Are high-frequency traders cheating?
Photo: Gregory Wilson. Source: Wikipedia
High-frequency traders use computer programs to buy and sell securities on computerized exchanges. They write algorithms to analyze the microstructure of the markets and then execute trades. They remind me of the “locals” who trade in the Chicago commodity pits, who use systems, street-smarts, and speed to scalp a few pennies here or there from other market participants’ orders. Only these new folks do it with routers and data lines.
Chicago Commodity Pit in 1993. Source: Wikipedia
High-frequency trading is in the news because of the recent arrest of Navander Singh Sareo, a 36-year old British man whose high-frequency program is alleged to have triggered the “Flash Crash” in 2010—a bizarre market gyration where the Dow fell 1000 points in just a few minutes. He’s now facing charges that he manipulated the markets in order to make tens of millions of dollars.
It’s hard to imagine that a one-man shop trading a few thousand futures contracts in a London suburb caused $700 billion in market value to evaporate. But today’s markets are dominated by these algorithms, and they don’t have the informal rule-enforcement that used to come in Chicago when another local—maybe a retired cop—could physically plant himself in your face and scream down your orders if he thought you were cheating. So we have to rely on the FBI, SEC, and other regulators to keep the markets fair.
Computerized orders are part of a complex market-making ecosystem, where programs mostly trade against other programs, trying to out-guess each other. They may seem like predators, but it’s complicated and they serve a purpose. The best way to beat high-frequency trading is with low-frequency trading.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!