In the Australian Stock Exchange’s Sydney data room, which is about the size of a big lounge room, there are six “cuckoos”. These are the banks of servers installed by high-frequency traders.
They sit against the wall opposite the ASX servers and each is connected directly into the host by a fat fibre optic pipe. Each cable is precisely the same length by agreement with the ASX so that none gets an advantage; if one server is closer to the input, its cable is looped around to lengthen it.
Think about that: one less metre of optic fibre carrying data at 299.8 million metres per second would give one share trader an unfair advantage over the rest. It suggests that something pretty quick is going on.
The question is whether it’s fair to the rest of us; whether those six parasites with their suckers fastened directly into the heart of the ASX should be allowed to get away with it.
The ASX is no longer a regulator, just a business, so it says that if the practice is legal and it pays a fee — not to mention a handy rent in the data room — then it can’t and won’t stop them.
For global regulators it’s actually too late: high-frequency trading accounts for as much as 70% of the volume on American stock exchanges, including the NYSE; the time to control it was 10 years ago.
What do the computers and their algorithms do? Well, as my relatively low-frequency brain can understand it, these machines constantly monitor order flow into the ASX servers and the sophisticated programs can pick up patterns that indicate when a reasonably large order has been placed. What they then do, in effect, is “front-run” — that is, they buy ahead of the order and make a small spread selling into it.
In other words, by operating at the speed of light they can “feel” a buy order coming and can dart in front of them and ensure buyers pay a little bit more than they were going to, without noticing a thing.
These operators begin each day owning no shares and end each day in the same position but they make a lot of money by doing thousands of trades every day. It’s a high-volume, low-margin business.
It’s not known how much money the HFT traders make, but whatever it is they weren’t making it 10-15 years ago, and stockmarket returns have not gone up in that time, so whatever they make has come out of someone else’s pocket.
That someone, of course, is you. The buy orders that the HFT operators are front running come from the superannuation funds in which ordinary people have their money. Now when they place an order, they usually end up paying a cent more than they would have because they are buying from someone who didn’t own any of the shares 10 microseconds ago and only bought to make that quick cent.
HFT represents less than 10% of the volume of the ASX, but in the United States it is much more, and there is no reason to think we won’t follow the US.
Should something be done to stop it? I think so, but it’s too late.
HFT firms such as the privately owned and aptly named Getco (for Global Electronic Trading Company), the world’s largest HFT operator, produce a large amount of self-justifying research material based around the proposition that they help investors by providing extra liquidity in the market.
This, plus presumably the hiring of expensive lobbyists, has snowed legislators and regulators and let the practice flourish, to the point where the parasites are taking over the host and it’s too late to stop them.
Stock exchanges the world over are now making a fortune from renting space in their data rooms to high-frequency computerised traders and would probably collapse without it (the ASX would not — yet).
As a result, investors are abandoning the “lit” markets and using “dark pools” instead. This simply refers to off-market share trading away from the official stock exchanges provided by investment banks where big investors know they are not being picked off by high-frequency front runners. The problem with that is that these “dark pools” are not properly regulated or transparent.
The joke is that in many cases, the same investment banks are doing both the high frequency trading and running the dark pools; they are causing the problem and solving it, each for a handsome profit.
*This article was first published at Business Spectator
Alan, don’t be shy. It should be banned, outright. As you describe it, it is electronic insider trading. It’s time for a global version of America’s Glass-Steagall, to put investment banks on a choker-chain and keep them away from speculating on the savings of ordinary people.
Alan, 299.8 m/s is faster than light. I understand why you rounded up, but don’t do it, unless the real scoop here is something else from CERN. 299,792,458 m/s is the currently agreed speed of light. As Robin Williams (US) said “In the future we will travel at the speed of light, we’ll have to lose our luggage before we get there”
Regardless of whether the trading is done at the speed of light, faster than the speed of light or a nano-second slower, history tells us that the traders still don’t get sufficient forewarning of a Lehmann Bros collapse.
All the HFT arguments about increasing liquidity and price discovery are self serving tosh. If the ASX and other exchanges are all about an open and transparent market, then they, (or in some parallel universe where our corporate regulator actually gave a toss), should enforce a minimum holding period of something like 1 minute for any transaction.
“Well, as my relatively low-frequency brain can understand it, these machines constantly monitor order flow into the ASX servers and the sophisticated programs can pick up patterns that indicate when a reasonably large order has been placed. What they then do, in effect, is “front-run” — that is, they buy ahead of the order and make a small spread selling into it.”
This is actually called Flash trading, where brokers pay a fee to the exchange to see orders before they are offered to another exchange for a small period of time approx 0.3 seconds. Due to this lag, they can then make profits using high frequency trades.
I believe this was banned in the US in 2009 and has never been offered as a service in Australia (due to the fact we only have one exchange here)
Most high frequency trading is really about arbitrage (or risk free profits); finding stocks/options that are slightly over priced or underpriced according to CAPM/Option Pricing/technical trading models, and then buying or selling the stocks/options to gain the “alpha” (or extra return). If anything, this form of high speed trading actually helps in valuing equities/derivatives due to the increased liquidity they add to the secondary markets.