In olden days, highwaymen would hang around stagecoach inns, waiting to see when wealthy people were travelling. Then they would hide out along their likely route, getting wet and cold, in order to take their cash.
Today the arrival of electronic trading has changed all this. High-Frequency Traders (HFT) now have computer programmes to act as their lookouts, and ultra-fast connections that mean they are sure to out-run their prey.
Even better is the fact that none of their trading activities are illegal. and there is no risk of being hung. In fact, many naïve regulators have even argued that HFT helps investors by providing liquidity. But this is not the liquidity of the old market-makers, who had to continue buying if the market crashed.
If you want to know more about how they do it, then you must read Michael Lewis’ new book, Flash Boys. He shows that their business model is very simple in concept:
- They place small buy and sell orders for every single stock traded on the exchange, at market prices
- When a large buyer or seller arrives at the exchange, this bait is traded, confirming the prey has arrived
- Immediately, the HFTs then rush to other exchanges to cover the full order ahead of the actual seller/buyer
- When the real order arrives, they then lock in a guaranteed profit
And yes, it does seem to be guaranteed. Unlike any other trader or investor, the HFT doesn’t take any risk to earn his money. As Lewis documents:
- The CEO of HFT firm Tradebor said in 2008 ”his firm had gone four years without a single day of trading losses“.
- Whilst last year, Virtu Financial boasted that it had suffered just one day of trading losses in five and half years. It added the loss was caused by “human error” – presumably someone wrongly programmed the computer
Unsurprisingly, the HFTs have come to dominate the markets in which they trade, as Lewis notes: “From 2006 – 8, HFTs share of total US stock market trading doubled from 26% to 52% – and it has never fallen below 50% since“.
And their profits are huge, running into billions of dollars:
- Thus the HFTs were happy to pay $40k/month to NASDAQ and the New York Stock Exchange (NYSE) for use of a computer line that cut 2 microseconds off their trading time. No ordinary investor would care about saving 2 microseconds in dealing time
- Equally revealing is that the new NYSE data centre is nearly 10 times larger than the old building on Wall Street – which housed all the floor-traders. The reason is that NYSE can charge the HFTs for “co-locating” their computers next to the exchange, saving them valuable milliseconds of trading time
Then there is Lewis’ story of Spread Networks. In 2010 it laid 827 miles of fibre optic lines on the straightest possible route between Chicago and New York. This ended up reducing round-trip trading time to just 13 milliseconds (the theoretical minimum is 7 milliseconds). By comparison, your eye takes 300 – 400 milliseconds to blink.
Spread was then able to charge each HFT user an amazing $10.6m on a 5-year contract. With added costs of signal amplifiers etc, they expected the line to generate $2.8bn revenue over 5 years, with Spread deliberately limiting the number of users to just 200 to add further competitive advantage for users.
The HFTs risk-free profits are obtained legally. But someone has to pay the bill for them. That someone is clearly the ordinary investor, or the employee investing her money in a pension fund.
The blog has written many times over the years about high frequency trading, and the damage it is causing to the integrity of financial markets. But it was still amazed, and surprised, by some of the revelations in Lewis’ book. Superbly written, and never dull, you will find it hard to put down once you start reading.
The blog lives in hope that its global impact may finally force regulators to act to restore true liquidity to the markets.
Benchmark product price movements since January 2014 are below, with ICIS pricing comments:
PTA China, down 11%. “Several Chinese producers were considering to export PTA cargoes in the near term, and were studying the feasibility,”
US$: yen, down 2%
Brent crude oil, flat
Naphtha Europe, up 2%. “Demand from Asia continues to draw upon volumes, although at lower levels than previously seen”
S&P 500 stock market index, up 2%
HDPE US export, up 6%. “Prices are too high to work in most global markets”
Benzene, Europe, up 7%. “Domestic prices remain structurally high compared to key downstream markets”