Wednesday, September 30, 2009

High Frequency Trading: The Truth

Mass confusion and conspiracy theories abound about high frequency trading. What exactly is it and how and who drives it? Does Goldman Sachs have secret software to manipulate it?

Here's a few good primers gleaned off the web:

From Wharton:

"It sounds like science fiction -- something from I, Robot or The Terminator, where the machines take over. But totally automated "high-frequency trading" is part of the stock market right now -- a big part.

According to some estimates, high-frequency trading by investment banks, hedge funds and other players accounts for 60% to 70% of all trades in U.S. stocks, explaining the enormous increase in trading volume over the past few years. Profits were estimated at between $8 billion and $21 billion in 2008.

Some market observers, members of Congress and regulators are worried. Are those profits coming out of ordinary investors' pockets? Is Wall Street's latest qet-rich-quick scheme going to harm innocent bystanders? "I don't think it would hurt people to become educated as to the intent of these strategies," says Wharton finance professor Robert F. Stambaugh. "What is their effect on the markets? There is a little sense of 2001: A Space Odyssey [in that it] does kind of create an air of mistrust."

Its defenders say high-frequency trading improves market liquidity, helping to insure there is always a buyer or seller available when one wants to trade. And so far, high-frequency trading doesn't look threatening, according to several Wharton faculty members. Indeed, it may well provide benefits to mutual fund investors and other market participants by reducing trading costs. But at the same time, several note that not enough is known about how trading at light-speed works, whether it can be used to manipulate markets or whether benign-looking moves by different players could interact to produce a new financial crisis."

From Advanced Trading:

"What we learned amazed us. HFT was now accounting for as much as 50-70% of the volume. And under every rock we turned, we found HFT engaged in: (1) what clearly looked like a questionable practice that cost institutional investors money, or (2) raised questions whether HFT was enjoying an unfair advantage versus classic institutional investors.

In response, we alerted our clients to what we learned. Eventually, others began to raise questions, too, including Senators Kaufman and Schumer. The SEC proposed banning the practice of flash orders, and has begun to look into other areas, such as dark pools, co-location, and how technology and automated trading have changed the market. HFT is categorized by the rapid trading of thousand of orders systematically and automatically, by computers analyzing instantaneous changes in prices and quotes. We have three issues with HFT."

From Bloomberg:

"The U.S. Securities and Exchange Commission is reviewing stock-market practices that use advanced technology to determine whether they give some traders unfair advantages, SEC Chairman Mary Schapiro said.

The agency is examining topics including high-frequency trading and instances where brokerages put computer servers close to exchanges, Schapiro said in a Sept. 10 letter to U.S. Senator Ted Kaufman. The SEC is also scrutinizing rules that let securities firms set up trading systems that compete with stock exchanges, she said.

If the interests of “long-term investors and professional short-term traders conflict,” the SEC’s “clear responsibility is to uphold the interests of long-term investors,” Schapiro said in the letter, which Kaufman released today.

Kaufman, a Delaware Democrat, and Senator Charles Schumer, a New York Democrat, have pressed the SEC to rein in computer- driven strategies that they say benefit hedge funds and may be harmful to retail investors. The SEC on Sept. 17 will propose banning so-called flash orders, which allow some traders to see information about stock transactions a fraction of a second before they are routed to other platforms."

Things get more interesting by the day. There seems to be no end to schemes to shave money. I sometimes wonder if all these financial wizards got their training from watching the movie "Office Space".

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