Greg Mills, the co-head of RBC Capital Market’s global equities division, is sitting in a dimly lit conference room in the bank’s downtown Toronto headquarters. He’s attempting to demonstrate how high-frequency traders, or HFTs, frustrate even the most routine of RBC’s stock trades. “Are you ready?” he asks. Mills taps the spacebar on his MacBook Air and launches a simulation of a hypothetical buy order. Dozens of little squares, each representing a bid or ask order, suddenly begin to fly around the screen.
Mills explains that HFTs launched a flurry of split-second trades the moment RBC hit the send button. “In some instances, the HFTs who we had expected to buy stock from, bought stock ahead of us, and then began to sell stock back to us,” Mills says. The take-home point is RBC paid a fraction of a penny more for each share than it expected to—and that can quickly add up. “We’re trading hundreds of millions of shares a day, and this implicit tax is constantly being extracted,” he says. “It’s being extracted from real investors.”
Mills is far from the first to raise concerns about the impact of HFTs. Their controversial approach relies on super-fast computers and complex algorithms to make hundreds of rapid-fire trades in the blink of an eye, collecting a few pennies each time. Though the technique is most closely associated with firms like Citadel and Jump Trading, it’s also used by a host of other financial players, including RBC (although Mills argues that RBC doesn’t engage in any “predatory” behaviour). Either way, high-frequency trading has become a major force in the stock markets, accounting for about half of all trades in the U.S. and slightly less in Canada.
Yet, despite its rapid growth over the past decade, the impact of high-frequency trading on the overall market is poorly understood. HFTs have been blamed for exacerbating the 2010 “flash crash,” when the Dow briefly plummeted 1,000 points in just a few minutes, and they’re at the centre of a recent scandal involving Thomson Reuters, which was selling key market data to high-paying clients two seconds before everyone else. “Who’s going to invest knowing they’re set up to lose?” New York Attorney General Eric Schneiderman recently asked.
Proponents of the highly automated approach point out that HFTs mostly compete with other computers, and that the benefits HFTs bring—like increased liquidity—far outweigh any costs. A fraction of a penny, it’s argued, will hardly make a difference to average investors who measure returns in weeks, months or years. But the same can’t easily be said for the giant pension funds and mutual funds where most regular folks park their retirement savings. Equally troubling, the rise of HFTs has called into question the role of stock exchanges, which benefit from the huge volume HFTs trade on their platforms. “I would say the exchanges are complicit in enabling the activities of HFTs,” says Mills, who is one of several people proposing a rival stock market to the Toronto Stock Exchange that promises to clamp down on the practice. “It allows them to execute their strategies and give them an advantage over traditional investors.”
The stock market has always been a great place to lose one’s shirt, but the rise of HFTs offers yet another troubling example of how the system increasingly favours a few sophisticated insiders—more than likely, at the expense of ordinary investors.
High frequency traders employ a variety of strategies, but the common thread in their algorithms, or “algos,” is sheer speed. One common technique is latency arbitrage. It aims to capitalize on the fact it takes digital information longer to reach some places than others. It may take a few milliseconds more for trades on, say, the NASDAQ’s servers in New Jersey to be crunched by America’s clearing house for stock trades and reflected in the National Best Bid and Offer, which is the best available price for a given security. If the HFTs can grab the data and make the calculations before it’s posted on the NBBO feed, they are in a position to make a quick profit—especially if they do it a few thousand times.
How do they get the data before everyone else? For one thing, most HFTs pay big money to “co-locate” their servers in the same buildings as major exchanges, ensuring they have direct access to market information. They have also sparked an arms race in fibre optic and other electronic connections between major trading centres around the globe. Due to demand from HFTs and other electronic traders, new fibre optic cables were laid between Chicago and New York that went through the Allegheny Mountains instead of following railroad right-of-ways. HFTs are also increasingly looking to above-ground microwave transmitters to carry their signals since, unlike fiber-optic cables, microwaves promise a direct, line-of-sight route that avoids the curvature of the Earth. One company, Perseus Telecom, is even proposing a network of microwave transmitters over the Atlantic held aloft by a network of weather balloons—suggesting no idea is too crazy when there’s potentially millions to be made with little or no risk.
While the strategy—speed—is simple, HFTs’ methods can be complex. Rebate arbitrage takes advantage of the rebate incentives stock exchanges pay out to liquidity providers—anyone who stands ready to buy or sell securities at a quoted price. It doesn’t matter if the HFTs make money in the trades themselves—as long as they don’t lose more than the value of the rebate. Another approach attempts to quietly detect patterns—a big block of shares being unloaded in small chunks—and then rapidly trade on the information. Still others attempt to trick other computers into launching a flurry of trades in the hopes of capitalizing on a rapid price movement.
Of particular concern for securities regulators is whether all of this light-speed trading has increased the volatility of equity markets, contributing to reduced investor confidence. In addition to the “flash crash,” there have been a growing number of painful stock market glitches in recent years that were either related to, or exacerbated by, computers run amok. In August 2012, Knight Capital lost nearly $440 million after buggy software flooded the market with orders during a 45-minute period. Stuck with its huge position, Knight was later forced to unload the shares at a massive loss. The firm nearly went bankrupt and was bought by Getco Holding Co., another high-frequency shop, earlier this year. Then, in August, a trading glitch shut down the NASDAQ for three hours. Another NASDAQ glitch also marred last year’s Facebook IPO. “These events involved relatively basic, albeit serious errors,” Mary Jo White, the chairman of the U.S. Securities and Exchange Commission, said in a recent speech. “Many could have happened in a less complex market structure. But the persistent recurrence of these events can undermine the confidence of investors and public companies in the integrity of the U.S. equity market structure as a whole.”
That waning confidence may be among the reasons 2013 is shaping up to be the slowest year for stock trades since 2007, according to some estimates.
Not everyone agrees high-frequency trading is a problem that needs solving. Rishi Narang, a co-founder of high-frequency trading firm Tradeworx, argues that it makes no sense to denigrate HFTs and lionize investors like Warren Buffet for fundamentally doing the same thing: betting on the future of stock prices. “People have jumped to a very questionable conclusion that predicting further out into the future—à la Warren Buffett—is okay, while predicting into the extremely near-term future isn’t okay,” Narang told financial blogger Jeffrey Dow Jones. “There is a sort of ‘holier-than-thou’ attitude taken on by many people in the press, the public, and even the tax man about longer-term holding periods.”
Kevan Cowan, the president of TSX Markets and the head of TMX Group’s equities division, is similarly unconvinced that HFTs are fundamentally different than human traders. He points to the controversy surrounding latency arbitrage and notes that it’s been done for more than a century. Prior to the use of telegraph machines, he says, “brokers literally competed to hire the fastest physical runners to run their quotes from the floor to the broker.”
Even so, getting a grip on high-frequency trading has been difficult for both regulators and the public at large. In part, that’s because many of the strategies employed by HFTs are deliberately designed to be stealthy, and because most exchanges don’t share trading information widely. Canada has a unique advantage in that all of the country’s exchanges feed their trade data in real time to the Investment Industry Regulatory Organization of Canada, the industry’s self-governing body. Using that data, IIROC studied a three-month period in 2011 and found that HFTs accounted for 22 per cent of trading volumes, 32 per cent of the dollar value of shares traded and 42 per cent of all trades executed. Victoria Pinnington, IIROC’s vice-president of trading review and analysis, said the next phase of the study will focus on the impact of HFTs on investors. “We feel that studying the issue in depth will help us to shape a regulatory response,” she says.
Many in the industry don’t want to wait. RBC has joined with Barclays, CI Investments, IGM Financial, ITG Canada and PSP Public Markets to create a new stock market venture called Aequitas Innovations that would take steps to limit the impact of HFTs. That includes employing a electronic countermeasure system designed by RBC to slow down certain data transmissions to markets so that orders all arrive simultaneously, giving HFTs no opportunity to capitalize on latency issues. “If we do this at the exchange level, then every broker dealer that uses Aequitas for their clients can benefit,” says Mills, Aequitas’s chairman.
Not surprisingly, TMX’s Cowan takes issue with the suggestion that investors are ill-served by the current market structure. He says electronic trading, and efforts to promote it, have largely been a positive development because they’ve increased market liquidity and narrowed bid-ask spreads (the cost of buying and selling stocks). As for selling HFTs and other electronic investors direct access to the TSX’s servers, he stresses that such services simply acknowledge the reality of today’s stock market, arguing that in the absence of co-location opportunities, savvy traders would simply try to “lease or buy the building next door.”
Instead of banning HFTs outright or making it more difficult for them to operate, Cowan says a better approach is to identify when HFTs are behaving in a manipulative fashion and clamp down on them just like any other investor. “If somebody is looking to purposely move a market, that’s illegal under current rules and should be enforced,” he says. As for the larger question of electronic trading and volatility, Cowan adds that, “what’s important is investing in the tools to make sure we have the appropriate protections in place.”
Even so, investors can be forgiven for thinking the stock market increasingly resembles a casino—a place that holds equal amounts promise and heartbreak, and where the real money is made behind the scenes.