Catching up with Super-Fast Computerized Markets

Written by William R. Rusk, GEI Associate

In anticipation of Michael Lewis’ new book, Flash Boys: A Wall Street Revolt (available April 1, 2014), GEI fuels your appetite for High Frequency Trading with this brief analysis. If you have any interaction with security markets, including most retirement accounts, then you have most likely been affected by HFT.

Computerized Markets

The benefits of computerized markets are pretty clear to just about anyone who is paying attention. Whether it is the vast amount of data that may be mined, or the convenience of trading and tracking securities virtually from anywhere, typically we share the belief that computerized trading has made our markets and therefore our economy more efficient. However, most people are not aware that for a fee, an institution may receive knowledge of large orders being placed a few fractions of a second before the general public is able to see the order. It is just a few fractions of a second, no big deal right? Wrong.

Enter the Data Oracles

In the blink of an eye a HFT, or firm with high frequency trading capabilities is able to not only determine the maximum price the buyer is willing to pay, but also effectively raise the price of the good to that max price. The HFT firms have the ability to raise the price of a good without adding any value, and a valid change in supply and demand is not occurring. Yet some experts still argue that HFT is making the markets more efficient and regulatory agencies are not exactly hot on the HFT trail.

Alright, so how are high frequency trading firms, which are mostly international banks, able to accomplish this technical and seemingly illegal feat of finance? Making the investment into super computers and complex algorithms is already assumed. Next the firm would participate in a “flash trade”, which is the name for paying an exchange for a sneak peak at a large order. What happens next is a bit complex but luckily it was eloquently explained by Karl Denninger in his article, “HFT: The High Frequency Trading Scam” written for Seeking Alpha back in July 2009.

Let’s say that there is a buyer willing to buy 100,000 shares of BRCM with a limit price of $26.40. That is, the buyer will accept any price up to $26.40. But the market at this particular moment in time is at $26.10, or thirty cents lower.
So the computers, having detected via their ‘flash orders’ (which ought to be illegal) that there is a desire for Broadcom shares, start to issue tiny (typically 100 share lots) ‘immediate or cancel’ orders – IOCs – to sell at $26.20. If that order is ‘eaten’ the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40. When it tries $26.45 it gets no bite and the order is immediately canceled.

All done in approximately 3 milliseconds, or less than the time it took me to type “milliseconds”. So who is left paying this added premium to the international banks? Turns out it is you, me, and everyone else with a retirement plan that is invested in mutual funds. These are many of the large purchasers in the market.

Nothing to See Here

Regulators do appear to be paying attention to this issue. As Telis Demos in his article for the Financial Times “US regulator convenes panel on HFT” stated that the Commodity Futures Trading Commission has appointed a panel to investigate HFT. However, it appears everyone on the panel except for one, is actually in favor of high frequency trading.

It seems likely that computerized insider trading will be around for a while. But have no fear because many large institutions are now buying their large orders through so-called “dark pools” or proxy buyers such as Goldman Sachs which decrease market transparency (What can go wrong there?). Getting rid of flash-trades would appear to be the better solution but there is presently little political will to do so. Another solution may be the creation of new markets which do not tolerate HFT, one of the topics covered in Michael Lewis’ Flash Boys: A Wall Street Revolt.

Editor’s note: Boris Kachka has a good “pre-review” of the new book in The New Yorker.  Kachka describes one of the most secretive book releases in some time and quotes the author regarding the impact the book may have on Wall  Street.  Lewis says:

“If this doesn’t actually provoke some interesting behavioral changes, then what’s the point of writing these books? This is my best shot yet.”

Sources:

• HFT: The High Frequency Trading Scam (Karl Denninger, Seeking Alpha, 24 July 2009)

• US regulator convenes panel on HFT (Telis Demo, Financial Times, 26 March 2012)

• Michael Lewis Is Betting His New Book About High-Speed Trading Shakes Up Wall Street (Boris Kachka, The New Yorker)