On May 6 2010, the Dow Jones dropped a thousand points within minutes. This astonishing nine percent decline came out of nowhere. Investors saw billions of dollars evaporate before their eyes in a matter of seconds. Furthermore, as crazy as the drop had seemed the recovery was equally shocking. That same day, a large part of the lost ground was regained. Wall Street could not believe its eyes. In the wake of what was later dubbed the Flash Crash, media seemed to blame the whole thing on High Frequency Trading firms. These firms were relatively new on Wall Street and had so far been flying under the radar. However, only a handfull of people really understood what had happened that day and they were wisely keeping to themselves. To their regret, the Flash Crash revealed to the public what had been a well-kept Wall Street secret.
A Game Changer
To understand the cause of the Flash Crash, let’s go back to where it all began, October 19 1987, more commonly known as ‘Black Monday’. On that day, the stock markets plummeted at such a pace that some brokers decided to stop picking up their phones. This resulted in an outrage among investors. As a response to this the Securities and Exchange Commission (SEC), the institution that regulates the markets, decided to kick-start electronic trading. From now on computers would take care of all the trades and this promised to be a big improvement. One benefit was the increased transparency of the markets. You were now able to get an accurate and up-to-date price of all the stocks and bonds. Furthermore, computerized trading seemed to cut out the middleman. Investors could now directly trade with other investors with the push of a button. The game had changed. And the financial intermediaries of Wall Street quickly started crafting their role in this new world.
Computerized trading seemed to cut out the middleman
This new way of trading opened up all kinds of opportunities. It also attracted a new kind of player to the playing field. The money and competition proved irresistible to many people with backgrounds in maths, physics and other technical fields of study. More often than not these new Wall Street employees were armed with a PhD. They were named quants. The quants started designing the plumbing for the increasingly complex system of the computerized markets. Pretty soon, the quants were the only ones that still understood the system. These former students of electrical engineering and bio-chemistry quickly adapted to life on Wall Street. They figured out early on that Wall Street is all about money. In fact, they swiftly realised that on Wall Street, when you are not the one doing the screwing, then you are the one getting screwed.
When you are not the one doing the screwing, then you are the one getting screwed
The quants got together and started forming so-called High Frequency Trading (HFT) firms. Their unique technological capabilities and understanding gave them a tremendous advantage over other parties trading on the stock exchanges. Before long they were exploiting this advantage. Suddenly, investors started noticing that the market they saw on their screen, wasn’t the market anymore. The moment they pressed enter to buy a stock the market seemed to move against them. As a result they would pay a higher price than the one they anticipated on. The same thing would happen when they tried to sell stocks. The price inevitable would drop the very moment they pressed their keyboard. The price changes often weren’t larger than a few cents, but over time this would amount to a significant loss. How was this possible? Who could explain to them what was happening and who was responsible for this?
An Elusive Market
Well, as you might have already guessed, the HFT firms had something to do with it. Basically, they employed three strategies. The one that the investors picked up upon is called front running. As is often the case on Wall Street, this financial innovation was made possible by a change in regulation. A new set of rules called REGNMS obligated brokers to find the best price for investors. It sounds harmless, but it made investor behaviour predictable and this could be exploited by HFT firms. The ones especially vulnerable to this front running are big institutional investors. Typically these investors would trade large quantities of shares. Say for example, that a pension fund wants to buy 10.000 shares of Apple. The order would enter the market and because it’s such a large order the stocks would have to be bought on different exchanges. Meanwhile, lurking in the shadowy corners of the markets, predator algorithms created by high frequency traders are waiting for their cue. These predator algorithms contain millions of lines of code and are able to teach themselves new behaviour. When they sense a large investor is about to buy Apple, they rush to buy all other Apple stocks themselves. Next, they turn around and sell the pension fund the shares at an slightly higher price. This all happens within a couple of microseconds. Furthermore, the HFT firms are taking virtually no risk. Meanwhile, the institutional investors pay a ‘tax’ on every trade they make. This ‘tax’ may only be a couple of cents, but over a longer period of time this amounts to very real losses for the pension fund.
Lurking in the shadowy corners of the markets, predator algorithms created by high frequency traders are waiting for their cue
A second strategy the HFT firms employ is rebate arbitrage. This strategy is only possible because of maker-taker fees introduced by the exchanges. A taker is a person that covers the spread, i.e. the difference between the price asked and the price offered. The maker is the one that is on the other end of the trade. When a trade is made the exchange charges a fee , typically this would be equal to the spread. At some point in time, the exchanges started to pay the makers part of the fee in order to encourage liquidity. This became a huge incentive for the HFT firms to collect as much maker fees as they could. To limit their risk they would hold almost no positions for longer than a few seconds. Ultimately, the people profiting the most from the maker-taker fees were the HFT firms. Hence, they became the ultimate middleman.
The third trick up their sleeve is known as slow market arbitrage. This has everything to do with the incredible speed the HFT firms are able to achieve. Their superior software and hardware allow them to outrun almost all competitors on the exchanges. Furthermore, it also allows them to process information faster and then make a move before anyone else can react. This all enables them to maintain a more up-to-date picture of the market than their competition. While this advantage can be as small as microseconds or even nanoseconds , it is enough for these firms to profit from the small price deviations on different exchanges. If, for example, the price of Microsoft stocks moved on the New York Stock Exchange, but had not moved yet on other exchanges they would profit from it. Again, they would only make as little as a cent per stock, but if you do this tens of thousands times a day it becomes very profitable.
Made Possible By..
The essential riskless profits the HFT firms create does sound quite desirable. Well, the big Wall Street banks thought so too and hastily joined the skirmish. With the arrival of the banks, the competition intensified. To stay on top of the game you have to spend hundreds of millions of dollars on equipment, employees and information.
Although the virtual part of HFT trading is crucial, the physical part should not be underestimated. To get an edge over competition, traders place their servers as close to the exchange’s servers as possible. The exchanges smelled blood and started selling space inside the building where their servers housed. Naturally, this would cost the HFT firms a few bucks. Consequently, trading moved from the actual exchanges on Wall Street to the borders of the city. Incredibly large halls were built to create the space required for the servers. Consequently, the trading isn’t happening on the actual trading floors of Wall Street. These former hubs of capitalism have turned into tourist attractions. This physical shift of the exchanges and the network created to sustain it costs the HFT firms hundreds of millions of dollars, but it seems like it’s all worth it.
These former hubs of capitalism have turned into tourist attractions
Not just the banks were noticing that the HFT firms were making a ton of profit. The exchanges were noticing it as well, and they wanted as big of a piece of the action as they could get. Moreover, they found a way to get their cut. They could sell privileges to the HFT firms. Just like they would sell the VIP spaces inside their servers, they would sell other kinds of advantages. For example, exchanges would sell exclusive detailed information to HFT firms or just at a faster pace. They would also sell special order types. An order type is used to specify the way your order is supposed to be executed. The order types the HFT firms were using allowed them to jump in line and do even more front running. In other words, the HFT firms are making a great deal of money and the exchanges seem to be in on it.
Back to the Flash Crash
In the process of creating the electronic stock market the quants have replaced the big hairy shouting traders that used to roam the trading floors. They created an incredibly competitive complex virtual world full of battling algorithms. Although the quants know exactly what their own algorithms do and how they act, they have no clue how they interact with algorithms of other quants. The very nature of the complex system that is created is the unpredictability of it. In fact, if exactly the same events would take place in exactly the same order as they appeared on the day of the Flash Crash, it is very likely that they would not have the same effect as on 6 May 2010. This all makes things even more complicated.
To say the least, it is questionable if electronic trading has really improved things for investors. There is no doubt that liquidity has improved, but at what cost? Helpless institutional investors are getting shredded to pieces and everyone is in on it. And you know who is supplying these investors with the capital to invest? You.