By Akhil Raj Gupta
Bob is thirty-five years old with a lithe physique, gelled black hair, and a smile that would make any lady go weak in the knees. He has an upright posture, a booming voice, and an appetite that would put professional wrestlers to shame. Like many of his peers at the Wall Street, he lives an extravagant lifestyle replete with tailored suits and black limousines. Yet, Bob carries a gnawing fear to work everyday. A fear that he along with all his trader buddies from Wharton are slowly becoming obsolete, replaced by physicists from Russia, computer programmers from China, or electrical engineers from India. He has realized that the competitive advantage on the Wall Street no longer lies with the best stockbroker or a financial analyst but with the most gifted coder. Only yesterday, he had executed an order to buy 10,000 shares on behalf of a client, and noticed that the price at which his bid and offer were matching had disappeared, replaced by a slightly higher quote. Because of the volume, this had implied the loss of a small fortune. He had no idea why.
Enter Sergey, the man sitting on the other end of the trade that Bob had (mis)executed. Sergey left his hometown of Kiev seven years ago with a PhD in Computer Science, and is currently employed with a high frequency trading firm that requires five stages of biometric scanning before he can take his seat. Sergey hasnt lost money in the markets on a single day in the past five years, including the infamous flash crash of 2010, when the U.S. stock market lost close to half its value and recovered in a span of ten minutes. His daily trading volume is in thousands, yet he goes to sleep soundly at night knowing that he does not hold position on even a single security!
[su_pullquote align=”right”]The infamous flash crash of 2010, when the U.S. stock market lost close to half its value and recovered in a span of ten minutes[/su_pullquote]
So who are these high frequency traders (or flash boys as Michael Lewis, the famous financial writer and author of Moneyball, likes to call them) and how do they operate? Are they good for the market because they increase the liquidity, as their lobbyists often claim, or do they represent another insidious financial innovation emerging from the foyers of a certain street with a dodgy reputation for endorsing toxic products. Are HFTs specifically designed to siphon money off innocent pension funds and employees retirement plans or do they play the altruistic role of market makers in a quest for greater efficiency?
As the name suggests, high-frequency traders rely heavily on timing to extract quick and risk-free arbitrage opportunities from the orders in the market. Think of a typical (and most elementary) operation like this A broker executes an order for 10,000 shares of XYZ Corp. trading at $100 per share with a spread of 2 cents per share. Typically, the trade would be completed at the mid-point of $100.01 and the stock exchange (like NASDAQ, New York Stock Exchange, etc.) would pocket a commission on the transaction. However, a high-frequency trader is able to intercept the large buy order and enters the market by quickly buying all the shares of XYZ Corp. and then selling the lot at 1 cent above the strike price.
The difference is worth microseconds i.e. a fraction of the time it takes you to blink an eye. They are capable because these HFTs are located at the perimeter of the stock exchange matching engine (thus receiving the signal with a time advantage) and most importantly, because there is a delay in the time in which an order arrives on different exchanges. So, our 10,000 share order would get allocated between five lots of 2000 each and arrive at various stock exchanges, including the sinister dark pools which are private exchanges operated by big banks), at different times. Suppose it arrives at the NASDAQ first and a high frequency trader picks up the scent. He teases you with a sale of 100 shares at the quoted price and discovers your willingness to buy. He then proceeds to scam you using the method described above. Its effortless, riskless, doubles trading volume for no apparent reason, and widens the chasm between the original buyer and seller. Strictly speaking, a high frequency trader has no business entering the transaction in the first place.
[su_pullquote align=”right”]They are capable because these HFTs are located at the perimeter of the stock exchange matching engine (thus receiving the signal with a time advantage) and most importantly, because there is a delay in the time in which an order arrives on different exchanges[/su_pullquote]
This was exactly the thought that Brad Katyusuma, a trader at RBC had when he got fed up of not understanding why his trades werent being executed in the same way as before. He set about unraveling this nexus of algorithms and high-speed signals that were making the financial markets scarier and more convoluted. He was also determined to set it right, and so he set up the IEX stock exchange platform with the support of a few colleagues to keep out the high frequency traders. Their solution is simple and brilliant at the same time. Whenever a trade is executed via IEX and goes to the other exchanges, they ensure that each order is delayed uniformly so that they all arrive at the same time, thus, undercutting the margins that a high frequency trader has. Of course this little narrative only skirts the surface of a sordid state of affairs. It is disconcerting to know however that stock prices, which should oscillate around their intrinsic value can express volatility in the range of thousands of dollars. Dont believe me? Look up what happened to P&G, Accenture, and Apples stock price on May 6, 2010.
[su_quote]Whenever a trade is executed via IEX and goes to the other exchanges, they ensure that each order is delayed uniformly so that they all arrive at the same time, thus, undercutting the margins that a high frequency trader has.[/su_quote]
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Akhil is currently in his second year at college, pursuing a Bachelor of Arts degree in Economics (Hons) at Sri Ram College of Commerce, University of Delhi. He has been passionate about writing since an early age and is currently involved with the official College magazine and Economics Department magazine at SRCC. His areas of interest include behavioural economics / finance, econometric analysis, macroeconomic policy, and political theory. He spends his free time reading extensively, watching interesting videos on YouTube, and trying to convince everybody around him that he really does know a thing or two about economics in the midst of all the pontification!