High Frequency Trading and You

Super fast computers in the investment market are causing you to lose hundreds… of thousandths of a penny, that is. High-frequency trading has come under severe scrutiny lately under the suspicion of “price skimming”, where they shave minute slivers of pennies off of every trade they transact.

Don’t let the miniscule amount of the skimming fool you. One high-frequency trading firm, Virtu Financial, earned $182.2 million in net income in 2013 from $664.5 million of revenue – some 27.4%. That’s better than Goldman Sach’s 23.4% income over revenue. Virtu reported it had just one losing day in 1,238 trading days from the beginning of 2009 to the end of 2013.

How did it manage that? By “buying and selling large volumes of securities… and earning small amounts of money based on the difference between what buyers are willing to pay and what sellers are willing to accept,” the company explained.

So all those tiny little slivers shaved off of your buy and sell orders is making other people rich – all because they can afford more powerful computers than you can. Is that fair?

Answering that question requires an entire book, a challenge which author Michael Lewis recently undertook in his publication “Flash Boys: A Wall Street Revolt”. In it, Lewis explains the many ways – some of which are highly unethical, even illegal – in which high-frequency traders use technology and specialized computer software to gain an advantage over the rest of us. Lewis goes as far as to declare stock exchanges as being “rigged”.

Since the book’s release in March, several agencies have intensified their scrutiny of the high frequency trading market, which had already been under fire for years. The New York Attorney General’s office, the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Federal Bureau of Investigation all have active probes into the practices of high-speed and automated trading.

What are they looking for? Where are they looking? Some say they should crack down on all the powerful technology and software algorithms HFT’s use. But as history shows, gaining an advantage through technology is really quite normal.

Technology Is Not the Issue

The use of technology to give merchants an advantage other rival merchants and even their customers goes back hundreds of years. Did you know that when Galileo made improvements to the recently invented telescope in 1609, he originally marketed it to merchants in the city of Venice?

Equipped with this new technology, merchants could spot incoming cargo ships two hours or more before they made landfall, cuing them to lower prices on their existing stock before the new stock arrived.

Then in the first half of the nineteenth century came the invention of the telegraph. In the second half came the ticker-tape machine – giving stock investors who could afford them a dramatic advantage over those who could not. Telephones and early vacuum tube “computation” machines kept the playing field uneven throughout the early- and mid-twentieth century, leading to the high power computer systems of today.

Location has also given merchants and traders advantages. Whether a merchant was located in the port city of Venice or the inland city of Paris, whether a broker was located on Wall Street or in San Francisco, their proximity to the heart of their industry was crucial.

Technology and location have always been part and parcel to the success of any business. Claiming that HFTs have an unfair advantage given their high-end technology and proximity to stock exchanges is a futile argument that has no terminating point.

Even among average investors, those trading on home computers using high-speed fiber optic internet connections will get their trades filled a few seconds before those trading on mobile platforms using their smartphones. If some investors are still using ADSL and dial-up connections because they can’t afford high speed, no one would accuse the high-speed users of creating an unlevel playing field.

As agencies conduct their investigations, they must be certain not to lose their focus. They must look beyond the actual technology and focus on how it is being used – in denying investors the best possible price.

The Real Issue is Price Denial

What should be considered when determining if high frequency trading is harmful is whether investors would have a better price without HFTs in the market.

If an investor’s order would have been filled at a certain price, but was bumped out of queue or re-routed through a high-frequency trader’s systems only to end up being filled at a worse price than the order would have been filled at if the high-frequency trader wasn’t there – then and only then is the high-frequency activity definitively detrimental to the marketplace.

Many believe that this is precisely what is happening. The suspicion is that when a trader submits a market order (an order with no specified price, which is to be filled ASAP at whatever the price then is), the highly sophisticated and lightening-fast HFT software spots the incoming order and accepts it, taking the order and thus agreeing to fill it.

But from the time the HFT accepts the order and finishes filling it, a few milliseconds can go by between the two actions. That may not sound like a lot of time, but it is plenty of time for the HFT’s software to purchase the stock in question on behalf of the firm, and then resell those shares to the investor for a profit.

For example: Mike submits a market order to buy 100 shares of Boeing, to be filled ASAP at whatever the price is currently. The HFT sees Mike’s order, accepts it, and agrees to fill it. The HFT’s program then quickly purchases 100 shares of Boeing at the market price, and then sells them to Mike for a few fractions of a penny more. Mike ends up paying more for his shares than he would have, with the HFT pocketing the extra amount. And it all happens in a fraction of a second, which no one notices.

In the Name of Market-Making

This seems like an easy case to judge. Skimming profit from trades is not just unethical but downright unlawful. But it’s really not that simple, because the activity looks extremely similar to market-making – a vital activity which is legal and very beneficial for the smooth operation of stock markets.

Large banks and hedge funds provide liquidity in stock markets by matching buy orders with sell orders among their own clients. If Mike wants to buy Boeing and Jennifer wants to sell, a market-maker can match the two orders with each other.

But the market-maker is entitled only to the commission, and is not allowed to skim profit off the prices. In fact, in July of 2012, the SEC instituted a rule that will permit large firms to trade at fractions of a penny in order to actually improve their client orders – known as “price improvement liquidity”.

If Mike wants to buy Boeing at $129.40 and Jennifer wants to sell at $129.39, the market maker is permitted to keep a profit if it improves the fills of both orders – so that Mike ends up buying at the better price of, say $129.398, while Jennifer ends up selling at the better price of $129.392. In this case, the market maker can keep the 0.6 cent profit between the two orders as an incentive for providing liquidity and improving clients’ prices.

This is what the high frequency traders are claiming they are doing… merely providing liquidity to ensure people’s trades are filled. Without such active participation by HFT firms, the bid/ask spread for stocks would widen dramatically, and would cost investors a great deal more when jumping in and out of a stock.

But there is a huge difference between matching customer orders in the interest of price improvement and being party to the order in the interest of skimming a profit.

So Difficult to Prove

Investigators have their arms full on this case. Even in legitimate market-making, the opportunity exists for firms to pocket additional profit by filling a customer’s orders with their own inventory. Who’s to say that the banks aren’t skimming profit by selling their own inventory to clients a fractions of a penny more than the current market price, just as the FHTs are doing?

Don’t look for any quick solution to this problem. Perhaps we can be thankful that the skimming typically amounts to only a few fractions of a cent. We ordinary investors might just have to swallow that as a tax, and somehow consider ourselves lucky we aren’t still paying the $20 or $30 commissions we used to pay 20 years ago.

Joseph Cafariello