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How high frequency traders rig markets
One function of a stock exchange is to make risk capital available to entrepreneurs. HFTs make money while adding no value to the process, which amounts to rent seeking.
Michael Lewis, who has written such highly-acclaimed books as Liar's poker, The big short and Moneyball, tackles the subject of high-frequency trading in his latest work, Flashboys: Cracking the money code.
Imagine that you are trying to buy a company's stocks priced at `100 over the Internet. As soon as you put in a bid to buy the stock, its price jumps to `102 and your order doesn't get executed. You wait for a while, get frustrated, and then ultimately buy the stock at the slightly higher price.
Something similar happens when you try to sell a stock. This time the price moves lower, forcing you to take a small loss. It is as if someone has read your mind, acted just ahead of you, and thwarted you. Today technology makes it possible for entities called high frequency traders (HFT) to do such front-running (which means to learn an investor's intentions and profit from them by acting ahead of him).
When you send a buy or sell order to a stock exchange, its matching engines match your buy orders with others' sell orders and enable you to buy a stock at the best possible price. But what if the process doesn't run cleanly? What if there are intermediaries who can intercept your orders midway and glean the information therein?
They then run ahead of you and buy all the stocks available on all the exchanges and then put in sell orders at higher prices, thereby forcing you to buy at those prices, especially when orders are very large sized. This is a simplified description of what high-frequency traders do.
Now, you might argue: how much would buying a stock for two rupees extra matter in the larger scheme of things? But imagine a couple of bucks earned on millions of transactions--some of them worth thousands or even millions of dollars. All those little gains then add up. That's how HFTs make their billions.
One of the functions of a stock exchange is to make risk capital available to entrepreneurs. Intermediaries like HFTs make money while adding no value to this process, essentially indulging in a form of rent-seeking. They end up raising the cost of capital for entrepreneurs. Their activities also render stock exchanges prone to flash crashes--those brief but sudden and inexplicable price swings that the authorities try to explain away by citing "technical glitches".
Here's the gist of how HFTs operated in the US. Equipped with super-fast computers, servers and optic fibre lines that convey information to them faster than an investor's order could reach an exchange's servers and get executed, HFTs pre-empted the investor. Even US stock exchanges were hand-in-glove with them, allowing them to place their servers close to the exchange's servers, thereby gifting HFTs that tiny micro-second's advantage. Broking firms also played a part. Instead of executing the orders they got themselves, they would redirect them to HFTs, who fleeced the customer while giving broking firms a kickback. It is this nexus that Lewis exposes in his book.
Lewis's book doesn't end on a downbeat note. A group of talented and conscientious tech-cum-financial wizards start an exchange whose aim is to beat HFTs at their game. And they succeed.
High-frequency trading is a complicated phenomenon, but Lewis has a gift for simplifying the abstruse. Is the book relevant for Indian readers? Well, HFTs have spread their tentacles to exchanges around the globe. The next time the price of a stock jumps suddenly when you try to buy it, or a flash crash occurs, ask yourself: have HFTs arrived?
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