High Frequency Trading, the Latest Greatest Thing on Wall Street…?

July 24, 2009

Attention to high-frequency trading has been triggered by two events: the first, a case brought against a former Goldman Sachs programmer who allegedly stole secret computer code that could be used to “manipulate the markets in unfair ways”; the second, Goldman Sachs’ impressive returns despite the recent turmoil in the investment banking sector.

High frequency trading occurs when software is used to make millions of millions of trades at a millisecond pace.  What is remarkable is how quickly it happens and how quickly strategies can be adapted.  Attacks and counter attacks are launched within a second. The trades are so fast that materiality matters. ‘Co-location’, which  involves situating the trading room next to the exchange so that the wires and cables running between them are as short as possible, actually confers an advantage to high frequency traders.

The exchanges are in competition to attract high frequency traders and the fees these transactions generate.  Abated and encouraged by the exchanges high frequency trading has changed the nature of the markets, putting smaller players like mom and pop day-traders, at a distinct disadvantage.  According to a NYTimes report, using the case of Broadcom as an example, “The result is that the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.”

5 Responses to “High Frequency Trading, the Latest Greatest Thing on Wall Street…?”

  1. danielbeunza Says:

    This is a fascinating and very political issue. I was yesterday meeting with officials at one large floor-based exchange and one large electronic competitor, and got completely opposite reactions.

    The floor-based exchange agreed whole-heartedly with the Times article. And the added that markets have become worse, not better, because of algorithms (“woodchippers”, the call them.) Here’s another interesting point: the institutionalization of the VWAP (volume-weighted average price of a stock) as the relevant benchmark to beat, execution desks have set for themselves a mediocre target, just as index funds now only seek to beat the SP. As one informant told me, “does nobody want to make money on Wall Street anymore”?

    The electronic exchange people pointed out that, first, the figure given by the journalist is not accurate, and, second, that all this is not new. “It is as if someone said today, look at that new car, the Prius.”

    Most remarkably, this issue places the finance researcher in the very scholastic position of the epistemologist. You hear your informants talk about orders that “are not real” and about a world of smoke and mirrors. I normally stay away from academic papers that doubt the standing of reality (too grad student)… but this is one extraordinary instance in which informants are indeed questioning what they experience.

    As with the regulation of derivatives, following this debate we are going to exchanges play a more prominent role in the public policy debate.

  2. danielbeunza Says:

    Great link. Thanks.

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