Profits Explode With High Frequency Trading
by Hiland Doolittle
Part One
An old fashioned shootout is about to happen on Wall Street and in global marketplaces where some of transparency’s biggest marshals are calling for a halt to some of the country’s biggest financial gunslingers who are boosted by ultra-fast high speed trading technology and a jump at the staring block. As the battle lines are drawn, market integrity hangs in the delicate balance.
The controversy evolves around millisecond transactions that are reaping huge profits with no risk to insiders capitalizing on what used to be privileged information. Many of these public and privately held “favored sons” may have posted disproportionate profits and reaped big bonuses while being viewed as representatives of the recession recovery and carrying the banner of success of the taxpayer sponsored bailout.
According to numerous media reports and The New York Times, New York’s Senator Charles Schumer served notice to SEC chairperson Mary Schapiro that “dark pool” and high frequency trading must come to an end. In a July 24th letter, Schumer demanded that the practice of “flashes” or advance notices distributed to certain high-tech traders like Goldman Sachs and Credit Suisse must cease. These and other financial giants and certain hedge funds have employed high-tech abilities to capture profits at the expense of other, well-intended but technologically slower traders.
Schumer served notice that the SEC’s failure to halt the practice would cause the Senator’s sponsorship of legislation ceasing the ethically questionable practice. Schumer’s letter said, “If the SEC fails to curb the practice, I plan to introduce legislation in the U.S. Senate to prohibit the use of flash orders.”
“Flashes” are notices that certain stock exchanges send to a select group of traders. This information is not available to the broader market at the time the flash is released. This select group of investors has advance notice as to trading activity. With this advance notice, traders employ ultra high-speed technology to buy on the low end and sell on the high end at the divulged ceiling levels of the slower traders. All this activity takes place in less than half a second.
Schumer says, “dark pool activity seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment.” The Senator further expanded; “If allowed to continue, these practices will undermine the confidence of ordinary investors and drive them away from our capital markets.”
For Some, Flashes Shed Light to Dark Pools
Flashes are notices of buy and sell orders sent by certain traders to the marketplace. These flashes notify the traders of pending transactions that are completed in milliseconds. In those milliseconds, these favored investors rely on the flash notice to buy stocks on the low side. The high-frequency traders then sell the shares to the buyer at a price just under the previously divulged ceiling.
Dark pool trading, also called “upstairs trading” raises serious ethical issues and helps to explain how firms like Goldman Sachs and Credit Suisse and hedge funds like Citadel Investment Group, D.E. Shaw, Global Electronic Trading Company, Renaissance Technologies and Wolverine Trading managed to post remarkable 2nd quarter profits well beyond market trends.
Goldman Sachs Geek Tells All
The Securities and Exchange Commission authorized electronic exchanges in 1998. The change was intended to offer anyone with a desktop computer access to the trading floor. The move was greeted with enthusiasm but ignited a furious technological battlefield.
The emergence of algorithms (algos) allowed millions of orders to be processed within fractions of seconds as computers scanned public and private marketplaces for the best pricing. Suddenly one second provided a lifetime of trading opportunity for dark pool high frequency traders and an eternity for slower traders.
The New York Times revealed information about the July 17, 2009, trading activity centered on Broadcom, a semiconductor company that stood to move up based on reports from Intel. Conventional traders wishing to buy, but not wishing to tip their play, divided their orders into smaller clusters. As the market opened, Broadcom was listed at $26.20.
As conventional trades were processing, high frequency traders had already read the details of these offers and had purchased available shares below the stated ceiling. In the milliseconds preceding the finalization of the purchases by conventional traders, the high frequency traders sold 56,000 shares at $26.39, just under the ceiling of $26.40.
The high-frequency traders profited $7,800 in less than half a second. Multiplied by the number of seconds in a trading day, there seems a pretty clear explanation of the profit levels being achieved by high-frequency traders.
Automated trading is growing at 6% per year. It is projected that high frequency trading will account for 19% of all 2011 transactions. The financial research firm, TABB, has been tracking the growth of high frequency trading. According to TABB, high-frequency traders profited $21 billion in 2008.
Andy Nybo of the financial consulting and research firm TABB explained; “Having the fastest quote engine, the speediest analytics or the fastest connection to an exchange is no longer sufficient.” Nybo expanded by reporting that big firms spend $15 million per year to support and improve technology.
While the 1998 SEC acceptance of electronic exchanges has been widely received, the question is what will Mary Schapiro do to protect all those investors whose trading windows have been opened and whose dollars are boosting safe porfit taking by high frequency traders.
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About the Author - Hiland Doolittle
Hiland is a professional writer with extensive entrepreneurial experience. He is a graduate of St. George’s School Newport, RI and the State University of New York at Albany where he majored in history. He has been active in the real estate business for 30 years and has founded and sold several businesses.
Hiland currently writes for several financial sites and is a published author of the novel The Last Parade. He has recently completed a manuscript for a children’s book entitled Sami and The Minnow Man.
