Trading at the speed of light

I see (reportedly) that a US-based high frequency trading (HFT) firm is advertising for technicians to manage their microwave networks.

Microwaves are faster point-to-point than fibre-optics because fibre-optics aren’t precisely straight, so running such networks allows HFT firms to make profits by arbitraging between tiny and fleeting differences in security prices between different exchanges. This prompted me to go and re-read Flash Boys, Michael Lewis’s excellent and insightful dissection of the high frequency trading game first published in 2014. The gist of the book is that when an investor partially fills an order on one exchange, the new price is not reflected on other exchanges instantaneously (we’re talking milliseconds), so firms that can route orders faster than the price delay can front-run the rest of the order to make essentially risk-free profits. If you are involved in investing assets for real people in the real world on real-life timescales, I strongly urge you to read it though be warned it won’t exactly help your faith in financial markets.

Short-term volatility in particular is an artefact of secondary market trading, it doesn’t actually mean anything in terms of wealth creation or actual investing. 

One would think that clearly this is not in the interests of the end investor who gets a worse price than they would otherwise have got. However, no less an authority than the European Commission (EC) has said that there are benefits in terms of wider participation in markets, reduced short-term volatility and narrower spreads. The EC has many wise people, so I suppose at some level this must be true, but I suspect we are losing sight of the forest for looking at the trees. HFT firms are not investors in any meaningful sense. Short-term volatility in particular is an artefact of secondary market trading, it doesn’t actually mean anything in terms of wealth creation or actual investing. 

 

I’ve been thinking long and hard and I can’t come up with any rationale for what the social purpose of an HFT is. As far as I can see they exist solely to take advantage of fractional informational inefficiencies in electronic markets. They trade on price information which is not available to the market generally. Is this not the very definition of market abuse? I find myself completely perplexed as to how this is allowed to persist. No wonder private equity is getting more and more popular.

 

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Stuart Dunbar

Partner

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