The image of a crowded trading floor with brash young stockbrokers shouting into telephones has ceased to be representative of how most financial assets are traded. Most of today’s trading has migrated from trading floors to virtual electronic exchanges. The benefits include a more efficient system, because they provide liquidity and transparency, and also better price execution. However, in the past few years, an insidious new trend, “high-frequency trading” (HFT), has developed and is spreading stealthily.
A few critical factors explain the rapid development of HFT: the increase in computing power available to investment banks and trading firms, for example, and the deregulation of many stock exchanges in the United States and Europe.
HFT firms employ smart programmers to develop algorithms that can assess market conditions and enable computers to issue thousands of buy and sell orders automatically in less than a second. In this world, speed is everything. Certain exchanges are renting space to trading firms to allow them to locate their computers as close as possible to the exchanges, in order to reduce what is known as “latency”.
In another effort to obtain a speed advantage (of roughly six milliseconds), a dedicated transatlantic cable is being laid to connect London with New York.
Some exchanges are also selling real-time price information to the HFT firms, allowing the latter to obtain prior knowledge of order flow. This enables them to place buy or sell orders ahead of the average individual or institutional investor. (This is analogous to being in a line to buy tickets for the theatre and, as you approach the front of the queue, a tout appears ahead of you to buy the last ticket for, say, £30, then immediately sells it to you for £35.)
These speed and information advantages allow HFT firms to reap millions of dollars of low-risk profits by, in effect, “scalping” pennies off each trade. Because of the huge volume of trades, this adds up to billions of pounds overall.
So what does this mean for you and your retirement funds? Advocates of HFT argue that it provides additional liquidity and so narrows the gap between buying and selling prices.
Yet when market conditions turn adverse, HFT firms can switch off their robo-traders and then liquidity vanishes – as we saw in the “flash crash” of 6 May 2010, when the US market fell by 9 per cent in minutes. Even in normal market conditions, the algorithms used by HFT can increase the volatility of stock prices, which in turn affects the price for those investing your pension money.
What can be done? One simple idea is to limit trading firms’ ability to buy and sell in time increments of less than a second, or to impose a tax or tariff on trades that are held only for such a short time frame.
What is certain is that if nothing is done, pensioners who have saved all their working lives will lose out to the robo-traders that determine most of the current action in the stock markets.
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