How much is a second worth to high frequency traders/
I recently read an excerpt from Michael Lewis’ latest book, Flash Boys: A Wall Street Revolt in the New York Times titled, The Wolf Hunters of Wall Street. It chronicles how several traders at Royal Bank of Canada (RBC), a Canadian bank, created a more transparent and fair stock market exchange, as a result of stumbling across high frequency trading.
Lewis’ book has shed some much needed light and scrutiny on high-frequency traders and the players involved. The SEC, FBI and the Justice Department have all opened investigations to see if any laws may have been broken. It seems that the law is having a tough time keeping up with technology.
Value of High-Frequency Trading
Supporters of high-speed trading (HFT) say that they create liquidity in the stock market, making it efficient and ensuring that there is always a willing buyer and seller. Computerized trading has also lowered commissions, and decreased the spread between the amount paid to buy a stock and the amount to sell.
While some are calling HFT financial innovation, others are worried. As Jim McTague wrote in a recent Barron’s article, “Our markets have become so technologically complex that a crash is only a coding error away.” That was evident from the “flash crash” on May 6, 2010 when the Dow plummeted 600 points to the more recent two-hour shutdown of electronic trading at Chicago’s Mercantile Exchange.
Brad Katsuyama was a trader at RBC in 2007, when he noticed some irregularities while making trades. There was a small delay between the time he placed an order for shares and the time it was executed. The delay was caused because his order was being re-directed to high-frequency traders (HFT), who would purchase the shares ahead of time, drive up the share price by a penny or less and then re-sell them at a profit.
All this would take place in fractions of a second without the customer’s knowledge. Those pennies can add up, according to Barron’s Gene Epstein, an economist who writes a regular column for the investment magazine. He estimated the amount at $21 billion a year.
The information advantage was made possible because brokers and investment banks sold their customers’ stock market orders to these HFT’s. According to Lewis, “the online broker TD Ameritrade, for example, was paid hundreds of millions of dollars each year to send its orders to a hedge fund called Citadel, which executed the orders on behalf of Ameritrade. Why was Citadel willing to pay so much to see the flow?” The combination of high-speed networks and advance customer information proved to be worth millions.
Speed equals profits
Brokers and high frequency traders invested significant sums of money in the infrastructure to build fiber-optic networks. As Lewis pointed out, “the single biggest determinant of speed was the length of the fiber, or the distance the signal needed to travel.”
The New York Times recently reported that Spread Networks just completed a tunnel through the Alleghany Mountains in Pennsylvania meant to carry fiber-optic cable. The cable would cut three milliseconds of communication time between the futures market of Chicago and the stock markets of New York.
Just how long is a millisecond? A millisecond is a thousandth of a second. According to Lewis, “it takes 100 milliseconds to blink quickly-it was hard to believe that a fraction of a blink of an eye could have any real market consequences.” As Katsuyama noted “People are getting screwed because they can’t imagine a microsecond.”
Katsuyama put together his own team of software programmers and traders who developed computer software that would eliminate the HFT’s advantage. The benefit of this new software program was that all orders for shares arrived at the exchanges at the same time. This eliminated any advance knowledge of big orders coming through.
For example, when Citigroup was selling at $4 per share, their trading software saved them $29,000 which was less than .1 percent of the price. It’s similar to not paying a financial transaction tax. According to Lewis, “It sounded small until you realized that the average daily volume in the U.S. stock market was $225 billion. The same tax rate applied to that sum came to nearly $160 million a day.”
The traders at RBC ended up creating their own stock exchange called Investors Exchange (IEX). IEX opened on October 25, 2013 and according to Lewis “eliminated the advantage of speed.” All trades would be treated equally and the informational value of a customer’s big order would not be exploited, creating a fairer market for investors. Banks and brokers took almost four months to start routing their big trades thru IEX. Although it hasn’t eliminated high-frequency trading, their trading volume has reduced.
The lack of transparency in the market is alarming. Many customers, including the big money management firms such as Fidelity, were unaware that the big brokerages and banks were not acting in their best interest. Brokerages have a fiduciary duty to clients. In a meeting with some of Wall Street’s biggest investors to promote his new exchange, Katsuyama was asked if there were any good brokers. He replied that their new exchange, IEX, does business with 94 brokers but that only 10 “seemed to be acting in the best interests of their investors. According to Katsuyama, “the system has let down the investor.” .