Wall Street's secret advantage: High-speed trading
They're unknown and invisible to most of us, but electronic trading programs now rule the stock markets
The Week posted on June 28, 2010, at 6:12 AM
What is high-speed trading?
High-speed trading accounts for up to 70 percent of trading in shares listed on the NY Stock Exchange. Photo: Corbis
It’s Wall Street’s winning edge. By harnessing massive computer power to buy and sell stocks in the blink of an eye, high-speed traders leverage tiny changes in value to make huge profits. The technique was pioneered in the early years of this decade by a hedge fund that hired astrophysicists, mathematicians, and statisticians to devise electronic trading programs. Other firms, including Goldman Sachs and Credit Suisse, quickly followed suit. Few outside the securities industry knew much about the practice until computer glitches helped cause the Dow to plummet 600 points in 15 minutes in May. But high-speed trading—also called high-frequency trading—now accounts for up to 70 percent of all trading in shares listed on the New York Stock Exchange.
How does it work?
Automatically. High-speed trading firms, from Wall Street powerhouses like Goldman Sachs to little-known shops with a handful of employees, program their computers to scan markets and exploit ephemeral price differences on the same stock trading on different exchanges. Their computer algorithms automatically generate thousands of transactions per second to profit from a price difference. For a fee, many stock exchanges even allow high-speed traders to get a few milliseconds’ preview of orders of 10,000 or more shares, giving them added incentive to handle unwieldy orders. “It is a rigged game,” says Sal Arnuk of Themis Trading, a brokerage firm. Some high-speed traders go one step further, paying a stock exchange for the right to install computer servers right next to the exchange’s own servers, a practice known as “co-location.”
Comment: High-speed is nothing more than good old-fashined arbitrage. What makes it different is the impact on the market, yes, and speed itself. Herein lies the problem. This kind of trading is as if a Formula 1 car showed up in regular commuter traffic. Technical crashes will become more frequent. At the micro level this rapid arbitrage makes the market more "efficient", but at the macro level the market becomes more mindless. A mega crash is only a question of time. Yet when the big one comes, the problem arises: who will (can) pay? A global chain reaction will affect every financial instrument, across all asset classes, countries and currencies.