Growth5 Blog

Saturday, August 1, 2009

High Frequency Trading: Not Illegal, Yet

Picking whether or not a stock will go up or down in any market can be difficult, especially our current one. But financial services companies need to post a profit regardless, so what do they do? They continue to game the system. How? Super fast fiber optic cables, lightning-speed processors, a couple good programmers, a decent network position close to market computers and about 30 milliseconds.

When Bernie Madoff was returning suspiciously consistent returns year after year, his critics thought he might be illegally "front-running" - peaking at orders for stock trades his clients were making, then sneaking his own investment orders in ahead of his clients. The idea was, his clients' orders would move the stock price, by getting in just ahead of them he could potentially get a better price and ride their orders to profit. Turns out he wasn't front-running, why do that when you're just flat out stealing the money, too much work.

Work that some financial services firms have turned over to their computers. In about 30 milliseconds these super fast computers run algorithms that assess the orders coming in before they hit the market, estimate where the price of the stock will go based on these orders, then conduct millions of trades to profit from this information. This is called High Frequency Trading.

If front-running is illegal, why isn't High Frequency Trading? "While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee."

How are hedge funds and the larger banks like Goldman Sachs making so much money so soon after the market nearly collapsed? "High-frequency trading is one answer."

The market of the last several years rode inflated housing prices at 40 to 1 leverage before everyone realized it was a house of cards. If the recent surge is based even partially on super computer "front-running" don't be surprised if the market drops back once this loophole is closed. Unless of course the next great loophole is exploited quickly enough.

Sources
Hurrying Into the Next Panic? (NYT)
Stock Traders Find Speed Pays, in Milliseconds (NYT)
Thanks Tom!

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