Be Smart, Be Speedy, But Most Importantly – Be Secretive

November 8, 2014

By: Mitch Wilson

When you sit in the airport lounge and glance at BNN on the screen, the omnipresent ticker tape scrolls across the bottom. And sure, you know that the ticker tape cannot possibly display all the day’s trades, but it serves as a decent enough representation of today’s trading activity. Right?

When you want tickets for the next Leafs-Habs game, you know with resignation in your heart that the game is sold out.  So you head online to StubHub, or Kijiji or you hang around outside the arena hoping to pick up a last minute pair of tickets from a scalper.  And hey, if they charge you more than face value, it’s the cost of doing business, correct?
Both of these scenarios are on the surface, very different.  But there is an unsettling connection between these two events.  For starters, the ticker tape display is laughably outdated.  It’s as ancient as the image of ruddy-faced men in suspenders hollering on the trading room floor of the New York Stock Exchange.  Even thinking that only a couple of exchanges exist is prehistoric.  In today’s trading world, no less than 13 exchanges exist in the state of New Jersey alone, most of which have existed for less than ten years. And traders have been overwhelmingly replaced by computers, where thousandths of a second make the difference between millions of dollars of profit.

How did the markets reach this point?  High frequency trading. Here’s how it works: Say a large, institutional investor, like a pension fund, wishes to buy ten thousand shares of a company’s stock.  Let’s say shares are trading between $20 to $20.02.  This is the market spread.  To make the purchase, there needs to be a seller.  However, the odds are extremely slim that ten thousand shares are available on the market from one seller. So the pension plan executes a bid to buy the shares somewhere within the spread.

Here’s a typical scenario:  A broker working for a pension fund, is asked to execute a trade to purchase those ten thousand shares at the market price of $20.02.  The broker executes the trade – and for an infinitesimal moment – there is a delay in time from the moment the purchase was submitted and the moment the trade was executed by the traders on the other end.  And those ten thousand shares likely have to be purchased from more than one seller. A high frequency trader has a faster connection to the market, sees the first block of shares bought (say for $20.02).  At this point, the high frequency trader recognizes and sees the desire for the more shares to be purchased and buys the shares himself.  Then, the HFT turns around and sells the remaining, outstanding shares to the original broker for a slightly higher rate.

Imagine you were waiting in a slow-moving line at a Blue Jays game for a hotdog, when some jerk in a faster-moving line next to you realizes you are about to buy a hotdog.  So he reaches the desk first, and buys every hotdog from the vendor, and then turns around and sells a hotdog to you for a markup.  It’s not exactly illegal, but it’s a first-class jerk move.  This is an appropriate metaphor for high frequency trading – you’re getting stiffed because somebody with a faster connection to the food is taking advantage of your wants.
See the similarity between your Leafs-Habs tickets that were scalped, and high frequency trading?  Sure, the gains made from each high frequency trade are only a few pennies, but when it happens billions of times, every single day, the proceeds from the scalping are staggering.  Remember, when it comes to high frequency trading, value is not being added to the market.  These HFT firms are holding positions for fractions of a second and are removing money from the market. The goal for a HFT brokerage is to end each day flat – meaning, no position hedged overnight.  The average individual investor has no idea this is happening to their portfolio.  Even worse, institutional investors who are fully aware of this process can be helpless to prevent it. Not every investor is trading in the same market – the capital markets of today exist in two classes: those that trade via lightning-speed connections within a dark pool, and those who are oblivious.

None of this article is an exaggeration. When Michael Lewis, prominent author of Liar’s Poker and Moneyball and a former bond trader at Solomon Brothers, published his HFT exposé Flash Boys, authorities took notice.  The FBI is pursuing an active investigation into high frequency trading. Three major law firms have launched lawsuits against HFT firms claiming unfair advantages against regular investors.  The New York Attorney-General continues its investigation, in co-operation with the SEC. And finally – in a precedent of what is to come – not three weeks ago, the SEC handed down its first penalty to an HFT firm.  Latour, a small but powerful high frequency trading brokerage, was found guilty and fined $16M for violation of trading rules and taking excessive risk with their short positions.

In the coming months, more information will surface about the dubious activity of high frequency trading.  Proponents of HFT say it reduces the spread, adds efficiency to markets and generates billions of dollars of revenue for those who employ it.  Everybody else recognizes the unnecessary volatility, the scalping of regular investors, and the obliteration of a fair market to invest in. The ultimate reason for a stock exchange’s existence is to provide an investor the ability to purchase ownership in a company. Gaming the system with HFT subverts a market’s existence. Regulation is on the horizon, and it will be fascinating to see the fallout effects.

DeGroote on Facebook DeGroote on Twitter WMA LinkedIn