A few weeks ago, I took a walk in Prospect Park with a friend. We had not caught up in a while and I had a lot to talk about. I am a judge for the Excellence in Financial Journalism Awards, presented by the New York State Society of CPAs, and I had just finished reading the many entries submitted by very talented journalists. Several submissions were on the subject of high-frequency trading and I was fascinated by the reports that I had read and watched. As I launched into my story, she interrupted me and asked, “What is high-frequency trading?”
I was less surprised by her question than I would have been three or four days earlier. This is because I had been asked that question every time I had started talking to people about high-frequency trading. Initially had been surprised that so few people knew about high-frequency trading but then I realized that I couldn’t assume that, just because I own the t-shirt, everyone else is a huge fan of Planet Money or, indeed just because I have the sweatshirt, the rest of the world is hooked on Radiolab. Both shows have covered the subject of high-frequency trading. Planet Money, in particular, has spoken extensively about high-speed trading.
That night, no joke, I tuned in to watch 60 Minutes and Steve Kroft was talking with Michael Lewis about his new book, Flash Boys, which talks about high-frequency trading and how it has negatively affected how stock markets work. Flash Boys is a popular book right now but, I wonder, though we are throwing around the term HFT (the now popular acronym for high-frequency trading) and discussing how markets are affected by HFT, how many of us really know what HFT is?
Watching television or the movies, the portrayal of the stock market has not changed much in decades. Bells ring to announce the opening and closing of the market and, in between, we see massive rooms of men (and it is just about always men) avidly watching screens of numbers, yelling madly and waving pieces of paper. Would you be shocked to discover that the stock markets are not “as seen on TV”? The markets have not operated in that way for a while now; things are far more complicated. Currently, there are 16 regulated national securities exchanges in the United States (and another 45 or so dark pools, which are not open to the public) and most of these exchanges are nowhere near Wall Street. Most trades are executed electronically and many of these trades are executed by computers using powerful algorithms. Initially, when electronic exchanges were first launched, there was a rule that, although the exchanges were computerized, orders had to be entered through the keyboard. The challenge to those using the electronic exchange, was how to be able to trade quickly and one such trader, Thomas Peterffy, built a typing robot to satisfy this requirement while increasing the speed of trading. The speed he achieved then is a joke compared to what high-speed trading looks like today.
Now there are no such rules and now the algorithms used by high-frequency traders have computers making multiple trades in fractions of a second. In addition to this, high-frequency traders can make trades and cancel them without paying fees for doing so. These traders are known to flood a market with orders, to get a feel of what is going on in that market, and then cancel the orders almost immediately. In fact, almost 97% of trades made in the US stock market are canceled and the bulk of these cancellations were from high-frequency traders. This activity tends to manipulate stock prices and, as a result, high-frequency traders can make pennies on trades. Because they can trade at incredibly high speeds and volumes, these pennies can add up pretty quickly to healthy returns. The returns are tempting enough that HFT entities are willing to pay to get information a mere two seconds before other people and are also willing to pay to get a few feet closer to the trading floor than their competition.
Now, how do two seconds and a few feet make a difference? This is because of the speed at which information can be processed and sent between traders and their markets. Any innovation that gets traders to the market before their competition so they can buy at a lower price and sell at a higher one is one worth spending on. This is the essence of high-frequency trading and traders able to execute millions of trades per second, can make many fractions of a cent add up to many dollars over a short period of time. The volume of trading has exploded in the last decade and the Nanex graphic of this activity is a very powerful visual.
Things can also go horribly wrong in markets with high-frequency trading. On May 6, 2010, at 16:42:44 (yes, down to the second) the stock market plunged 600 points in five minutes and this drop was stopped only when the market paused trading for 5 seconds and then started up again. The market regained the 600 points almost as quickly and as mysteriously as it had lost them. There is no consensus on what caused the Flash Crash of 2010, though most point to high-frequency trading as at least one of the factors responsible. That people cannot agree one what the causes of the crash were and that it took almost half a year for the SEC to come out with a report on what happened, shows just how complicated and difficult to understand trading and, in particular high-frequency trading are. I mean, once we start talking high math and algorithms, most of the world’s population is left cross-eyed and dizzy (and that means, me too).
There is no shortage of opinions to be found on high-frequency trading. Some use everyday English and exciting anecdotes to explain themselves while others employ fancy acronyms, mathematical phrases and financial-speak to put forward their thoughts. Whatever opinions and explanations you decide to explore, the first thing to do is to understand the basics of what they are talking about. How, really, can you have an opinion if you don’t even know what people are talking about? This is a very fast market. Nanosecond quick, so you better hold on!