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High-frequency trading is kind of a tough subject to wrap our arms around. I imagine I'm not alone in having a strong sense that it's unfair and all. But how much money do they take out of the market, and should I really be up in arms about it?
As per this recent study written up in Fortune, the answers are respectively 1) probably a lot of money and 2) yes, I should.
It's well known that some high-frequency computer geeks at firms like Getco LLC take advantage of latency, just as it's well known that some Blackjack-playing computer geeks count cards in Las Vegas casinos. But it's never been clear how much this type of trading costs the little guy on Wall Street.
Terrence Hendershott, a professor at the Haas business school at the University of California at Berkeley, wanted to find out. He was recently given access to high-speed trading technology by tech firm Redline Trading Solutions. His test exposes the power of latency arbitrage the way Ben Mezrich's Bringing Down the House exposed the power of card counting.
According to his study, in one day (May 9), playing one stock (Apple Inc. (NASDAQ:AAPL)) Hendershott walked away with almost $377,000 in theoretical profits by picking off quotes on various exchanges that were fractions of a second out of date. Extrapolate that number to reflect the thousands of stocks trading electronically in the U.S., and it's clear that high-frequency traders are making billions of dollars a year on a simple quirk in the electronic stock market.
Latency refers to the microscopic time difference that it may take for a quote to hit one screen versus another. A machine seeing one market ever so slightly earlier than the masses can essentially pick off a "stale" quote. That's why these firms running the algorithms pay to co-locate at the exchanges, get access to cables running across oceans, et. al. Those microseconds afford the machines the opportunity to jump ahead of you and me and everyone else.
So what did the professor do in this case?
Here's how Hendershott's latency-arbitrage strategy worked: Redline allowed him to use its "direct market access" -- cables that run directly from exchange servers to its own. Redline's server was co-located with that of BATS Exchange so that the "latency" on information and orders coming from BATS was cut down to barely one thousandth of a second. As a result, some of the quotes on public feeds such as the crucial "national best bid and offer" feed were a few milliseconds behind those Hendershott could see on his direct link with the exchanges. With a half-decent trading algorithm, Hendershott would have had ample time to buy Apple at a stale price with a guarantee that he could sell at a profit. Every couple of seconds. All day. Risk on the trades: zero.
I mean, that's just ridiculous. And it's clearly not cost free. All that money, multiplied by a bazillion, simply goes out of the collective world pocket and into their pockets.
It's all fine and good. This is capitalism, and if someone can find a trading edge, good for them. But it's really not fine when the exchanges not only allow it to go on, they outright encourage it. They not only provide better, faster access to some, they often reward them with volume rebates. The professor's big AAPL profit is likely even understated, as it doesn't appear to factor in any discounts.
The exchanges kind of throw up their hands and say it's just technology and there's nothing they can do about it … while at the same time earning money based on the artificially ramped-up volume. Yes, turning exchanges from quasi-public member-owned entities to private, for-profit corporations shockingly had a downside. It's simply good business for them to serve the algorithms at the expense of the public.
But apparently there's a relatively simple tweak that would curtail all this, proposed in June by a couple of professors from the University of Michigan.
The authors suggest that the perpetual motion tape be replaced by a stop-motion tape. Instead of a continuous, free-for-all market, the session would take the form of a series of lightning-fast-auctions at intervals of a few milliseconds. This would give exchanges a reasonable amount of time to disseminate information (most only take a few thousandths of a second to catch up on the "direct access" feeds). It would also give traders a reasonable amount of time to place bids and offers on a given stock. The average investor would not see the difference because prices on active stocks would still be changing many times per second.
Such a system would be impossible to game. It would end the high-speed arms race. Firms like Strike Technologies would have no reason to lay cables from Chicago to New York just to make sure high-frequency traders remain a few millionths of a second ahead of the manager of your retirement account's mutual fund.
I wouldn't suggest holding your breath until this happens.
On a day-to-day basis, there's really not much we can do. It's unclear whether it increases or decreases volatility. I'd suggest it magnifies volatility moves in both directions, but who really knows, as there's no "control" market without the algorithms. Those pennies you may lose to them here and there will add up over time. It's a de-facto transaction cost, so maybe it's worth trying to trade a little less frequently, but otherwise, not much to do at this point.
Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.