Super ArbitrageThe role of high-frequency trading is gathering pace, commanding a bigger and bigger share of financial markets’ activity worldwide in equities, bonds, commodities, futures and currencies.
High-frequency traders are behaving like computer jockeys. They run complex trading algorithmic software on superfast computers and search the markets for tiny price differentials so that they can carry out super arbitrage.
By trading hundreds of millions or even a billion units a day at lightning speed, high-frequency traders pick up fractional pennies each time. The more volatile the market, the easier it is for them to make money jumping in and out of assets across multiple exchanges. High-frequency traders are really just trying to skim the bid to offer spread on a trade. It may only be as low as $0.01 on many trades but, if one does it for 100,000,000 — 100 million — units that’s over one million dollars a day of profit! High-frequency trading firms rarely go home with a position if they can help it because they make money by maximising transactional volume and minimising risk.
What Does Volatility Mean?
Markets become volatile when liquidity dries up. This means people can’t trade stocks at a fair price, when they want. High-frequency traders thrive off volatility, because when liquidity is in short supply, it becomes very profitable for them to provide it. On days with big movements, in the realm of triple digits, high-frequency traders can make a lot of money via this super arbitrage. As a result, May 2010 proved to be the biggest gold mine for high-frequency trading firms since the crash of late 2008 and early 2009. While many long-term investors lost their shirts during The Great Unwind (2007-?) and The Great Reset (2008-?), the high-frequency traders posted huge profits.
In their defence, high-frequency traders say that because their intense trading provides liquidity, they help markets run smoothly, improving the environment for all investors. They say their actions make the markets more functional and fair to typical investors. Given that the high-frequency traders and broker dealers have a symbiotic relationship, they are both actively masquerading as liquidity providers when in fact they are normally liquidity takers, the knowledge transfer of the transactional information being all important. It is clear that high-frequency trading serves no larger purpose. It does not raise capital for companies, create jobs or stimulate innovations in the broader economy. The trades remain completely divorced from underlying economic fundamentals. The high-frequency traders know little or nothing about the companies their computers are feverishly buying and selling. If one combines the speed at which they operate, the outsourcing of decision making to computer algorithms, and an almost complete lack of regulation, this shadow market can fuel and exaggerate volatility.
High-frequency traders have been branded as the new “black hats” of high finance. Their computer-driven methods, which now account for upwards of two thirds of all US equity volume, are proliferating. To a large degree, fundamental investment strategies — such as buying and selling stocks based on a company’s long term performance — have taken a back seat to high-frequency trading algorithms hunting for inefficiencies in daily pricing and super arbitrage opportunities.
Reach, Richness and Speed
High-frequency trading has been spreading from the US and Canadian stock markets into new geographies — Europe, Asia and Latin America — and all asset classes including equities, bonds, commodities, futures and currencies. Assuming the new financial regulatory reform bill forces over-the-counter derivatives on to exchanges, high-frequency traders will no doubt trade them too. Every day, things are getting faster in the world of high finance and trading. Four years ago, executing a trade in a millisecond — one thousandth of a second — was considered fast; now the top high-frequency trading firms and broker dealers are trading in microseconds. That’s one millionth of a second.
Law-makers and regulators are right to get nervous. Senator Ted Kaufman — Democrat from Delaware — who understands the risk of high-frequency trading, or HFT, has said, “I’m afraid that we’re sowing the seeds of the next financial crash.” He called for the Securities and Exchange Commission (SEC) to investigate high-frequency traders and the impact they have had on the broad markets in mid-2010.
In the aftermath of the May 6th “flash crash” in 2010, the Securities and Exchange Commission (SEC) voted to propose rules that would give the agency and securities exchanges more timely information about high-frequency trades so that they can better oversee the markets. The proposal required exchanges and broker dealers that trade on the exchanges to provide detailed information about quotes, orders and trades to what would be a newly created central repository.
Whilst the creation of a central repository may be helpful, it is unclear how this could prevent a “flash crash” caused by high-frequency trades in the future. Human real time is measured and understood in minutes and seconds, whereas the machines are trading in millionths of seconds. In order to be able to understand what happens in a future “flash crash” the regulators would have to play the data from a central repository in slow motion over days or even weeks! What good is it to drive an open-top car at high speed with one’s eyes glued to the rear view mirror?
Based on an ATCA briefing published on 30th May 2010: The Achilles Heel of Markets?
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