High Frequency Traders Go to Work
Occasionally I like to take time from discussions of value investing, to call out shenanigans when I see them. I had been considering a discussion of High Frequency Trading (HFT) for a few days, driven by the recent gravity-defying run-up in the markets. I couldn’t wait any longer, given that the New York Times blew the lid off of this sadistic genie in a bottle in this article.
What is High Frequency Trading?
HFT is a type of trading that utilizes supercomputers and proprietary trading algorithms to automatically and intelligently make trades within microseconds. HFT systems sometimes sit in the actual stock exchange in the server rooms that run the exchanges themselves, which allows for even faster trading. The concept itself is fairly benign, but — like most things on Wall Street — the devil is in the details.
What’s the Big Deal?
The main problem with these systems is that they enjoy privledged information. The major investment firms that use these supercomputers for internal trading and reserve them for their best customers, pay an extra fee to the exchanges that allows their supercomputers to have access to real-time market information before it reaches the trading public. By being able to see trades before anyone or anything else, and executing bids and transactions in microseconds, these supercomputers are able to predict very short-term market trends and be the favored buyer and seller for any momentum on any stock. These systems make money by getting a slightly better price — on the scale of pennies or fractions of a penny per share — on millions of trades.
It is just a Penny, who cares?
While making only small sums on trades, HFT systems do this at such high frequency that the net-effect is massive market manipulation. More than half of all trades are conducted by HFT systems these days, and according to the article, it is estimated that Wall Street pocketed $21 billion off of HFT last year.
HFT systems drive up the costs of investing for everyone else. By using privileged information, HFT systems get the best price possible for most trades, effectively raising the cost of investing for all investors. This is essentially a $21 billion money transfer from funds — mutual, pension, and other wise, and average investors like you and me directly to the pockets of Wall Street firms. In turn, there is no value added. These computers are not investing in companies, they’re manipulating ticker symbols on a microsecond scale. Outside of Wall Street, no one is better off because of HFT systems.
Conspiracy Theory
While I can’t prove it, I suspect that the problem is much deeper than this. Given the enormous amount of control that HFT has over the markets in the form of volume, I fear that there is enormous potential, and incentive to manipulate markets on a broader scale. While HFT is legal, if firms were to illegally collude, then they can have almost complete control over the direction of a market given the dominance of these systems. Given the profits at stake with market domination, and the need for the major firms to generate capital to pad their poor balance sheets, the incentives are ripe for such a scenario.
I believe that this may be happening. Lately, the markets seem to be defying all reason and gravity. Despite lackluster earnings reports, the markets have surged for 11 days straight — this is unheard of. These swings seem to hide behind less-bad news and completely ignore bad news. I think that someone is manipulating these markets — pushing them higher and higher so as to profit more when they fall.
I know I’m the same person who says to ignore the day-to-day, week-to-week, and month-to-month swings of the market. I know I say that a value is a value. This is all true, but the fact is that we — as a world of investors — are losers in a world dominated by HFT. HFT makes value plays a little bit less valuable, and if manipulation is at work, may be setting up millions of people for major disappointments on their 401k statements.
Heads they win, tails we lose.
