High Frequency Trading: Wall Street’s New Rent-Seeking Trick
Martin Hutchinson
Contributing Editor
Money Morning
Goldman Sachs Group Inc. (NYSE: GS) disclosed recently that it had 46 “$100 million trading days” in the second quarter of 2009. That was a record number, even for one of the biggest players on Wall Street.
When the U.S. economy is facing collapse and merger and acquisition volume is way down, it seems odd that investment banks like Goldman had record quarters.
Well, here’s the secret: They’ve found a new way to skim more of the cream off the top of U.S. economic activity. It’s called “High-Frequency Trading” (HFT).
High-frequency trading uses the speed of supercomputers to trade faster than a human trader ever could. Human owners of the supercomputers program them to take advantage of information milliseconds faster than other computers, and whole seconds faster than ordinary human traders. This is not a minor development; HFTs now represent about 70% of the trading volume in the U.S. equity market.
HFT computer servers are able to beat other computers because they are located at the exchanges. They take crucial advantage of the finite speed of light and switching systems to front-run the market. They also gain information on orders and market movements more quickly than the market as a whole. They operate not only on the New York Stock Exchange (NYSE), but also on the electronic trading exchanges such as the NYSE hybrid market.
According to a paper “Toxic equity trading order flow on Wall Street” by the brokerage Themis Trading LLC, there are a number of different types of HFT. Liquidity rebate traders take advantage of volume rebates of about 0.25 cents per share offered by exchanges to brokers who post orders, providing liquidity to the market. When they spot a large order they fill parts of it, then re-offer the shares at the same price, collecting the exchange fee for providing liquidity to the market.
Predatory algorithmic traders take advantage of the institutional computers that chop up large orders into many small ones. They make the institutional trader that wants to buy bid up the price of shares by fooling its computer, placing small buy orders that they withdraw. Eventually the “predatory algo” shorts the stock at the higher price it has reached, making the institution pay up for its shares.
Automated market makers “ping” stocks to identify large reserve book orders by issuing an order very quickly, then withdrawing it. By doing this, they obtain information on a large buyer’s limits. They use this to buy shares elsewhere and on-sell them to the institution.
Program traders buy large numbers of stocks at the same time to fool institutional computers into triggering large orders. By doing this, they trigger sharp market moves.
Finally, flash traders expose an order to only one exchange. They execute it only if it can be carried out on that exchange without going through the “best price” procedure intended to give sellers on all exchanges a chance at best price execution. The Securities and Exchange Commission (SEC) has now promised to ban this technique, and flash trading on the Nasdaq will stop on September 1.
This toxic trading has caused volume to explode, especially in NYSE listed stocks. The number of quote changes has also exploded and short-term volatility has shot up. NYSE specialists now account for only around 25% of trading volume, instead of 80% as in the past.
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The bottom line for us ordinary market participants is that insiders are using computers to game the system, extracting billions of dollars from the rest of the market. While it is illegal to trade on insider knowledge about company financials, these people are trading on insider knowledge about market order flow. That’s how Goldman Sachs and the other biggest houses make so much from trading. By doing so they are rent-seeking, not providing value to the market.
There are two ways to stop this: Ideally, the SEC will employ both. First, they can introduce a rule that all orders must be exposed for a full second. That will reduce the volume of HFT, but still doesn’t truly protect non-computerized outsiders.
The second, and better, solution is to introduce a small “Tobin tax” on all share transactions. It could be tiny; maybe 0.1 cents per share. (The SEC would also need to ban “exchange rebates” to traders.) Such a tax would make the worst HFT types unprofitable without imposing significant costs on retail investors. It would also provide funds to help run the vast apparatus of regulation and control that seems to be necessary to run a modern financial system.
Goldman Sachs, and other financial institutions of its ilk, have imposed huge costs on the U.S. public with their “too big to fail” status. Now they are adding to the problem by scooping out money from the stock market through HFT. It’s about time the government imposed some taxes to stop the worst of these scams and recover the public some of its money.
News and Related Story Links:
- Wall Street Journal:
What’s Behind High-Frequency Trading - Themis Trading LLC:
Toxic equity trading order flow on Wall Street - Nasdaq:
Nasdaq to Stop Offering Flash Order Types on Sep 1 - Money Morning:
Citigroup and Bank of America Post Second-Quarter Profit but Will Likely Struggle in the Second Half - Money Morning:
JPMorgan, Goldman Sachs Profit Surge is an Accounting Mirage, Not a Sustainable Sector Trend
Comment by robert bontempi on 14 August 2009:
when public finda out it will finally be the last nail into the golden goose wounded now . this will kill it
Comment by Joe Hughes on 14 August 2009:
Thanks for the incredible insight.
Comment by Nick on 14 August 2009:
This article is BIAS crap. HFT has been around for over twenty years. The technology has finally come to a point where it represents a higher volume of the market. People are just freaking out over something they don’t understand. HFT makes markets more efficient by reducing bid ask spreads. Stop Hating.
Comment by Tony Chapman on 14 August 2009:
Thank you for YET AGAIN exposing the depths to which these LOW LIFE CON- ARTISTES will sink to skim off money, LEGALLY or ILLEGALY.
Time the Government Closed them down or Taxed then into oblivion before JAILING them for BIG NUMBERS.
Comment by How to use this as an advantage on 14 August 2009:
how to use this as an advantage for the regular ‘joe’ investor?
Comment by Andrew Jefferson on 14 August 2009:
An interesting article exposing long standing challenges introduced with the advent of electronic trading and exacerbated in the past several years as computers exponentially improve. Technology also enables every dim-witted moron to trade stock in their underpants at 2am from their rec room based on the talking heads on TV – why don’t we tax them too? Oh that’s right, we’re gonna tax everybody. Why don’t the SEC simply rebrand itself as the DEA where the drug is money. Fact is technology will always add opportunities for smart people to find new ways to profit.
The problem isn’t the intent to profit, the problem is the impact on others who aren’t so smart or simply don’t have access to the technology. The author suggests taxing the trades – that way instead of the smart people getting the money the government gets it – BRILLIANT (NOT)! The last thing we need is more tax, and more Gumby types on the government payroll.
Instead, how’s about putting together a SIMPLE list of guidelines where INTEGRITY is the key – 3 to 5 rules max. Anything that doesn’t meet the guideline is a crime with the penalties being refund of profit + fines + jail somewhere ugly.
Alternatively we can call a spade a spade… very few people are committed enough, connected enough, AND smart enough to consistently make real money in the markets. The rest of the “lumpen” as Mr. Bonner would say, deserve what they get. In fact, those people should stick to GICs and simple insurance assets and live their lives blissfully ignorant. Of course the challenge is that if that happened there’d be fewer DIY’ers buying investment newsletters!
This article is basically hype – the problems are real, the solutions are complex, tax and hatred are NOT the answers.
Comment by Don Fishgrab on 14 August 2009:
As was pointed out, these trading systems withdraw money from the economy, without providing increased value. These efforts to get something for nothing are the major cause of our current financial problems. Greed has been thde cause of collapse of nations and empires throughout history.
The stock market started to provide funding for business, but has lost it’s plan, becoming interested only in quick profits for those involved. Investors no longer care about the health of the company, only what their return will be. As a result, they have been content to allow such activities. Only so much can be taken out before the system begins to collapse.
Comment by anonymous on 14 August 2009:
Martin has no idea what he’s talking about. Goldman derives less than 1% of its profit from HFT (do your homework!!!!)…it makes FAR more money trading commodities, fixed income etc.
Do your homework!
Second, the barriers to entry into this market are TINY. There are numerous brokerage firms which will let you co-lo for peanuts. The REAL barriers to entry are in other markets (try getting good spreads in corp bonds as an individual investor!!!! Don’t see you bitching about that!) Do your homework!
HFT is ALSO responsible for DRAMATICALLY lowering spreads. Investors have benefited hugely from this. You completely fail to realize that if you tax HFT, spreads will widen accordingly and the average investors will be affected.
The REAL cost to investors isn’t the 1/10 of a penny taken by the HFT guy (in turn for BEARING RISK!!!!), but rather the $10 commission charged by Schwab etc. Think before you write about something you clearly know nothing about.
Comment by Pete Ewing on 15 August 2009:
Don’t even start with the tax per trade at any amount. With this administration the tax will be up to 10 cents a share in no time and $1.00 within 4 years.
Comment by Carlos Comesana on 16 August 2009:
Don’t understand how is it posible that the controlling agencies didn’t stop timely this illegal inside trading computer transactions !. Get taxable from now on this methodology and with the historical computer records let’s identify the dirty HFT transactions to be fined acorddingly and claw back the rebates!
taign porocedujrew ut this criminal procesdjure this
Comment by Madeline on 16 August 2009:
It really is an outrage for Goldman Sachs to take money from hard working Americans. They have already lost billions over the past year and a half. Practices like HFT should definitely be stopped. It has advantages, just like insider information, that the rest of us don’t! This is not how our system is suppose to work. Goldman Sachs should be ashamed of themselves and should answer for what they have done.
Comment by Jay on 17 August 2009:
“HFT makes markets more efficient by reducing bid ask spreads.”
Nick, these people are stupid enough to believe that if the current bid/ask is $2.30/$2.32 that Goldman can go out and make an instant profit by buying for $2.30 and selling at $2.32.
If you don’t get the last paragraph try these links…
http://www.investopedia.com/terms/b/bid.asp
http://www.investopedia.com/terms/a/ask.asp
Comment by RK on 29 September 2009:
I have a better idea. Scale capital gains taxes to the amount of time a security is owned. If you own it a day, you pay a 95% gains rate. Own it ten years, cash out free. Own it millisecond, the tax rate is %125.
Pingback by Open Letter to Timothy Geithner: Is Your Nose Getting Longer? on 17 November 2009:
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