The ultimate need for speed- High Frequency Trading

The first time I heard about the term “High Frequency Trader” was on episode 19 of “The Investor’s podcast” when they reviewed the book “Flashboys” by Michael Lewis. As it was only an episode on review of just another book, that too for a non-finance book, I wasn’t very much moved (the real deal was that I couldn't get a clue about High frequency trading even after the episode). Soon after, I heard it again on episode 36 when they had a discussion with 'Josh Schmitt', he had started his own stock exchange for promoting the high frequency trading but defeating the evil part of it. After listening to this episode I felt an urge to read more about this concept of HFT (High Frequency Trading/ High Frequency Trader). The concept was so alien to the world that there weren’t too many good books available which explained what HFT actually was and how some of the traders were using it to gain an unfair advantage for themselves in the highly competitive market of stock trading. I was so fascinated by the term HFT that I decided to read the book “Flashboys”. I had earlier read the book “The Big Short”, "Moneyball" and “Liar’s Poker” by Michael Lewis which guaranteed this book to be an amazing and thorough read.

The interesting thing to know here is that, Michael had begun writing this book after FBI arrested Russian programmer, Sergey Aleynikov. As a Goldman Sachs employee, Aleynikov was charged by US government for stealing lines of computer code after he had quit his job. Michael began to search for answers behind this mysterious incident and he found shocking answers that inspired him to write this book. He found about the HFT, the fiber optic cables, and the fact that HFT guys have found a way that places them ahead of everyone else by milliseconds, thereby giving them an unfair advantage over other traders and investors.

Just for your reference- an average human eye blink takes 300 to 400 milliseconds. And HFTs were fighting for the advantage of 2 milliseconds over others i.e. Almost a 200th part of blink of an eye.

During 2009, 1640 workers of “Spread Network” divided in 205 teams of 8 each were assigned to dig trenches and holes as straight as possible, even though it meant digging through mountains and riverbeds to build a line that was supposed to lessen a few milliseconds in the trading network. The owner of Spread network 'Dan Spivey', came with the idea that a faster speed in trading could help the customers of spread network have a huge competitive advantage over the market. In the hindsight, he was Damn! right.

Does speed help in trading and what difference could a few milliseconds make?

Imagine Mr. A ordered its broker-X to buy for 5 million units of apple stocks. As per the norms, the broker-X is required to buy at the cheapest price and then to the next cheapest and then to the next. While doing the same, the broker-X needs to consider prices at all the active stock market at that moment. This price check has to be done irrespective of the quantity available on the other side of the trade.

Let’s assume the situation of market at the time of this order is like this. In ascending order of prices:-

New-York stock exchange (NYSE)- Sell 10 quantity- 45.30 $

Dow Jones – Sell 50000 quantity- 45.40 $

MCX exchange- Sell 500000 quantity- 45.50 $

New-York stock exchange (NYSE)- Sell 10, 00,000 quantity- 45.55 $

Dow Jones- Sell 40, 00,000 quantity- 45.6 $

Due to statutory guidelines, the broker-X first is required to put the entire order at NYSE where the stocks of apple are available at cheapest price. Here only 10 out of 5 million quantities required would be fulfilled. But as per the requirement, broker X has to fulfill the order at NYSE irrespective of the quantity available on the other side of the trade. Then the broker-X would move to the next cheapest price and would go to the Dow Jones and dump in the entire order there to grab the maximum stocks at cheapest price but only 50,000 quantities would be fulfilled there. And then he will move to MCX and then to New York and then to Dow Jones, unless his requirement gets fulfilled. Of course these orders are not humanly possible to execute so quickly, these transactions are ordered and executed with help of algorithm. And all this happen in fraction of a second, before you can even imagine.

Now, if you track the movement of broker-X, you can imagine the impact of speed on this very transaction. Here as soon as the order of broker-X hits the NYSE for its first execution, the HFT guy would know that an order has hit the market for which the demand cannot be fulfilled at NYSE. Keeping the order quantity in mind, HFT would scan all the stock market exchanges and available orders and accordingly anticipate the next exchange where the order would hit and with what quantity. This anticipation is more or less a surety because HFT also knows that the broker-X is obliged to buy the cheapest at first. By logic as we can see, after execution of 10 quantities at NYSE the order should hit the Dow Jones market.

Here comes the real twist, Just as the first transaction of 10 shares gets executed, Imagine that a new order for selling 2 million shares of apple ordered by someone at New York stock exchange at 45.20 and 8 Million shares of apple were ordered to sell at Dow Jones at 45.25. Here comes the role of the speed. With the help of speed, the HFT guys would know about such order few milliseconds before the normal market. Now that they know the market is willing to sell 2 million at 45.20 and 8 million at 45.25 but the normal investor does not know about it yet because that information has not reached to the market, they will create an order for selling 2 million shares at New York at 45.35 (Which is cheaper than the existing offer price at Dow Jones of 45.40 so that the order for 2 million quantity get settled at New York Stock exchange itself.) Simultaneously it will create the position of 3 million quantity at 45.35 at Dow Jones stock exchange as well (Assuming 5 cent is the minimum price movement margin i.e. an order for either 45.30 or 45.35 or 45.40 could be placed and 45.39 cannot be placed) By placing the order at 45.35 at Dow Jones by HFT the remaining order of Broker-X would automatically arrive to HFT instead of already existing seller at 45.40 because that offer is 5 cent more expensive than HFT’s order.

Even before the market knowing about upcoming orders and HFT selling short its 2 million shares of Apple at 45.35 at NYSE and 3 million shares (- 10 shares) of Apple at 45.35 at Dow Jones, HFT knows that a sell order for 2 million shares at 45.20 and 8 million shares at 45.25 is about to arrive at NYSE and Dow Jones respectively. Immediately after executing the sell order or we can say simultaneous to sell order (at 45.35 for 2 million quantities at NYSE and 3 Million quantities at Dow Jones) the HFT would order buy for 2 Million units at 45.20 at NYSE and 3 million units at 45.25 at Dow Jones which would be fulfilled by the upcoming order which is HFT is aware of but the market is not. Spread between 45.20, 45.25 and 45.35 is the profit made within milliseconds.

It is important to know that it is outside the ability of human kind to execute such transaction at such rapid pace. These transactions are ordered and executed by highly efficient and powerful computers with help of highly efficient network like fiber optics. It’s impossible for human kind to even track the changes in speed, let alone matching it.

The unanswered question

After understanding this super complicated system, one question still remains that if even the market was not aware of the order then how did the HFT get to know about the buy order of 2 Million shares and 8 Million shares of apple at New York stock exchange and Dow Jones respectively?

The answer is very simple, the access to brokers. The brokers (Not everyone of course) provide the access to the information of their clients order details to the high frequency traders against the huge sum of money paid by HFT to these brokers. Apart from brokers, certain exchanges provided the information to HFT about the transaction which these exchanges were to shift to some other stock exchanges because they were not able to fulfill it on their own.

The mad-rush of speed

The entire book can be summarized in one single line. "People were fighting to reach near to stock exchanges's central processing computer. In a building, people were moving their computer from one desk to other desk to get that small advantage of speed. Some of them created spaces in the wall to be nearest and hence quickest to reach to stock exchange".

Josh Schmitt's Idea

Josh Schmitt is not the first person with the idea of opening a stock exchange to conquer High frequency trader's evil intention. Brad Katsuyama started a war against HFT by educating the traders and in the end opening a separate stock exchange "IEX" to maintain fairness of the stock market. But his idea was different then Josh Schmitt. Josh Schmitt is not against high frequency traders, he just does not want a high frequency trader to behave in a certain way that can create adverse situation for other traders. Brad's idea was simple, no one should have the advantage in the market just because they have better speed or some broker have cut a deal with them.

HFT in India

So far there has not been a huge impact of High frequency trading on stock exchanges of India due to 3 main factors.

1.      There are not as many stock exchanges in India as USA.

2.      In India the broker is not bound to check the prices of each and every stock exchange before executing the customer’s order.

3. In India , there is a concept of security transaction tax. Security transaction tax means that a certain % of trading value is charged as tax with on each transaction. This transaction tax increases the transaction cost and makes the low margin trading unfeasible for traders. In Simple words, The trading can not be feasible unless the margin is sufficient enough to cover both the STT of buy side and the sell side. Covering these margin at such short term trade is practically not possible.

Aleynikov's Problem

In the aftermath of 2008 Financial crisis the world saw a lot of drama and action ranging from 700 Billion dollar government bailout to millions of dollar bonuses to big wall street firm executives. The only thing missing was arrest. It was one of the biggest fraud in history of the world and the number of people that went to jail for this could be counted on fingers with some of them left spared. Even out of these limited number of arrest, everyone got out of jail on bail except one "Sergey Aleynikov". He wasn't a finance guy or an investment banker selling crappy junk bond, he wasn't the bank guy making crappy loans without papers, neither was he the rating agency guy who rated junk bonds as AAA. His only fault was to transfer the code of some "open source (free available on internet) software" to his personal email id without taking precaution as he never thought that he could be arrested for something which he used to do on weekly basis, just after leaving the company where he had made a mark as being one of the best IT guys. The real reason of Aleynikov's arrest was that he knew more about Goldman's high frequency trading desk than anyone else in the firm and they didn't want him to share the same with anyone else.

Conclusion

HFT’s are not alone in preying the investors and traders they have complete support of biggest brokerage houses and stock exchanges. There is no benefit of speed unless you know it from its source. Running in the opposite direction at amazing speed wouldn’t help you win the race. For winning it you must know the direction to win, these directions are provided to HFTs by brokerage houses and stock exchanges hundreds of time during a day. With help of this every partner (HFT, Brokerage firms, Stock exchange and corrupt government official wins), the only looser here is the ordinary investor.

The next time you see the ticker of a stock on screen, always include a small probability of the fact that even though you may have been the first to see such price and take action over it, you may not end up winning that game as you would have liked.