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After technology put their trunks in a knot, the folks who run international swim competitions quickly banned the supersuits that helped Germany’s Paul Biedermann hand Speedo-sporting Michael Phelps his first defeat in four years at the world championships in Rome. In capital market pools, on the other hand, stock exchanges have actually encouraged high-tech traders to deploy supercomputers now accused of soaking investors who own shares for more than a second.
High-frequency trading players don’t care about long-term prices. Using algorithms to data-mine buy and sell orders issued by slower punters, like pension fund managers, they flip shares in a matter of milliseconds, targeting tiny spreads to build up huge gains a fraction of a penny at a time. They also play a lucrative volume game, flooding markets with supersonic orders and collecting rebates that exchanges offer to drum up business.
Dubbed by the press as the Rise of the Machines, this activity can account for as much as 70% of equities trading in the United States. It also generates huge profits for the likes of Goldman Sachs and CIBC World Markets (which argues it began high-frequency trading in response to the needs of its clients, and has an obligation to its own shareholders to lead profitable trends). But regulators — not to mention the media — are just now waking up to the issue and its many implications.
In Canada, where HFT activity is reportedly behind 15% of stock trading, institutional investors such as the Ontario Teachers’ Pension Plan are still content to simply monitor the issue. But Joe Saluzzi, a market strategist with New Jersey–based Themis Trading, thinks institutional and retail investors should be outraged.
Saluzzi has been raising the alarm, claiming HFT computers generate misleading market signals and distorted prices that cost ordinary investors. He warns there is now another threat to the system. “Due to the fully electronic nature of the equity markets today,” he says, “one keypunch error could wreak havoc. Nothing would be able to stop a market-destroying order once the button was pressed.”
Kevan Cowan, president of TSX Markets and Group Head of Equities, thinks a Wall Street version of Terminator would make “a good movie.” But he argues there is no need for public fear or a knee-jerk regulatory reaction, especially in Canada, where controversial flash orders — which provide select players a quick peek at market data — are not allowed. (The SEC is now moving to ban these flash orders from the U.S. market.) Simply put, Cowan says HFT prices and signals are real, and that there is nothing wrong with markets that reward the fastest and smartest players, especially if they improve liquidity.
But the self-proclaimed James Cameron fan might benefit from watching a non-fiction account of battles between mankind and you know who. After all, there are documentaries on the crash of ’87, which was exacerbated by trading programs that clogged the system, forcing flesh and blood investors to make decisions in the dark.
Furthermore, while flash orders are not an issue, the TSX does allow supersonic traders to pay a fee to place computing servers on exchange grounds, which gives the HFT set the ability to act on market data faster than mortal traders. And that’s like holding a blackjack tourney in which some players use the HAL 9000 to count cards and others can’t.
Now, if I really understood algorithms, this wouldn’t be my day job. But according to the smartest Bay Street insider I know, the HFT invasion is awesome. He sees an opportunity to start playing HFT distortions. “These quants,” he says, “could move markets well beyond what the fundamentals might suggest, but eventually companies get valued based on the cash flow they are expected to generate.”
And that’s why my friend — a math genius who used to run a multi-billion-dollar fund — thinks many professional traders, not to mention retail investors, should see the future as a “very scary” place.
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