What You Need to Know About High-Frequency Trading

It's been almost a month since the so-called flash crash wiped almost 1,000 points off the Dow. And the comments on my May 31 MarketPlace interview suggest that the public is concerned about what caused the market meltdown.

Based on interviews I conducted with a trading expert and a quantitative finance guru, I now have a better idea. It's important information for anyone who wants to have money around when they retire.

To explain all this, we'll first review what happened with the flash crash, pivot to a discussion of how electronic trading networks operate, discuss the different roles of flash trading and high-frequency trading in those networks, examine how liquidity is created and destroyed there, and conclude with a look at how these traders boost volatility to enhance their earnings while making the markets hostile to their original purpose (to raise capital for business).

In case you forgot, on May 6 at around 2:40 p.m., the Dow plunged nearly 1,000 points before swinging back up to close down 300 or so points. While initial explanations had something to do with a so-called fat finger, where a trader keyed in "billions" instead of "millions," it turns out that wasn't what happened. And a month later there is still no official explanation.

How Electronic Trading Networks Operate

Not surprisingly, this makes the average investor nervous. To get some insight into what's going on, I first spoke with Bernard Donefer, a lecturer in finance at Baruch College in Manhattan with a long track record of running trading systems before he started teaching. (Donefer retired from Wall Street after 9/11 -- he missed a meeting he was scheduled to be in at the World Trade Center; the others who made the meeting perished.)

To understand the flash crash, you first have to know how an electronic communications network, or ECN, works. Without human intervention, an ECN takes orders to buy or sell securities, matches them with a party willing to take the other side of that trade, and then executes the transaction. An ECN, like Nasdaq, differs from hybrid exchanges like the New York Stock Exchange in that the NYSE still has a person who matches up buyers and sellers of specific stocks.

Let's say you want to sell 100 shares of IBM (IBM) for $125 each. The ECN would find a buyer at your price and complete the sale.

But there's a little twist in this simple story: Regulation NMS (National Market System). Reg NMS, a series of SEC initiatives to modernize stock trading in the U.S., requires that an ECN that receives an order go to other markets to see whether it can find a better price. And if it finds a buyer of your 100 shares of IBM for say, $125.10 each, it goes to that market and executes the trade there.

Flash Traders and High Frequency Traders: Same Networks, Different Objectives

And there's yet another twist to the story. If your broker requests it, the ECN will make the order available for flash trading, or FT. With FT, your order to sell 100 shares goes out to high-frequency traders -- HFTs -- that have a fraction of a second to execute that order at the same price or higher -- or take a pass.

Those flash traders are able to trade ahead of those orders. If they know that a customer order is about to be executed at the exchange, they can place their own trade a fraction of a second beforehand and make a profit. High-frequency traders, for whom flash trading is a sideline, made $21 billion in 2008 profits, according to TABB Group.

An ECN cares about this because it's more profitable to get the order executed by flash trading than if the ECN has to go outside its network. That's because of the "maker-taker" incentive system that rewards customers who make liquidity and requires those customers to pay to take liquidity.

If a flash trader is willing to execute the transaction, the customer's broker is considered a market maker because it "makes" liquidity giving a better price for the customer's shares while the ECN receives 0.25 cents once the transaction is executed. If the customer's broker accepts an order from the ECN, it's a liquidity "taker," so it pays the ECN 0.33 cents, which in turn pays 0.25 cents to whichever broker executed the trade. And if the trade is routed away to the market, the customer's broker pays higher fees.

We're almost at the part where all this connects back to what caused the flash crash. According to Donefer, only about 2% to 3% of stock-trading volume is from flash traders, and between 60% and 70% is conducted by high-frequency traders. HFTs break up a block order, say, to sell a million shares of IBM, into smaller pieces in order not to alert the market to the need for a big sale.

When the HFT Book Becomes Unbalanced, Liquidity Dries Up

HFTs are supposedly trying to make a tiny profit, say a penny, on the spread between the bid and ask price of the trades they help execute. In order for them to cover their massive computing expenses, the HFTs need to conduct huge volumes of trading so that they can make a profit.

But these high-frequency traders also try to keep what is known as a balanced book. This means that the number of buy transactions must always equal the number of sells. And should the book become unbalanced, depending on the amount of capital that an HFT is willing to risk, the HFT will stop trading.

And that appears to be the leading explanation for what caused the flash crash. All this so-called liquidity, which generally makes it possible for buyers and sellers to meet, suddenly disappeared because the high-frequency traders' books became too imbalanced. So the HFTs stopped trading, the liquidity dried up and the market plunged.

HFTs and Hedge Funds Turn Markets Hyper-Volatile to Boost Their Fees

This will continue to be a huge problem according to another expert I interviewed, Paul Wilmott, an Oxford University graduate with a DPhil in Mathematics (whose accent reminds me of John Lennon). Wilmott, who is one the world's top experts on derivatives, suggests that finance has become the tail that wags the economic dog.

Wilmott thinks HFTs and hedge funds are deliberately trying to make trading more volatile and difficult for the average investor so they can make more money. They accomplish this by using trading algorithms that lead to what Wilmott calls positive feedback loops, wherein all traders pursue similar strategies, which causes the market to move up and down more dramatically.

Since HFTs and hedge funds effectively control the market, he believes, they're able to earn 20% annual returns while creating tremendous volatility. This causes more institutional funds to flow to the HFTs and hedge funds that can earn such high returns -- something that those outside their club cannot accomplish.

The Worst Is Yet to Come

The result is that the stock market is no longer a place to raise capital in order to build businesses and employ people. Instead, it's a casino where the high rollers become wealthier at the expense of everyone else.

Wilmott is an expert on collateralized debt obligations, which contributed so heavily to the 2008 financial crisis. In his view, CDOs were safer than high-frequency trades because at least ratings agencies spent some time looking at the collateral (although in a shoddy fashion).

HFTs, in contrast, are able to act without regulatory scrutiny. If you thought May 6 was bad -- just wait.