What Is Predatory High Frequency Trading?
As I mentioned in the introduction to this series, not all High Frequency Trading (HFT) is created equally. Some HFT actually serves to create more and faster access to investor capital, what we call liquidity.
HFT was developed by people in innovative firms familiar with the way trade information is disseminated electronically between the various stocks exchanges and the exchanges’ antiquated, patch-worked computer systems. These firms have better, sleeker technology and higher paid computer programmers that give them quicker access to stock pricing information than most exchanges have. This along with more direct physical server location to each exchange, creates speed the exchanges can’t compete with. This speed and co-location allows them to see stock prices before anyone else, including the Securities Information Processing (SIP) system which was designed and implemented by regulators in 2007 to coordinate security pricing from all exchanges to produce an average or “best” price for a security.
As you can imagine, advanced pricing information made this innovation ripe for exploitation. Enter predatory HFT. With a lot of help from expertly designed algorithms, some high frequency traders decided to manipulate bid and offer prices by small percentages or fractions of a percentage then pocket the difference or “spread” between the original prices of the stock and their newly engineered price. The profit derived from each spread transaction may only be a fraction of a penny so most traders don’t notice it.
However, large institutional traders that trade thousands of shares of each security at one time noticed. For them, the price instability they were suddenly seeing made it impossible to trust the pricing information they rely on to make important trade related decisions for their clients. This added not only a layer of uncertainty, but also additional cost, shrinking their profit margins. They knew something had changed, but they weren’t sure what. It took a small group of dedicated individuals, led by an exceptional Wall Street trader to figure it out and decide to do something about it. More about that later.
Meanwhile, high frequency traders involved in this skimming practice pocket billions of dollars each year, take no risk and never truly own any stock they bid on.
Worse yet, because stock exchanges consider HFT a very important service that helps create more liquidity for clients in fast moving markets, both helpful AND predatory firms are usually paid a fee. Unfortunately, that means that the very exchanges being exploited are paying for that privilege and creating even greater profit and incentive for predatory HFT firms to keep on keeping on.
I’ve really only scratched the surface of what HFT is, the many ways HFT firms profit and how it infiltrates the markets today, but it’s beyond the scope of our discussion to go further. The best explanation I’ve seen is a short video on the Investors’ Exchange Trading (IEX) website. To watch it click here.
Who Does It Hurt?
At this point you may be saying to yourself, “What do I care if a bunch of wealthy Wall Street traders have to pay more for their trades?” I’m here to point out that while fractions of a penny on large institutional trades may seem like someone else’s problem, it’s really OUR problem. Trickle down may not work so well for spreading the wealth, but it seems to work pretty well for spreading the pain.
You and I may usually trade in small amounts of shares, 100 shares or less, but we are still paying a little more for each trade on securities affected by HFT and when your long term financial health depends on your ability to save and compound the maximum amount possible over time, every little bit matters.
As I mentioned in the introduction to this series, it also hurts the fragile credibility of the American financial systems creating more suspicion and animosity around Wall Street. With every new scandal reported in the media, every day Americans are less likely to become investors. While I completely understand why they feel that way, I cannot stress enough how important it is for us all to understand that there is no way to escape Wall Street altogether. If you have a loan, a retirement plan, a bank account or any other financial instrument, you are ultimately involved.
Last but not least, it hurts the financial services industry and professionals like me. Most Advisors that serve individual clients in financial planning and Registered Investment Advisor firms all over the country, don’t have any direct connection to the underlying Wall Street institutions that create the market. Most of us truly want to do what’s in the best interest of our clients and work hard to build trusting relationships with the people we serve. It’s upsetting and unfair that we must constantly pay the price for the bad behavior of some big Wall Street bankers, traders and the minority of unethical Advisors like Bernie Madoff. It’s something we all struggle to overcome on a regular basis and every time another scandal hits I can almost hear a collective groan among my peers.
How, then, if it’s so pervasive and damaging could we let this happen?
We’ll talk about how this happened and what we can do to restore fairness to our market systems in my next installment. Stay tuned for more.