Recognizing the real-time myth.

In most of the major exchanges today, trading is handled by computers that match buy and sell orders. And the speed of execution is almost beyond comprehension. Trades are now routinely executed in fewer than 200 microseconds. (A microsecond is a millionth of a second.) For comparison, the blink of an eye takes about 350,000 microseconds. That gives you some idea of the turbocharged speed of trading today.

In addition to executing trades, high-speed computerized systems generate and distribute reports of trading activity that heavily influence buying and selling decisions. But it is important to remember that in each case the communication is not instantaneous. It is not real-time.

As the information travels from sender to receiver, an infinitesimal, but measurable amount of time elapses. And geographical distance is a key factor in the timeframe involved. That’s why it takes more time to send trading information from New York to London than it does from the Bank of New York Mellon at One Wall Street to the NYSE Euronext exchange down the block. And that communication takes more time than it does to send an order to the exchange from a broker located in the same building.

To a layman, the incredibly short delay between sending and receiving—a factor network computing experts call “latency”—may seem irrelevant. But in a world where an increasing number of trades are managed by computers using sophisticated algorithms to make unthinkably fast decisions, a few microseconds difference in price discovery or order execution could give one trader a significant and highly profitable advantage over another.

In a March 2, 2012 blog on the Huff Post Business section entitled “Business at the Speed of Light: What Is a Millisecond Worth?” Tony Greenberg, the CEO of RampRate, a consultant for IT and cloud computing sourcing decisions, captured his Chief Technology Officer’s view of the ultra-low-latency arms race:

“‘It can be difficult to imagine how milliseconds or nanoseconds of latency make a significant difference,’ says Internet technologist and RampRate CTO Steve Hotz, ‘but from the viewpoint of a data transaction making the trip hundreds or thousands of times, that incremental advantage can add up.”
Understanding the problems
caused by collocation.

This critical split-second advantage is one of the reasons why High Frequency Traders—which account for only about 2% of today’s 20,000 trading firms, according to a survey by the AITE Group—are so interested in placing their trading technology as close as possible to the supercomputing systems operated by the major exchanges.

This practice—called “collocation—could involve a building close to the exchange or even space in same building. In fact, some exchanges offer collocation services directly to their customers, a questionable activity that has raised concerns at regulatory agencies like the SEC.

According to a March 1, 2012 article on the website Wall Street & Technology, Nasdaq OMX established the lowest latency route from the New York metro region to Brazil’s leading exchange in December 2011.

The new connection provided Nasdaq customers with a 2-millisecond round-trip data transmission advantage over the route operated by NYSE Euronext. The difference is less time than it takes for a housefly to flap a wing. But clearly it was meaningful to Nasdaq customers who are willing to pay for the benefits of collocation.

“When trading advantages are measured in mere thousandths or millionths of a second, co-location could be the difference between success and failure,” explained David S. Hilzenrath in a February 22, 2012 article on High-Frequency Trading published in The Washington Post.

From a competitive standpoint, it makes perfect sense for the exchanges—many of which now operate as for-profit corporations–to offer the best possible services to their customers and to seek meaningful differentiation.

Nevertheless, the trend toward collocation and the dramatic increase in High-Frequency Trading pose significant threats to the fundamental principle of fairness that’s a professed goal of regulators and is essential to the long-term health of the financial markets.

In fact, in a 2011 report to Congress recommending major changes in the organization of the SEC, the Boston Consulting Group pointed out that today’s computerized, high-speed trading opens the door to market manipulation and potentially creates “an uneven playing field.” (The report was cited in The Washington Post article noted above.)
As you can see, this concern about inequitable trading is based on commonly recognized market practices. But there are other issues that threaten to undermine the operations of the major international exchanges.
Here are some prominent examples.

The new profit potential of classic arbitrage strategies.

If you can move faster than the competition with Ultra-Low-Latency and High Frequency trading techniques, you can reap enormous profits on virtually every liquid security asset class by exploiting temporary deviations in price on investments offered in multiple markets.

For example, a classic arbitrage strategy like covered interest rate parity in the foreign exchange market profits from the relationship between the price of a domestic bond, the price of a bond denominated in a foreign currency, the spot price of the currency, and the price of a forward contract on the currency. But that’s just one application of this approach.

With help from sophisticated algorithms and supercomputers, arbitrageurs can take advantage of increasingly complex models that utilize considerably more than four securities. And they can literally take billions of dollars out of the market that might have benefitted other investors, including institutional investors, endowments and pension funds.

The disruptive force of flash trading.

Hedge funds and other high-powered traders use this controversial computerized practice to issue orders and then cancel them–within the allowable timeframe– before they are filled.

As a result, they are able to see orders from other market participants before the information is available to everyone. This unfair advantage gives them insights into how others are trading and helps them gauge supply and demand. The SEC proposed banning the practice in 2009.

“Concerns have been raised that the use of flash orders by exchanges and other markets may detract from the fairness and efficiency of the national market system,” Mary Shapiro, Chairwoman of the SEC, said at the time. “Specifically, flash orders have the potential to discourage the public display of trading interest and harm quote competition among markets.

“In addition,” she continued, “flash orders may create a two-tiered market by allowing only selected participants to access information about the best available price for listed securities. Investors that have access only to information displayed as public quotes may be harmed if market participants are able to flash orders and avoid the need to make the order publicly available.” (Source: Shapiro Speech Before the SEC Open Meeting, September 17, 2009)

Although some advocates believe that flash trading enhances the liquidity of markets, critics are concerned that it increases market volatility and can cause disruptive “flash crashes” like the one that occurred on May 6, 2010 when the Dow Jones Industrial Average lost almost 1,000 points in a single day.

Flash trading also has an unfortunate and under-recognized impact on “stop loss orders” which are offered by brokerage houses and online trading venues to unsophisticated, casual investors and the general public.

Here’s how it works. Traders use flash trading schemes to discover the price points of stop-loss orders and automatically trigger the sale of the shares involved. Then high-speed computers quickly scoop up the shares at an artificially lowered price, which sabotages the price protection presumably offered by the stop-loss order trading option in the first place.

This questionable practice clearly violates the principles involved in fair trading, especially when you consider that most consumer-oriented computerized trading venues still offer stop loss services.

Pages: 1 2 3 4 5 6 7