HIgh Frequency Trading - The Great Bank Job

If you invest in the stock market, have a pension or life insurance and have never heard of High Frequency Trading then it is extremely likely you have lost money to this practise.

High Frequency Trading is essentially the use of computer programs known as algorithms and high speed internet connections to find out what stock trade is being made and to then buy or sell that stock before that trade can be made, taking an instant commission from the price jump. It’s like invisible Gazumping only much faster and you only get in the middle of the trade for a millisecond.

Traders have to know a trade is being made and get in on it making a small percentage on the exchange, with no downside. They can see that someone wants to buy or sell so they can quickly get in the middle of the trade, marginally raising the buy price which is taken as profit. The percentage earned may be small but it carries no risk and it can be done many, many times..

High Frequency Trading accounts for over half the profits made in the stock market today, which means that High Frequency Traders are taking a small percentage of a very large amount of money. We are talking in the billions here.

So how does High Frequency Trading work.

You can now trade on many stock exchanges as they defragmented in 2007 and the stock market has become much more volatile as computers can adjust prices instantly, meaning that any buy or sell will result in prices moving up or down instantly.

High Frequency Traders have been investing vast sums of money to obtain faster internet connection speeds to market exchanges, as even a millionth of a second will give these traders a big financial advantage.

Most trades are made on slow internet connections which means that people with high speed connections can be informed of a potential trade and get in the middle of it, pushing the price up and pocketing the difference.

The company with the fastest connection gets in before the original stock offer is completed, buying and selling it to the buyer at a slightly higher price. The connection speeds are measured in millionths of a second, but all that’s really important is to be the fastest, or fast enough to buy and sell before the buyer order gets through the exchange.

Imagine you could find out who wanted to buy all the houses in your area, knowing how much they would pay for the houses, and knowing that for a million pound house, they would all still buy it if it was £10K more. You would buy all the houses around and sell them on, knowing that each time you would make £10K profit.

It would be like the estate agent not only taking his fee but being able to tell the buyer and seller of the house two different prices. Neither would know the true price and the estate agent pockets the difference. The estate agent tells the buyer that it will cost a million and the seller that it will be ten thousand more. He does not have to buy or sell himself, he merely has to be able to hide the true cost from both parties.

Now obviously it’s not worth doing this for houses as the cost and time of the transaction is too high.

But here’s the bit to pay attention to:

Imagine if a computer program could do this instantly at no cost at all in a millionth of a second on every house purchase in the world. You could just sit there and watch your bank account total spin around like the speedometer of a Ferrari with no brakes.

To be fair High Frequency Traders have to invest a lot of money in high speed connections to the exchanges, these need updating often as they are competing with others to get there first. They also have to pay in various ways to get the information that a buy is being made. However once those costs are met you are essentially taxing every transaction made on every trade you can catch.

How do HIgh Frequency Traders find out about these deals? Sometimes they pay the banks for access to the exchange so they can see the deals happen. They also offer small amounts of stocks to sell at a low price and once these offers are taken up, they know that there is a buyer looking to get more. They then buy these and sell them to the buyer in a fraction of a second, making the money on the slightly higher price they have managed to sell it for. The price goes up the moment people are buying it to reflect the rise in demand/value. All this is automated using very fast software.

The reason these trades can be made without anyone knowing who is buying what from whom is down to the rise of new exchanges known as Dark Pools. These are market exchanges that sit in hard drives in banks and trades are made in secrecy hiding who is on either end of the trade. All the major Wall Street Banks have Dark Pools and they bring in a lot of revenue.

The first thing that came to mind is Richard Pryor in Superman Three when as a programmer he figured out that the company he worked for rounded off to the nearest penny for every account, but the money rounded off did not go anywhere. So he just sent the cents rounded off for every employee straight to his own bank account. Even he was surprised at the cash the next morning.

HIgh Frequency Traders are effectively taking money from every pension fund, investor, insurer and exchange in the world, without giving any service in return. They are an invisible tax.

The irony is that the press constantly warn about computer security and that some poor hacker might steal a few quid from his bedroom in Lobnya. These banks are paying coders multi millions to write these algorithms. If they are sitting in bed, it’s in the plushest suite of the Waldorf Astoria and they are definitely not alone. “Keep the jacuzzi running Devushka, I’m almost done”.

Is that outright stealing or is it a technological advantage and therefore just business? You decide. High Frequency Trading may have its place, but the way many companies are using it leaves little room for doubt. Some companies are having to hide huge profits illegally to stay off the radar.

It’s like being Al Pucino in Scarface:

“Then you'll find out your biggest problem
is not bringing in the stuff...

...but what to do with all the f***ing cash!

But for the best explanation read Michael Lewis’ book Flashboys:

The company that brought all this to light against fierce opposition: http://www.iextrading.com/