Time is Money Pt. 2

By now it is clear that High Frequency Trading means money. As was highlighted in part 1, technological superiority allows HFT traders to react to public stock market information (market signals) before their competitors do. What becomes inherently clear is that frequency traders do not compete with the average investor—they compete with other HFT traders. The crucial question therefore becomes: ‘why is not everyone in on HFT?’

 

High entry Barriers

Barriers to entry are any obstacles within a free market that prevent new competitors from entering an industry segment. Common barriers to entry include customer loyalty, strong brand identity, and bureaucratic red-tape barriers such as licenses or patents. In every case, barriers to entry result in high startup costs that often discourage competitors to compete with established market players. HFT is no different. 

HFT is solely enabled by the split-second advantage at which traders receive information. What lengths do HFT traders go to secure and maintain this advantage? As was comedically put by Michael Lewis in his book Flash Boys, traders would have sold their grandmothers for a microsecond’.

From a technical stand point, HFT relies on data transmission speeds. Data transmission speed is based on two factors: proximity to data centers, and the utilized medium. Firstly, traders must find, secure, and lease access to glass fiber optic connections to data centers to beat competition. To truly appreciate the technical speed of this connection: glass fiber optics allow data to be transmitted at nothing less than the speed of light.

Next, traders must minimize both the length and the amount of times the cable is bent to improve data transmission speeds; the shorter the optic and the fewer diffractions of light between centers, the faster the transmission. With this, HFT traders must find and rent spaces as close as possible to data centers for direct proximity. Needless to say, these locations are highly contested.

The barriers continue into capital: algorithms must be continually improved to maintain a competitive advantage, and this can come at a hefty fee. Competitive HFT algorithms are tailor-made, most often in-house, and the associated programming costs are very high.  Licensing partnerships (the associated rental costs of fiber optic connections) and algorithm maintenance compound this. In order to have the financial means for the large volumes of trades necessary to make HFT profitable, as well as the high-risk absorption, HFT traders require high amounts of upfront capital, capital available only to a small minority of active traders.

If these high barriers are not enough, remember that the competitor never sleeps. If a HFT trader were to neglect investing continually to nurture its speed advantage, the second a competitor closes the gap, the original investor’s previous capital investments are rendered worthless. Remove the information asymmetry enabled by a speed advantage, and a HFT trader becomes a relatively ordinary market participant.

Grey Area: Market Manipulations and HFT
Following the 2008 crash, the field of finance has increasingly become subject to public scrutiny for fraud schemes and a lack of transparency. The following are known as “Predatory Trader Strategies”. While these are not unique to HFT, they share a common enabling factor: information asymmetry.  In today’s stock markets, information asymmetry is enabled through systematic differences in the time between data being sent and received. Simply put, fractional discrepancies in speed at which market players receive information.

Front Running (Aka Tailgating): Front running occurs when a trader knows in advance of another party’s willingness to buy an option and subsequently uses this knowledge against them. Front runners buy high quantities of the option to force the other party to buy from the original trader at a markup. While front running is illegal when exploiting privately held information (considered insider trading), there is no legal restriction on this strategy for public information. As the data centers of stock exchanges are public channels, HFT firms can operate freely. In this, HFT capabilities naturally enable a form of information asymmetry, that is not subject to legal restrictions.

Spoofing (Aka Layering): The idea behind spoofing is simple: generate a high amount of overpriced purchase offers that exist for fractions of time and cancel the order before another trader can place a bid. These so called ‘phantom offers’ work as market signals for other market participants, spurring on price volatility. Simply put, spoofing allows HFT firms to create momentary volatility or feign a price increase that artificially creates an arbitrage opportunity for HFT firms to exploit. With this, HFT firms can now sell previously acquired futures at an unmanipulated price to make profits off artificial volatility.

Quote Stuffing: As HFTs rely on glass fiber optics and data center proximity, even HFTs face a technological constraint in improving their speeds. How do you best improve your information speed advantage once you have reached a technological limit? You slow others down. Quote stuffing is the practice of overflowing the market with thousands of insignificant offers, which result in a loss of valuable milliseconds. While other algorithms must first sift through these offers, the original offer placer can ignore these and react faster.