High Frequency Trading, HFT, is a stategy that has garnered much negative press of late. HFT relies on computer algorithms to execute trades at unimaginable speeds, with firms competing to gain just billionths of second advantages over each other.
Q. So Bloomberg and others are reporting that the SEC is investigating some HFT firms right now. First, what’s the term mean?
A. “High Frequency Trading” refers to what can fairly be called a technology war that’s broken out over the past few years, all about the speed at which trading firms can ping exchange servers not just to execute trades, but to get information about where the buyers and sellers are at any given moment. The competition is literally over billionths of a second; even that much time can give a firm arbitrage opportunities.
Q. And is it a big phenomenon?
A. Huge. More than half the volume on the exchanges is generated by HFT. And in fact exchanges which specifically cater to this market are growing like crazy. One, called BATS, is now the third largest exchange by volume, 11% of US volume. They’re just going public now—today’s their first day of trading– but the SEC is investigating them and other HFTs on several issues.
Q. So, like what? What are the implications for normal market participants?
A. Big debate over that. We discussed some of the ways HFTs make money in an earlier buzzword segment called “latency arbitrage”. That trading strategy aside, there are at least 3 other big issues that thee SEC is probably looking into: one, the basic instability that can be caused by enormous volumes at incredible speed (Flash Crash). Two, it looks like tere is a difference in how the exchanges disperse basic bid and ask prices to different market participants (probably unfair). Three, the HFTs are doing enoromous volume, which is how the exchanges get paid, so the exchanges give them discounts. But that means normal traders, even institutional ones like mutual funds, are paying more.
Q. This may sound like a silly question, but do these firms really have some sort of connection speed advantage over everybody else, or what?
A. In a word, yes. Just one tiny example that I love: light travels at about a foot per nanosecond. The HFTs therefore compete with each other to get closer to the exchange servers in co-location facilities, and pay more rent the closer they are. Because 10 feet closer is 10 nanoseconds faster, and that’s enough to make a difference. But everything about these firms is designed for speed: their algorithms are more efficient, their bandwidth is wider, etc. etc. Humans don’t stand much of a chance!