The Wall Street Journal reports that high speed traders are exploiting a hidden loophole in the Chicago Mercantile Exchange’s (CME) computer systems, and that the CME has had knowledge that they are profiting from it.
This is something people have talking about a lot in Wall Street circles. One of the reporters on this piece, Scott Patterson, wrote an entire book about it last summer called Dark Pools: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market.
The thing is, stock exchanges have never admitted outright that this is happening. The Journal’s report relies not only on human sources, but also on a review of the CME’s trading records. The CME is the largest futures exchange in the United States.
The problem is that high speed traders have a direct connection to the CME’s trading computers. That gives them access to a lot of information, not least of which, according to the report, is the execution of their own orders 1-10 milliseconds before the rest of the market can see them.
Any firm that connects directly with the CME can do this, but not every trading firm has the technology to do it or even knows about this.
As a result, non-high speed traders can experience order delays that the CME calls “latency.”
There are “times when customers experience a latency of a few milliseconds between the time they receive their trade confirmations and when the information is accessible on the public feeds,” she said, noting that the delays “are not consistent and vary across asset classes.”
High speed traders say that this millisecond advantage is a positive thing for the market overall because they wouldn’t want to trade as much without it. It would make high speed trading riskier, they argue, and without their trades the market would have less liquidity.
However, Pete Kyle, a finance professor at the University of Maryland and former member of the Commodity Futures Trading Commission’s Technology Advisory Committee, says that this is tantamount to “a tax on other traders.”
Firms can use their early looks at CME trading data in several ways. One strategy is to post buy and sell orders a few pennies from where the market is trading and wait until one of the orders is executed. If crude oil is selling for $90 on the CME, a firm might post an order to sell one contract for $90.03 and a buy order for $89.97.
If the sell order suddenly hits, the firm’s computers detect that oil prices have swung higher. Those computers can instantly buy more of the same contract before other traders are even aware of the first move.
Firms can also capitalise on that early information by buying a related product on another exchange before other traders know of a market shift. For example, it takes about 200 microseconds for trades to get from CME’s Aurora, Ill., data centre to the computers of IntercontinentalExchange Inc. ICE +3.61% about 33 miles away. A microsecond is one-millionth of a second.
This is complicated stuff, so it’ll be a while before it all shakes out. In the meantime, head to WSJ for the full report>