trader, and then relay the stock seconds later for a small profit. Although the profits per trade may be small, HFT generates a significant portion of the wealth traded on the stock market in the United States. HFT’s main issue is latency arbitrage. This refers to algorithmic trading that uses sophisticated technology and computer algorithms to quickly trade securities.
Private exchanges pay huge amounts of money to run high-speed fiber optic cables directly from trading venues to their servers. This speeds up market data processing by milliseconds.
This is how high frequency trading firms use time intervals of multiple shares within a single trade. You buy 20 shares of Bank of America for $17.80147. Your online brokerage places the order. The brokerage purchases 5 shares from an investor from Chicago, 5 from Los Angeles and 10 from Denver. The brokerage sends your order via high speed fiber optic cables directly to Los Angeles, Chicago, and Denver. Your order will reach Denver as soon as it arrives. Firms with cables connecting directly to the exchange will be able to see your potential order. After you have purchased 10 shares from Denver and 5 from Chicago, high-speed trading firms will sell Bank of America stock at $17.80689, an even higher price, once your order reaches Los Angeles. Many manipulations are used by firms to sell large quantities of stock to investors and other businesses across the country.
Software developed by companies such as Royal Bank of Canada allows each party to instantly receive information. In other words, your order to purchase Bank of America will reach Chicago and Denver simultaneously. This means that high-frequency traders won’t have to wait for your order to be processed. Fidelity and other trading firms have also installed fiber optic cables spanning 80 kilometers between them and other traders. The coil delays trades between the firm and other traders. High frequency traders send their trades to Fidelity. Their data travels through optical cables for 80 km and reaches them at the same moment as all other trades.
Companies that have the financial resources to trade at the top of the queue are likely to do so. These companies are not ambivalent about what they trade; they trade because it is guaranteed that they will make a profit. High frequency traders don’t play the market; they are the players. HFT has been the domain for mathematicians, physicists since its inception. It is not unusual for physicists to have their own niche trading on the stock market. This should raise eyebrows. These traders are not investing capital, they are simply collecting what amounts to a tax on every share of equity traded. It is legal, and the big banks aren’t too upset about it. They simply need to place themselves on the same plane with high frequency traders. This would include trading algorithms that stagger each trade, or high speed fiber optic cables which physically reduce the rate at which data is received by all parties.
Although latency arbitrage is legal in high frequency trading, it is not without consequences. Investors who don’t have the same trading tools as high frequency traders are required to pay marginally more. HFT was not free of cost. However, HFT firms did pay substantial sums to get it done. This lends merit to the idea that each firm has the right to decide what is best for them. Since the inception of the New York Stock Exchange, arbitrage is a common trading strategy. The stock market plays an important role in the growth and development of the economy.
The stock market investment is one of few financial win-win investments that can be done for a person (minus the inevitable introduction of capital gains tax). Complexities like HFT in the market are disincentive to an economy that is driven solely by its invisible hand. If there is no taxation, I believe overall market participation will decrease. Investors should trade on the same plane. Investment evaluation does not include security analysis or quantitative and qualitative analysis. It also doesn’t consider location of high-speed fiber optics. An appropriate government agency must regulate algorithmic trading once it is no longer unilateral, such as merger arbitrage. Ironically, the only way to keep the basic principles of laissez-faire economics intact is to use the vast powers of law through regulation.
The Securities and Exchange Commission plans to eliminate a number high-frequency trading firms as of April 13. The SEC plans to use new rules and trading techniques that will limit latency arbitrage.
Let’s not forget Bernie Madoff invented high frequency trading at its current level.