Latency arbitrage, electronic equity exploitation, and high frequency trading are the financial jargon that has been discussed regularly this past month. People claim that the U.S. stock market is fixed; by high frequency traders, investment banks, and private stock exchanges. But what does it all mean?
Public and private exchanges contain high performance computers that are programmed to trade financial vehicles at the speed of light. Each computer trades large portions of equities at fractions of seconds, simultaneously receiving information on the same equities, milliseconds before regular investors receive the data. The high frequency trading firms collect data only milliseconds in advance, so what is the issue?
The concept of latency arbitrage is surrounded by the idea of people receiving market data at different times; the disparity in time is minuscule. Latency arbitrage occurs when high frequency trading algorithms engage in trades a split-second before a competing trader and then relay the stock moments later for a small profit. While the profits per trade are small, the aggregate revenue from HFT is a considerable portion of the wealth traded in the United States stock market. Essentially, latency arbitrage is the forefront issue of HFT – algorithmic trading, specifically utilizing sophisticated technological tools and computer algorithms to rapidly trade securities.
Today, we find private exchanges that pay large sums of money to lay high speed fiber optic cables from trading venues directly to their servers, skimming milliseconds off the time they receive market data.
Here is an illustration of how high frequency trading firms exploit time intervals of multiple shares in a single trade: You purchase 20 shares of Bank of America at $17.80147. You put the order through your online brokerage. The brokerage 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 through high speed fiber optic cables to the parties in Denver, Chicago and Los Angeles. As soon as your order reaches Denver, firms who have cables running directly to that exchange will see your prospective order, and within the 4 milliseconds that you purchase 10 shares from Denver and 5 shares from Chicago, high speed trading firms sell Bank of America stock to you at $17.80689 and an even higher price by the time your order reaches Los Angeles. Firms utilize various manipulations, as such on large scales to investors and firms all over the country.
Companies such as the Royal Bank of Canada have developed software that staggers a trade in order to allow each party involved to receive the information immediately. Meaning (in the context above), your order to buy Bank of America will reach Chicago, Denver, and Los Angeles all at the same time, not leaving a nanosecond for high frequency traders to front-run 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 the trades that run in and out of the firm. When high frequency traders submit their trade to Fidelity, their data goes through optic cables for a full 80 kilometers, and reaches the trader at the same time as all other trades.
Essentially, companies who have the financial means to skip to the front of the line to trade, do so. These firms are ambivalent to what they are trading; they trade because they know they are guaranteed a profit. High frequency traders are not playing the market, they are playing the players. HFT has from its inception been the domain of mathematicians and physicists. The simple idea of physicists having their own niche in trading in the stock market should raise eyebrows alone. These traders are not actually investing capital; they are collecting what is essentially a tax off of every share of equity that is traded. Unfortunately, it is legal… and interestingly, big banks are not up in arms about it. Simply put, all they have to do is place themselves on the same plane as the high frequency traders, which would include either trading algorithms that stagger each trade or coils of high speed fiber optic cables that physically combat the rate at which all parties receive data.
Ultimately, the latency arbitrage form of high frequency trading is legal, but it certainly is not victimless anymore. All investors who do not have the same means of trading as high frequency traders, are forced to pay a marginally higher price. On one hand, the firms engaging in HFT did pay large sums in order to do so – allowing merit to the notion that it is each firm’s prerogative. Additionally, arbitrage has been a concept used by traders since the creation of the New York Stock Exchange. On the other, investing in the market is a fundamental aspect of our economy and the stock market plays a pivotal role in the growth of industries, respectively. Investing in the stock market is one of the few true financial win-win activities for the individual (minus the inevitable implementation of capital gains tax). Complexities such as HFT in the marketplace provide disincentive to an exchange that is driven by the invisible hand in which our economy’s platform exists. I believe that once disincentive beyond taxation is allowed, overall participation [in the market] decreases. All investors should be trading on the same plane – investment evaluation does not include security analysis, quantitative and qualitative analysis, and location of high speed fiber optics. As soon as algorithmic trading is no longer unilateral (such as merger arbitrage), it needs to be regulated by an appropriate government agency. Ironically, the way to preserve the rudiments of laissez-faire economics is to employ the considerable powers of legal action through promoting regulation.
As of April 13, the Securities and Exchange Commission is preparing to remove a number of high frequency trading firms. Additionally, the SEC looks to employ a campaign of new rules and trading practices that would limit latency arbitrage.
Lastly, some food for thought – the practice of high frequency trading [at its current level] was devised by Bernie Madoff.