Summary: Stock markets around the world have seen new techniques take hold due to the increasing use and speed of computer trading algorithms. Most of these algorithms fall under the description of 'high frequency trading'. This page looks at the growth and impact of this technique.
Some estimates suggest that the percentage of turnover by volume on major stock markets (information here) of high frequency trades has risen to over half by 2010. Yes, that means that potentially on some exchanges, 50% of all trades and value are traded automatically by computer. Pretty amazing.
We had better take some notice!
HFT (as it is often known) uses techniques called algorithmic trading to find minute differences in quotes. These algorithms use a dizzying array of mathematics to spot the differences and (often) to then 'arb' the difference. Arbitrage is the term used broadly to define taking financial advantage in different prices for the same asset.
Usually, an arbitrage happens on different markets, or in different locations. Some very major corporations are listed on multiple exchanges for example and perhaps time or currency differences mean that the same stock is valued slightly differently offer the possibility to buy and sell at a profit.
Since statistical arbitrage is a strategy that has been used like crazy by many hedge funds (information here), the opportunities seem to be limited. In fact, during the 2013 meeting of the World Economic Forum in Davos, hedge fund legend George Soros explained that there are so many funds with so much money chasing so few opportunities with the same strategies that it is almost impossible for them to outperform. This obviously includes volatility trading and algo trading.
For this reason, a very specific branch of finance called market microstructure is often used to enable the entire mechanism for buying and selling to be analysed for minute advantages.
However, the HFT world uses lightning speed and accuracy to pull off it's trades. An example of this is called co-location which is a process of building the computer equipment used for trading in the same building as the actual stock exchange equipment. Going even further, laser beam technology is being deployed because trades can be made more quickly than by fibre-optic cables. Why do this? Because the saving of milliseconds during a transaction can be profitable!
Technology at this level is clearly beyond the means of most of us. Therefore, there is no real off the shelf high frequency trading software that we can buy and run ourselves. Well, there is, it just isn't good enough to compete with the big trading firms and their unlimited budgets.
In the old days, buyers and sellers needed to be near to an
exchange to actually complete a trade. Then as computers took over, the
trades happened electronically and there was no physical stock exchange
location - everything was virtual. Now, as technology has advanced, and a capital market exists on a number of servers (perhaps 20 to 40) being
closer to the stock market servers offers a business advantage.
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The world of high frequency trading has proved in its short lifespan to be problematic for regulators. Quite amazingly (since it accounts for perhaps 50% of market volume) most operations are trading on their own account! They have not raised funds in the normal ways that a mutual fund, unit trust or hedge fund would have.
In fact, most are simply limited companies. All they need to do is have the capital to trade with, the computer equipment to handle the trades and the algorithm that does the trading. With no outside investors, there has been little reason or legislation in place to monitor them.
As the law has tried to keep up, some funds have moved further away from the exchanges. They operate in what are known as dark pools (pools of investment capital hidden from the light of regulation or oversight). These trades typically happen between major funds and investment banks with no need for a broker or an exchange to be involved (thus removing their fees).
Regulators also suffer from the same problem that faces them when confronted by investment banks that are 'prop' trading and hedge funds - the best minds are lured into the funds by very high potential wages and bonuses. The regulators simply do not pay enough to be able to afford people that understand these techniques.
Typical high frequency trading jobs involve lots of mathematical analysis and / or the ability to program computers. To say that it is a 'nerdy' profession is something of an understatement. In the investment industry these people are known as mathletes or quants (because they are involved in quantitative finance).
Since the real money is in developing the algorithm, there is a very real premium paid to staff that are able to conduct this analysis and think through the problems. A very large percentage of quants have studied to PhD level. Once they have been recruited, the high frequency trading companies pay very, very well and do everything they can to retain staff and ensure that there is a wall of secrecy to protect the secret sauce that makes up their trading strategies.
To prove a point, just visit this website and as a lay person read a few paragraphs and be amazed at how little you understand. The words are English, but not as we mere mortals know it...
This secrecy means that there are very few useful books or pdfs available to learn about the subject. If most practitioners have been through an advanced education on related topics that lasted years and written a thesis, there probably very few books that can explain the topic so that a normal person could understand it. In this regard it is a little like nanotechnology or brain surgery.
This level of secrecy means that there is generally very little news or press coverage either. The likes of the Wall Street Journal and CNN have little more access to this world than the rest of us, helping to provide an air of mystery to the arena. After all, if you really understood this arena well, wouldn't you rather be involved and earning (potentially) millions of dollars per year rather than reporting about it for a TV channel and earning tens or hundreds of thousands?
However, in an unusual break of secrecy, Goldman Sachs successfully prosecuted a former member of staff in 2013 (read this for details). They accused him - and the case was won - of stealing vital information and code, though he argued that most of it was Open Source! The mere fact that GS uses Open Source technology to create it's most highly sensitive of systems is itself interesting.
Recruitment is notoriously competitive since the funds are trying to find math prodigies and by definition there are not many prodigies! This means that the rest of us mere mortals will fight it out with impressive resumes and references while the fund owners look closely knowing that if they choose a person it is very likely that over time they will become very wealthy. The leading recruitment agency for these kinds of jobs is called Janikin Rooke.
There have also been a few 'odd' market happenings that have been broadly blamed on HFT that are raising the awareness of it to the public. The best example for many people as to why high frequency trading is a bad thing is the flash crash of 6th May 2010. In the space of roughly 20 minutes, the Dow Jones Industrial Average lost and then regained around 600 points. Intra-day, the loss was a touch under 1,000 points! However, some analysts think it was reasonably rational.
Either way, many people are quite reasonably concerned that the investment and pension funds of the developed world are being played with in quite this way. It could easily be argued by many that HFT simply adds more systemic risk to a financial system that was proved in 2008 to have too much systemic risk.
Whether good or bad, HFT looks set to continue to grow. A number of stock markets around the world as more equity markets have plans to enable co-location next to their servers.
It might be worth pointing out that this does not just relate to algorithmic trading for equities. There are many other markets (including currencies, oil and commodities) that have global reach and are traded on constantly by these firms.
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In a bid to communicate better with the outside world and the rest of the normal stock market participants in particular, The Principle Traders group has been formed. One argument for HFT is that it provides liquidity in the market - many brokerages pass their trades through HFT firms because of this liquidity - and this positive aspect is one that they are trying to advance in people's minds. In other words, some aspects of HFT are gaining a poor reputation and some major players are hoping to highlight the positive benefits of their work.
The banking crisis of 2008 forced regulators to take the operations of hedge funds, prop traders and algorithmic funds much more seriously. It was clear that while regulators had not been too worried, technology had moved stock markets forward quite dramatically and the systemic risks had changed, as had the potential victims (governments bailing out financial firms). Therefore, 2009 saw the start of legislators working hard to better understand what was going on.
The problems caused by regulatory arbitrage (where different locations are chosen for their taxation or regulatory benefits) pushed the United States and EU to work more closely to ensure their new rules worked together (ie, were identical wherever possible). For example, clamping down on "dark pools" was one priority (a dark pool is a an off exchange trade which is out of sight of regulation - this might mean that a trade is conducted directly between financial funds or institutions or out of hours (information here)).
The Other Side Of The Story
In his excellent book Flash Boys, the acclaimed financial author Michael Lewis investigates the story of some of the key players trying to uncover the methods of the HFT firms. What those key players uncover, while forming their own transparent exchange called IEX, and Lewis then reports upon, is a world of front running and unusual deals that give a poor deal to investors and a huge income to the HFT firms.
The story is obviously very complex and we cannot pretend to explain it well here - we suggest that you read the book. However, it adds significantly more weight to the arguments that HFT is not as great a force for good as is often claimed, that the "liquidity" they provide is an illusion, that many of the existing dark pools do not offer a good deal to private investors and that these firms have not developed new ways of managing risks, but instead are simply getting in the way of real trades to make risk free profits.
To read about more aspects of investment, please follow these links:
Are There Really Any Stock Exchange Secrets?
Are Corporate Executives Privvy To Stock Exchange Secrets?
Are Merchant Banks Trading Using Stock Exchange Secrets?
Are Some Stock Exchange Secrets Available To Everyone?
Stock Exchange Information
What Is Insider Trading?
Stock Market Corruption - Just How Common Is It?
What Do Central Banks Do? Do They Influence Stock Markets?
Is The Stock Market For Kids?