High Frequency Trading (HFT): Wall Street's Latest Scam

August 17, 2009by CaraTan

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High Frequency Trading (HFT)

"It appears exchanges are conspiring with a privileged group of high-frequency traders in a massive fraud," Fund Manager Whitney Tilson.

Wall St, New York, USA, 17 August 2009. The new cream-skimming trick in Wall Street's playbook is called High Frequency Trading, or HFT.

It works like this: big trading banks invest in super-computers that can process information at every faster speeds, splitting nano-seconds into smaller and smaller units. These super-computers can process instructions faster than regular computers, and much faster than humans. Next, they place these super-computers in the exchanges themselves. This gives direct access to the exchange, cutting out the latency of connections from remote locations. By trading faster than smaller investors, profits can be constantly churned.
Institutional investors will often divide large purchases up into many small blocks that will be bought or sold within specified price ranges. HFT players seek to determine the price range by sending out quotes that are issued and almost immediately cancelled. They can execute thousands of such trades in a second. If they hit on a price in the acceptable price range, they can fulfil the order and then sell it on to the investor microseconds later for a tiny profit. Do this long enough and you can rack up impressive profits.This is not an obscure phenomenon. Estimates say that 50 per cent to 70 per cent of traded volume on the NYSE is carried out by High Frequency Traders, or HFTs. That's right; high-speed gouging of retail investors and large institutions now makes up the bulk of trading. It has directly led to Goldman Sachs pulling in record profits, and recording 46 '$100 million' trading days, when the economy is dead and corporate M&A activity is at record lows. If you wondered how they pulled that one off, here's how. It has become the very heart of investment banking, which explains the vigour with which Goldman's pursued a former employee who tried to create a new business using HFT computing code that he had developed. He has been arrested for theft. We would argue that Goldman Sachs is guilty of much worse crimes. True it is legal, but Democratic Senator Charles Schumer and the London Stock Exchange are looking to change the rules to stop at least some HFT practices.

High Frequency Traders, or HFTs, come in a number of guises. Academic research published in the paper

"Toxic equity trading order flow on Wall Street" lists the following types of plays, which it says are more responsible for market volatility than the financial crisis:

Liquidity rebate traders - Exchanges (at least some of them) offer rebates of about 0.25 cents per share to large brokers who bring in liquidity. They can re-offer shares at exactly the same price and still make a profit. Of course if they can offer the shares at a marginally higher price they will make more profit, as will the exchanges. Tilson said the exchanges are complicit because of these rebates, and the additional access they offer.

Predatory algorithmic traders - By placing small buy orders that are withdrawn, they fool institutional traders by bidding up the price of the stock, which is bought at higher prices as the series of small orders are executed to fulfil the big transaction. Later in the process the "predatory algo" shorts the stock at the higher price it has reached. The institutions then cover the short at the higher price.

Automated market makers - This HFT play involves"pinging" stocks with probe orders that are almost immediately cancelled, as described earlier. When a price is discovered, the shares are bought elsewhere and sold-on to the institution.

Program traders - By buying large numbers of stocks at the same time, they can trick institutional trading programs by triggering large buy orders that are tied to price moves. Once the institutions bite they can sell the stocks for a profit, leaving the traders as the 'patsy'. Flash traders - In this HFT scam, flash traders give an order to only one exchange. They execute it when - and only when - the order can go through without triggering "best price" procedure intended to give sellers on all exchanges a chance at meeting the best price. The Nasdaq will close the flash trading loophole on the 1st September 2009, and the SEC says it will ban this technique.

Nobel Economist Paul Krugman has been analyzing these traders and finds no economic value in what is being done; in fact he believes that if anything they are destroying value. "The stock market is supposed to allocate capital to its most productive uses, such as by helping companies with good ideas raise money. It's hard to see, however, how traders who place their orders one-thirtieth of a second faster than anyone else do anything productive," said Mr Krugman. "There is a good case that such activities are actually harmful. HFT probably degrades the stock market's function, because it's a kind of tax on investors who lack access to super computers and at-exchange connectivity - which means that the money Goldman spends on those computers actually has a negative effect on national wealth. As economist Kenneth Arrow said in 1973, speculation based on private information imposes a 'double social loss', by using up resources and undermining markets."

Not satisfied with milking the taxpayer, Goldman and friends have also escalated the profiteering arms race and are looking to skim everyone in the trading arena - partners, clients and each other. Can regulators keep up with the speed of their innovation and put in place sensible restrictions to protect the rest of us?

Juan Abdel Nasser, EconomyWatch.com