‘Flash Boys’ hit a three millisecond speed bump


The hero of Lewis’ 2014 book, Brad Katsuyama – a former Royal Bank of Canada head trader in New York -established his own exchange, IEX Group, with a speed bump of 250 millionths of a second after realising that his orders were being “front-run” by high frequency traders, meaning he was paying marginally higher prices than he had expected to fill buying orders.

In effect the traders, using the speed advantage established by the location of their advanced technology platforms within the exchanges, could “see” his orders, buy the shares he wanted and then on-sell those shares to him at a fractionally higher price. It was akin to an invisible tax on his transactions.

His speed bump means the IEX exchange can update prices before the high-frequency traders can take advantage. It eliminates the arbitrage opportunity of the different data transfer latencies between traditional investors’ activity and that of the high-frequency traders.

‘Pernicious’ practice

The ICE bump, unlike IEX’s, isn’t symmetrical – it doesn’t impose a delay on all orders. Critics of this approach say it would enable traders/investors to cancel orders at the last millisecond if the market was moving against them, providing a false picture of activity and liquidity during periods of market volatility.

While the US Securities and Exchange Commission has described latency arbitrage as “pernicious”, the introduction of speed bumps to exchanges is a contentious issue. Indeed, the larger debate about the costs and benefits to investors of high-frequency trading is a multi-dimensional one.

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Around the world, including in this market, institutions and, indeed exchanges, have created “dark pools,” or private and opaque markets, to shield their activity from high-frequency traders. That would suggest they too believe the practice is pernicious.

For those who see high-frequency trading in those terms, the activity of the traders, aided and abetted by exchanges that generate fat income streams from co-locating the traders’ technology platforms to minimise latency (high-frequency trading can be measured in nanoseconds), is predatory and parasitic.

That activity, some of which can be described as “front-running,” adds another layer of “friction” costs to more traditional transactions, without adding any economic value.

The critics believe exchanges have created a playing field between high-frequency trading and “real” investing tilted in favour of the traders by allowing them to piggy-back and pick off their orders; one that can add dangerously to the volatility in markets when they are already under some pressure.

“Spoofing” orders, generated by algorithms and facilitated by high-frequency trading, have been cited as a contributing factor in the “flash crash” in 2010 that caused a momentary but scary trillion-dollar collapse in US sharemarkets.

Hurting others, or adding liquidity?

There are others, however, who argue just as vehemently that high-frequency trading benefits markets by adding liquidity, increasing efficiency and encouraging innovation.

In the US, with the smaller role the big investment banks are playing as market-makers since the GFC, there is an argument that high-frequency trading adds a layer of liquidity that wouldn’t otherwise be available.

One of the dissenting CFTC commissioners also argued that those who invent, and invest in, faster platforms to capitalise on market dislocations ought to be able to reap the profits of their advantage and that high-frequency trading enhanced market efficiency.

Serving investors, or traders?

The high-frequency trading issue isn’t as big an issue in this market as it is in the US because its prevalence is much lower, due to different market structures and an approach to pricing that makes it more expensive to place multiple orders for securities that can be withdrawn before a trade is executed.

The debate does, however, raise the basic question of whether markets are there to serve investors or traders, and whether there is a distinction between good liquidity and market activity, and bad liquidity and activity.

There are no definitive answers, although it is not a good look in terms of investor trust and market integrity if some investors, facilitated by exchanges, have an advantage they can profit from.

The types of stockmarkets pioneered by IEX and futures markets where ICE’s success might be emulated – and the dark pools — at least provide investors with a choice of where to execute their transactions.

The more exchanges with speed bumps there are, the easier it will be to determine the perceived merits, or otherwise, of high-frequency trading as investing institutions vote with their orders.

Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.

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