HFT: Who’s the prankster in Rock-Paper-Scissors?

Who’s the prankster in Rock-Paper-Scissors?
The financial community has embraced the term ‘high-frequency trading’ (HFT) as its buzz word in 2009. In early July, a programmer at Goldman Sachs was caught for stealing confidential algorithms that were used for financial transactions. The stolen programmes were designed for high-frequency trading. The fuss became much bigger when the FBI implied that the programmes could have been used for market manipulations.
Stock Traders Find Speed Pays, in Milliseconds (New York Times)

Transactions at major financial markets such as NYSE or Nasdaq are done on computerised marketplace. Participants order sales or purchases, the exchange establishes the instructions, and the confirmation will be sent back to the participants. All of these are conducted with a delay of a fraction of a second.

The brink of delayed moment, however, is not equal to all participants. Some participants have the advantage of receiving the information more quickly than other participants by a nick of second, if they pay 500,000 dollars per month so that they can use part of the exchange’s computer server as a rental collocation server. The exchange first sends information to participants within its servers, and then disseminates to the rest.

Automated transaction programmes enable businesses by hundredth of a second. If a participant can obtain information quicker than others by hundredth of a second, he or she can anticipate the future movement of equity prices. Financial institutions further develop special algorithms that were developed to anticipate general tendency of market participants, and pay extra fees to the exchange to embed them within the collocation server. There are several other automated trading using the subtle variances between errors and enclosing the market, while the HFT is focused on time differences.

Legality and source of profit
Another reason of scrutiny is that the high-frequency trading was seen as the main source of earning for major US financial institutions such as Goldman Sachs. Financial research firm Tabb Group revealed that the aggregate profit of the largest 300 financial institutions made by the HFT amounted to 21 billion dollars in 2008 in the US.
High Frequency Trading Technology: an anthology (Tabb Group)
Other analysts estimate approximately 20% of such profits was made by Goldman Sachs, which aggressively pursues this method. Reuters argues against it, denying the accuracy of the Tabb Group research. Goldman itself insists that less than 1% of its profits was made by the HFT. At present, nobody knows with a certainty how Goldman Sachs had made record profits only half a year after the financial crisis of 2008.

Before the computerisation of stock markets, the matching of sales and purchases was done on the exchange floor. Traders congregated around the staff to know the new prices of the equities as quickly as possible. The exchange industry refutes that such competitions are now done electronically by placing special algorithms within the computer servers, which is permitted by the exchange.
What’s behind high-frequency trading (Wall Street Journal)
High frequency trading is a rent-seeking activity, and has been practiced for quite a while. Only when this type of transaction become excessive, exchanges warned the participating financial institutions to lower the order volume. Meanwhile, US Congress ponders to enact new regulations, blaming that HFT is a type of insider trading.
The Impact of High-frequency Trading: Manipulation, Distortion or a Better-functioning Market? (Wharton School, UPenn)

While the argument submitted by the financial industry seems reasonable, it potentially has negative consequences when the HFT occupies 70% of daily equity trading in the US. With this magnitude, depending on how the programmes are constructed, they may move the average stock prices upward without paying considerations to the real economy. HFT increases profits by placing a large number of transactions with very small margins. This is also advantageous to stock exchanges, which long for increasing trade volumes. The exchanges have an innate interest in keep near-illicit HFT afloat. That said, if Congress bans HFT as an illegal trading practice, the trade volume of US equities will suddenly crumble, leading to another stock catastrophe.

Most major US financial institutions utilise identical programmes to run high-frequency trading. If the computer infrastructure is similar across the market participants, they tend to behave in a similar fashion. When the falling stock prices cause panics, the spread of the fear will be quick. It has an unfortunate resemblance to LTCMs that profited from high-frequency trades in the bond markets and collapsed during the 1998 global monetary crisis. The HFT is a lucrative short-term transaction, but is not a sustainable idea for the long-term stability of the financial system.