An Adjunct to High Frequency Trading

 

Recently, I posted some information about how companies use High Frequency Trading techniques as a way to reap profits by acting as a middleman of sorts.  They are able to get between orders being placed in nanoseconds, affecting the price that you and I and mutual funds pay.  Through the wonders of croneyism in our society amongst those in power, there are no laws against this practice.  Here is a review:

HFT computers can detect large buy orders for a stock, the kind of buy orders mutual funds make, even when the funds try to disguise them. The HTF system can then purchase that stock before the mutual fund’s order is executed. The fund ends up paying more per share, and the HTF traders pocket the difference.

This isn’t illegal; it’s akin to cutting into a long line at the supermarket. And it’s just as infuriating. "It just ticks off mutual fund managers who feel their stock moves against them every time they show up," says Al Berkeley, chairman of Pipeline Trading Systems, a trading service designed to help institutions and brokers outsmart HFT systems that try to detect their orders.

How much does all of this cost mutual funds in higher stock prices, or lower prices when they sell? It’s not clear, but one study by the Tabb Group estimates that high-frequency traders made about $21 billion in profits last year — much of that at the expense of mutual funds.

Wall Street’s High-Tech War on Investors

As unfair as that sounds, there is an even more blatant abuse of the financial system called flash orders.  Flash orders are essentially the very quick display of trading orders to a select few group of insiders.  In an effort for small, upstart exchanges to compete with established ones like the New York Stock Exchange (NYSE) and Nasdaq, they offer these flash orders to large customers in the hope that they big customers will split the fees with the small exchange.  A primer:

Smaller exchanges have to pass along big orders to the big exchanges if it looks like they can’t fill them. To avoid this loss, they "flash" these orders to big customers for less than half a second. The hope is that big players will help fill the order, splitting the fees with the small exchange.

But this also gives the insider an advance look at a trading price you and I never see. Mind you, it’s a half-second advantage; you and I couldn’t do anything with it anyway. But those with HFT systems can.

Wall Street’s High-Tech War on Investors

What’s more, is that the HFT systems are so fast and powerful that they can search the market every few milliseconds and have the ability to sense the supply and demand for a given stock.  They can then use this information to purchase the stock with a limited supply and sell it for a quick profit.  Here is how it works in graphical form:
How Flash Orders Work

When it came out, and the SEC offered lip service to the issue, all of the exchanges said that they would stop providing them soon.  I would advise people not to hold their breath.  There is a lot of money and lobbying in this sector, and money trumps reason in our country in almost all instances. 

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~ by jvaudio on August 30, 2009.

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