Opinion: How High Frequency Traders Cost Us Billions of Dollars Every Year


High frequency trading costs global stock investors billions of dollars every year.

This estimate comes from an academic study that was recently accepted for publication in the Quarterly economic review. Entitled “Quantifying the High Frequency Trader ‘Arms Race”, the authors of the study are Eric Budish of the University of Chicago, as well as Matteo Aquilina and Peter O’Neill of the Financial Conduct Authority of the United Kingdom.

High Frequency Trading (HFT) is the trading of securities carried out by powerful computers with high speed connections to the various exchanges. These computers are capable of executing a large number of transactions in a fraction of a second. Budish, in an interview, said that, depending on how it’s measured, HFT in 2016 was almost half of total trading volume. I suspect that percentage is even higher now.

This new study is the first to my knowledge that actually measures the cost of HFT. The researchers were able to calculate this because they had access to previously unavailable data on HFT traders’ attempts to execute profitable trades. Basically, this newly available data included not only those attempts that were ultimately successful, but also those that were not successful.

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This is called “high frequency trading” because a large source of profitability for HFT comes from exploiting very short-lived situations – a stock trading at different prices on two different exchanges. . An HFT firm can make a definite profit if it can buy the stock on the stock exchange with the lowest price and simultaneously sell it on the stock exchange with the highest price. But that requires executing the trades before other companies find out about the price differential and arbitrate it.

(Keep in mind that a stock doesn’t just trade on a single stock exchange. A company can be listed on, say, the New York Stock Exchange, but will actually trade on multiple exchanges. In fact, according to the researchers. , “In the US Stock Market, there are 16 different exchanges and over 50 alternative trading venues, all trading the same stocks.”)

The winners of the HFT race win by a hair. Budish said the margin of victory is typically only five to 10 microseconds – 0.000005 to 0.0000010 seconds. This is why the large HFT companies have gone to great lengths to create high-speed connections to the floors of the various exchanges. The Wall Street Journal recently reported that HFT companies, which until now relied on technologies such as lasers, microwaves and advanced fiber optics to gain a competitive advantage, are now looking to satellites for get even faster connections.

HFT advocates insist that all investors are better off because of these countless tiny arbitrage deals that happen multiple times a day. Bid-offer spreads are much smaller than they would otherwise be, for example, which reduces trading costs.

Budish doesn’t disagree. Markets today are much more efficient than they were in previous decades, when human beings had to find and correct price differentials. But, he added, the HFT also has a downside: it reduces liquidity.

This reduced liquidity is the result of “buyers and sellers fear that their offers to buy or sell stocks will become stale and be picked up by the HFT companies,” Budish explained. To illustrate, imagine that XYZ stock is trading at $ 49 bid / $ 51 bid. (This example is mine, not Budish’s, and is entirely hypothetical, as spreads currently rarely exceed a few cents.) If the liquidity of this security had not been reduced due to the HFT, maybe 100 000 shares would be and the offer – which means you can buy a block of 100,000 shares immediately at $ 51 or sell such a block at $ 49.

Due to the fear of stale prices being picked up, fewer shares will be available in the bid or offer, say 25,000 shares each. So, you can only buy or sell a fraction of your 100,000 block of shares at these prices, and it is very likely that the price will have moved against you when you attempt to execute your trade with the 75,000. remaining.

To be sure, the price you get is probably not going to be any worse than a small amount. On average, according to Budish’s estimates, the cost to any trader who gets worse execution will only be a single price tick, or even just half of a price tick. But even though it’s so small that you or I probably wouldn’t even detect it, it still represents a huge sum in the global stock market. He and his fellow researchers estimate that in 2016 that cost totaled $ 5 billion. It is undoubtedly much bigger than that these days. And when you add in HFT trading in other markets, such as futures, treasury bills, currencies, options, the total cost would increase even more.

Rigged markets?

So does all of this mean that the markets are rigged to favor these big, wealthy HFT companies? Many think so, including author Michael Lewis in his bestselling book “Flash Boys”.

Budish hedges when asked for his opinion on this. On the one hand, he says HFT companies aren’t doing anything wrong. They simply exploit the fact that the same stocks trade on many different exchanges, inevitably creating arbitrage opportunities. The “law of one price” – what University of Chicago professor Richard Thaler calls the “second law of economics” – implies that any incipient violation of this law will be quickly arbitrated.

On the other hand, Budish adds, this does not mean that we have to allow the current situation to continue. The efficient stock market would become even more efficient if the billions of dollars accruing to HFT companies increased the liquidity of the market instead. “Do we really want to encourage these companies to spend untold amounts of money in an ever more intense arms race to communicate their orders to the stock exchanges in increasingly tiny fractions of a second?”

Budish and his fellow researchers recommend a simple change – in concept – in the structure of markets, called “frequent lot auctions”. The specifics of these auctions go beyond the scope of this section. But their net effect would be to force HFT companies to compete on price rather than speed. In other words, assuming frequent batch auctions are adopted, HFT orders will only be successful if companies are willing to sell at higher prices than everyone else, or buy at lower prices. This is exactly how the market should work, isn’t it?

Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment bulletins that pay a fixed fee to be audited. He can be contacted at [email protected]

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