Wednesday, March 19, 2014

High Speed Trading: Who Does it Serve?

High Speed Trading: Who Does it Serve?

High frequency trading is receiving more unwanted scrutiny these days.  New York State Attorney General Eric T. Schneiderman has launched an investigation into the practice.  Those of you who think that you are receiving amazingly quick execution when your trade on Fidelity, Schwab, or E*Trade is confirmed within a second or two don’t understand speed.  In the time it takes you to execute a trade on a retail platform, high frequency traders have more than enough time to buy and sell the same stock hundreds of times over.

FoF (2002)
High frequency trading has three important elements.  First, the trades are largely based on algorithms that automatically buy and sell securities if certain parameters are met.  The computations are made in fractions of a second, and the trades are completed before you can make a single stroke on your keyboard.  Second, the firms want to locate as closely as possible to the stock exchanges and be connected with the fastest fiber optic cables available.   Remember, nanoseconds are of the essence.  Third, any given trade only nets a penny or two of profit.  However, the volume generated by high frequency trading can create massive profits.

Mr. Scheiderman is investigating whether high frequency trading amounts to the electronic equivalent of insider trading.  In other words, are these incredibly fast trading platforms simply picking off information and profits by standing in front of conventional investors?  We’ll see where Mr. Scheiderman’s investigation goes.

I’m interested in the industry’s defense because it’s pretty shallow.  Proponents argue that high frequency trading is a benefit to all of us because it improves liquidity in the markets.  On most days the market has plenty of liquidity, and big institutional investors and retail clients alike have been able to buy and sell shares to their heart’s content.  When the markets become illiquid during a financial crisis, the high frequency traders either disappear or in some cases exacerbate the price swings.  I’m not blaming high frequency traders.  They are in business to make money.  They aren’t in the business of making our investment lives any easier.

I’ve also heard it argued that if high frequency traders aren’t allowed to co-locate their computers near exchanges, it will drive up their cost of doing business because they’ll have to acquire real estate near the exchange.  In my view that would be a very good thing, because it would force high frequency traders to incur the true cost of executing their strategies.[1]

Perhaps Mr. Scheiderman’s inquiry is coming too late to do any good.  One high frequency trader, Virtu, has filed to go public.  Although the S-1[2] filing still has a lot of blanks, it is clear that Virtu has been highly profitable and uncannily successful over the past two years.  If Virtu’s founders and investors are willing to share the profits with public investors, you might wonder whether the best days for high frequency trading are winding down.    One thing is for sure.  High frequency traders serve one interest: their own.

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