How High Frequency Trading is Frontrunning the Stock Market


If you aren’t disillusioned enough with the financial system, you could take a look into the High Frequency Trading debate. It recently hotted up nicely.

High Frequency Trading is all about computers using algorithms to make trades. One form of HFT is about using information from stock orders that are about to be processed to gain an advantage. At least, that’s our interpretation. Here’s how it works:

Say there are two data streams for processing orders. Retail customers get to use the slow one, also known as the ‘dumb flow’. HFT trading machines look for patterns in the orders flowing through that order stream. If they see a bundle of big buy orders for stock XYZ making their way to the stock exchange, they jump on the faster data stream and place their own buy order. The price is bid up by the retail client’s orders and then the HFT bot sells. It’s sort of like time travel.

Very cool stuff. If only it were used for something other than disadvantaging the retail buyers and sellers.

So the issue is, who is monitoring which data stream how, where, how well and with what ability to jump the queue. One trader, quoted in a book by Michael Lewis, made it a lot simpler. He called the market ‘rigged’.

The dodgyness goes to the top. A recent lawsuit accused the Chicago Mercantile Exchange of selling faster data streams to traders.

Some practices are even more nefarious than all this. Intermediaries can bundle retail client’s orders together to make them larger. Larger orders mean bigger price moves, allowing a front runner to generate more profit. The Aussie version of this is to re-rout orders to the smaller Chi-X exchange, where prices move further on smaller orders.

This type of HFT is particularly ironic. HFT proponents argue they provide liquidity to the market. But if that liquidity is frontrunning, it actually hurts instead of helps others in the market. The key argument in favour of HFT is a red herring.

All this is leading to a bit of a revolution on Wall Street. Trading firms are using the closure of their HFT units as some sort of ethical marketing material. Exchange service providers are banning the faster streams. And the older established exchanges are telling TV hosts they did not have sexual relations with that woman. It’s all very embarrassing.

In Australia, Industry Super Australia calculated the cost of HFT to investors at $2 billion.

One proposal Industry Super Australia supports is a Tobin Tax. That’s a small tax on financial transactions, which would scalp the scalpers. High Frequency Taxing to fight off High Frequency Trading.

Of course, in the end the Tobin Tax will end up scalping the retail trader too. So at best, it replaces a private HFT firm’s scalping with public sector scalping. In the world of politics, you just can’t win.


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Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

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2 years 6 months ago

And they wonder why retail investors have deserted the stock market in droves. HFT is just one of the many reasons

Yes indeed, the market is rigged. Heavily in favor of the gaming set

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