It takes anywhere from 1/5 to 2/5 of a second for an eye to blink. A pretty remarkable speed considering blinking is hardly noticeable and does not interfere with our daily life. We don’t count the blinks of an eye—they are just there, imperceptibly doing nature’s work.
But the blink of an eye is too slow for Wall Street. High Frequency Traders (HFTs) measure their success by reaching their targets before anyone else, expertly injecting themselves between buyers and sellers; they profit without adding value to the transaction they are involved in. At the end of the day, HFTs hold no positions in the stocks they trade during the day, and they almost never experience a loss. Their most valuable commodity: Milliseconds, Microseconds, and Nanoseconds – speeds respectively measured at one thousandth, one millionth and one billionth of a second. HFTs spend millions of dollars for rapid access to their targets: buyers and sellers of stock.
The following is how I understand the thesis of Michael Lewis’ recent book, Flash Boys, an account of how a trader discovered Wall Street’s dirty little secret and made it his goal to create an “honest” stock exchange, where shares could be exchanged in real time, for fair prices. The trader described in the account is Brad Katsuyama.
Katsuyama traded for Royal Bank of Canada, a small player by Wall Street standards. He discovered that banks were creating “dark pools” where buyers and sellers represented by the same bank could ostensibly trade in private. Credit Suisse, Barclay’s, and Goldman Sachs had such pools. The problem with these private pools is that some were secretly leasing access to HFTs, those fellas with the microsecond speeds, allowing them to get between the buyer and seller which it turn affects the price of the stock; it wasn’t much, a cent here, a cent there, and the HFTs made billions a year as middlemen.
Katsuyama, according to Michael Lewis, also discovered that HFTs were competing for close physical access to various exchanges (for example: NYSE and NASDAQ) to, once again, “front run” (defined as beating the investor to his goal by seeing what he planned to do in one place and racing him to the next place). HFTs were making money by being faster than the market. HFTs were able to see what the price of stock change in one exchange and rush to pick up orders before the other exchanges were able to react, thus pocketing the price change without actually providing liquidity in the market – in what is known as “slow market arbitrage.”
Many argue that these activities are neither illegal nor unethical; that HFTs are on the forefront of technology and that speed is a commodity. The reality is that technology has created a new world where stock price ticker tape is outdated; its stock prices are wrong, even though they are reported as quickly as the stock exchanges can get the information out.
Apparently, many investors are getting upset about “being had,” and have instructed the banks they do business with not to do business with HFTs. And today, it was reported by the Wall Street Journal that investors and brokers cut ties with Barclays’ black pool following a lawsuit by the New York Attorney General accusing Barclays of misleading customers into believing that the bank’s black pool was free of HFTs, while all along catering to such firms.
Civil lawsuits cannot be too far behind.