FYI.

This story is over 5 years old.

Tech

Are Wall Street Robots Killing Ordinary Investors?

Computer-powered high-frequency trading may be pushing out all types of traditional investors, says a new report.

The lightning speed algorithmic automation that has taken over the financial markets is pillaging the pockets of regular investors, concludes a new study from a top government economist.

The unendorsed and yet to be peer reviewed study by Andrei Kirilenko, the chief economist at the Commodity Futures Trading Commission, notes that high-frequency trading outfits are making up to $5 a pop against small-time traders using common financial products, reports the NY Times. Kirilenko’s findings go against the general consensus: that the benefits of HFT -- increased liquidity, reduced volatility and thus lowered transaction costs -- outweigh its potential downsides. “We’re not estimating,” Kirilenko said in an interview Monday. “Our data is excellent.”

Advertisement

High-frequency trading has made headlines in recent years mostly for wreaking havoc on financial markets, including the 2010 Flash Crash, which saw the Dow plunge and recover 1000 points in minutes, as well as the trading glitch that caused Knight Capital Group to lose $440 million in 30 minutes over the summer (or about $15 million a minute). HFT now makes up the majority of trading volume on most major exchanges around the world.

While the commission has yet to take an official position on the study, which was submitted at a CFTC conference last week, one of the five commissioners said Monday that “what the study shows is that high-frequency traders are really the new middleman in exchange trading, and they’re taking some of the cream off the top.” The study focused on S&P500 futures since these instruments are heavily traded among a variety of institutions. Explains the Times:

Using previously private data, Mr. Kirilenko’s team found that from August 2010 to August 2012, high-frequency trading firms were able to reliably capture profits by buying and selling futures contracts from several types of traditional investors.

The study notes that there are different types of high-frequency traders, some of which are more aggressive in initiating trades and some of which are passive, simply taking the other side of existing offers in the market.

The researchers found that more aggressive traders accounted for the largest share of trading volume and made the biggest profits. The most aggressive scored an average profit of $1.92 for every futures contract they traded with big institutional investors, and made an average $3.49 with a smaller, retail investor. Passive traders, on the other hand, saw a small loss on each contract traded with institutional investors, but they made a bigger profit against retail investors, of $5.05 a contract.

Advertisement

Kirilenko says  the markets are a zero sum game, and the big loser here is clear: everyone else. The establishment will argue that this is a simple case of “sophisticated investor” versus “ordinary investor,” so of course the experts will have an upper hand over newbies in the cutthroat game of trading for dollars and cents. The problem with HFT is that it has significantly widened the chasm between the haves and the have-nots, so much so that some commentators are calling it legalized insider trading.

The robot invasion, visualized. The chart shows daily trading volumes across major exchanges over the last five years. Via .

Since HFT firms rely on millisecond time advantages to make their juice on huge volume trades, they’ve started to “plug-in” directly with the exchanges they’re trading on. Many exchanges now offer firms access to exchange information for certain fees, as well as a service called “co-location,” which allows firms to install servers right next to the exchange. The proximity results in reduced transmission time for market data and order messages.

In effect, the big boys will always get the necessary and thus profitable information before anyone else. In October, a British trading firm was caught using multiple connections to the platform to gain an unfair advantage. "As the operator of one of the largest FX dealing communities, providing a level and fair playing field for the community is paramount," said a Thomson Reuters spokeswoman at the time. The firm, Lucid Markets, is now under investigation.

Advertisement

It’s not just the mom and pops that have been left befuddled by Wall Street’s robot siege, but also industry veterans. Former Goldman Sachs and UBS trader Haim Bodek wondered for months why the market was killing his trades and bleeding his own high-frequency trading firm of profits. He didn’t find the answer by scouring his algorithm code or studying financials. Instead, it was passed to him on a napkin at a party, as told in Scott Patterson’s book, Dark Pools: High-Speed Traders, AI Bandits, and the Threat to the Global Financial System.

As it turns out, Bodek was using limit orders, a common order type that gets run over in the new robot-driven market. “But that’s what everyone uses,” Bodek said, incredulous. “That’s what Schwab uses.” A rep explained to Bodek that newer firms were now using highly complex order types that hid their price and purpose while allowing them to jump the line in front of other traders. “You’re totally screwed unless you do that,” the rep told him at the bar. “If we changed things, the high-frequency traders wouldn’t send us their orders.”

This is the other big problem with the ascension of a robot-driven market, the mind-imploding complexity. Take for instance the typical flow an order goes through for the market to match buyers and sellers.

If you understand what’s going on there, you’re probably the exception. If you don’t, it’s possible that you’re getting screwed (or not, it’s really hard to tell at this point). What we do know is that HFT is starting to wear on the markets. Reuters reported that foreign exchange trading volumes on its platforms plunged 23 percent year-over-year in October, citing “frustration with high-speed computer algorithms operating on the major dealing platforms” as one of the major causes. The algo-invasion is scaring investors away, leaving well, just the robots. “They will go someplace that’s darker,” Kirilenko said at the CFTC conference.

Advertisement

The main benefit of HFT -- liquidity and thus theoretically a more efficient marketplace -- may also be bunk, explains Elke König, who took a 50 percent pay cut to become chief regulator of Germany’s securities industry. König believes HFT contributes to market extremes and that the liquidity it provides may be a mirage.

“The liquidity apparently created is an illusion because many of those deals are never actually executed,” König told Der Speigel. “The automobile industry has built cars capable of travelling very fast, yet the industry has agreed that 250 kilometres an hour should be the upper limit. Along the same lines, I wonder precisely what economic good we achieve by trading at nanosecond speeds."

Germany could implement speed limits by imposing fees that would slow things down and “render large-scale gambling for marginal yields unattractive,” König said. In September, Germany lawmakers advanced a bill that would do just that. The measures will not only collect fees from high-speed traders but also require firms to register with the Federal Financial Supervisory Authority and install circuit breakers to protect the markets from mass calamity. "The goal of the German law is to limit the risks associated with high-frequency trading," a senior official said.

Meanwhile, the SEC is still trying to wrap its head around what all of this means. “And we all concluded that we have concerns, but we don’t have enough data yet to really be able to justify significant additional steps at this point,” recently-resigned SEC chairman Mary Schapiro said at a Q&A session earlier this year. “We need to have a much deeper understanding of the impact of high-frequency trading on our markets.” But even if we can’t yet come to grips with the true risks of unfettered computerized trading, Shapiro lamented that the robots have fundamentally changed how we look at investing.

“It’s got very little to do with whether you think IBM’s got a great business plan and solid earnings growth in its future . . .and a lot more to do with what’s the minuscule aberrational price move that you can take advantage of because you’ve co-located your computer with the exchange and can jump on that in microseconds,” she said. “And that worries me in some ways.”

It’s this unknown that has left lawmakers in a state of regulatory stalemate. This latest study could be a step in the right direction “to put forth regulations in a streamlined fashion,” said CFTC commissioner Bart Chilton. “It’s a key step in the process and it should fuel-inject the regulatory effort going forward.” Unfortunately for Chilton and the rest of us, Kirilenko’s study may not be as conclusive as it initially appears. As Dealbreaker’s Matt Levin points out, even at the upper bound of $5.05 lost, the figure represents just three-quarters of one basis point, which is certainly not insignificant, but also not the profit-sucking machine the Times leads us to believe.

What the study does provide however, is fresh light on a process that continues to be opaque. And for what it’s worth, HFT is here to stay. Computerized trading represents the natural evolution of the markets and there’s no question that a large portion of HFT is hugely beneficial. The big question is whether or not we can understand it fast enough and potentially reel it in before this robot monster morphs into something truly untenable.

Follow Alec on Twitter: @sfnuop