Top academic tells BBC Radio 4: Execution must be under 1 microsecond or you’ll fail
IEX CEO and activist against exchange-dominated HFT Brad Katsuyama goes head to head with University of Edinburgh professor Donald MacKenzie as the BBC’s David Grossman dissects why HFT is loved by some, hated by others
High Frequency Trading, often referred to by its three-letter acronym HFT, has been a polarizing subject for regulators, banks and traders alike over the past few years, with some entities considering it to be disruptive and abusive, whilst others, including many Tier 1 banks, consider it to be very standard practice, and in the words of Australia’s national financial markets regulator some five years ago, “part of the financial landscape of the world.’
HFT employs the use of very complex algorithms which automatically execute trades on either a equities venue or on an OTC basis in order to attempt to gain a time advantage over other traders and benefit from many factors such as beating latency arbitrage or simply running large numbers of orders very quickly through an executing venue in order to get the real time prices quicker than competing traders.
This week on BBC Radio 4, one of the most edifying broadcast media sources for in depth discussion, academics and industry professionals alike looked at HFT, and what the BBC has termed ‘a new age of capitalism.’
The BBC introduced the concept of HFT in a format that those outside the professional trading desks of London, New York and Chicago would be able to relate to, stating “Imagine you are heading to the shops and someone steals your shopping list. Then they race ahead and bought all the goods ahead of you, forcing you to buy your shopping from them at a higher price.”
“That is what is happening to ordinary share traders like pension funds. When they go to buy some shares, they find high frequency traders have snapped them up nanoseconds before them and want to sell them at a higher price. These traders now account for the majority of all trades on major stock markets” commented the BBC.
In the Radio 4 documentary, David Grossman explored the rights and wrongs of this new world with Brad Katsuyama, CEO of IEX, the executing venue which wants to clamp down on high frequency traders, and Professor Donald MacKenzie of the University of Edinburgh.
Mr Grossman stated that the reaction time of an Olympic sprinter is approximately 150/1000 of a second, in order to give an approximate insight into the difference in reaction time between even the most alert and physically fit humans and their computerized counterparts.
Professor MacKenzie’s comments were very interesting indeed. “If you want to be state of the art in automated HFT, your computer system needs to respond to an important relevant piece of incoming data in less than a microsecond, which is one millionth of a second and indeed these days, quite substantially less than a microsecond.”
“So that really is blisteringly fast. Light in free space travels just 300 meters in that time, so we are talking about speeds that are impossible to achieve via manual trading.”
Mr Grossman then asked Professor MacKenzie how close we are to nanosecond trading. “We are indeed heading toward that sort of speed. A nanosecond is a billionth of a second. Light in free space travels 30 centimeters in that time, and this is the speed trading is heading toward. It has not got there yet, currently if you are executing orders in 100th of a nanosecond, you’re doing pretty well, but the level of advancement is now so rapid that it won’t take long to get to the point where almost nanosecond trading is achievable for some.”
BBC reporter Mr Grossman then turned to Brad Katsuyama, CEO of IEX, a relative newcomer to the otherwise very establishment-orientated equities venues, introducing him as a former trader who works to expose what he sees as a system that is stacked against ordinary traders.
Mr Katsuyama explained “All the trading happens in datacenters these days, and if people thought about this much harder, they would probably want to do something about it.”
Mr Grossman then asked how Mr Katsuyama would sum up why this matters to people who thinks the intervals of time don’t matter and that this is what banks do, therefore do not want to get too involved.
“When considered properly, it would become obvious that most people outsource trading to someone else, whether it’s a financial adviser that is picking mutual funds or stocks, or whether it is pension funds. Whether it is known or not by the investor, money is being traded in the automated markets every day, and there is a tax on your money that is unnecessary, and as a result it is diffuse harm. Bits of money are being stolen from lots and lots of people but the benefit is concentrated and is going to exchanges and certain HFTs, and as a result of this concentration, they are making billions of dollars which increases their influence and spending power to continue to extract money, and that is the system that we are trying to fight against” – Brad Katsuyama, CEO, IEX
In the United States, there are 13 listed equities venues, most of which are based in the traditional commodities and futures trading city of Chicago, and four datacenters, all of which are located in New Jersey.
Mr Grossman last year went on a tour of all four datacenters, which was particularly interesting because he is a mainstream BBC journalist rather than an industry professional from within the institutional financial technology world, hence his findings would be different from those of us who have spent years working within the technological topography of the financial sector.
“All are huge windowless, warehouse-like buildings, with no external signage to say what is inside. All that draws the attention is huge power lines going in, and masses of back up generators around the outside. There are also huge communication towers all over the roofs, and then there is the blanket security” said Mr Grossman.
Interestingly, Mr Grossman was greeted on approach by extremely forceful resistance by security when approaching the NYSE datacenter, especially when he identified himself as being ‘from the BBC’. “What are you filming?” was the hostile response.
Mr Grossman was allowed in to one of the four datacenters, but was told not to report about it, or identify anything that he had seen. Access was via airtight doors, unlocked by the palm print of the security officer who accompanied Mr Grossman.
Things were very different in the 1990s. When I was at BT (Now BT Radianz) I was allowed to work as a development engineer for two years on trading server infrastructure, followed by 18 years worth of self employed consultancy within banks. My colleagues and I literally used to walk in and out with as little as a lanyard and name tag, even though we were not directly employed by any of the firms we provided services to.
This, however, was well before the days in which many traders worldwide could implement their own algorithmic trading systems, and before the vast majority of trading servers were centralized at major datacenters such as those operated by Equinix. Back then, outsourced connectivity providers such as BT implemented their systems directly on a per-venue basis.
Speed matters, because many of the same derivatives and other products are traded on all the exchanges. Changes in the price on one exchange are then reflected on the other exchanges, but the price change signal takes time to travel around the system.
Mr Katsuyama stated this weekend, when looking at what happens when a mutual fund owned by lots of individual investors wants to buy an investment, as in the case of an ETF. “A large mutual wants to buy an ETF, and enters an order into the market to buy 50,000 shares of the ETF and instead of trading at one exchange, that order is then cut up and sent to many out of 13 US exchanges and a high speed trader could be waiting on one exchange to pick up a signal that there is a buyer in that ETF and to electronically front run that same order whilst it’s in flight to other exchanges.”
“The HFTs have have no fundamental interest in buying it, they are simply doing it because someone else wants to buy it, so they buy it in front of them and then sell it back to them at a higher price which causes the mutual fund to pay a higher price which means that the underlying fund holders of that mutual fund are paying more for an asset that they would otherwise have got for a cheaper price. That profit then goes to the HFT and this is happening thousands of times per day” he said.
This is a victory for technological speed, and as this improves, is that companies have to go to continually greater expense to develop increasingly faster computer systems, which has given rise to the long standing idea that HFT has created a ‘technological arms race’.
Professor MacKenzie then said “Traditionally, in around the year 2000 to 2010, you got the signal via fiber optic cable, and if you think about a standard internet connection, if you have fiber optics, that is quite fast, hence most of the connectivity was provided by buried fiber optic cables between one datacenter and another, however these are made of glass, and light in glass does not move at its full maximum speed. It is going at around 2/3 of that speed. If you can transmit the signal through the atmosphere, via radio transmission in microwave or millimeter wave, or laser signals that pass through the atmosphere, and all of those are potentially much faster than fiber optic cable.”
“Everyone has to invest in this, as you have to be close to the maximum possible speed” he said, to which Mr Katsuyama stated “I saw some research into particle acceleration whereby if you send nutreos through the earth, it takes the curvature of the earth out of the equasion and this is where we have got to, and I think the major takeaway from the will to invest in that type of extremely expensive transmission technology is that nobody would be talking about shooting nutreos through the earth if it didn’t matter quite so much about being first.”
Mr Katsuyama considers that the reason why IEX exists comes from what he sees as a situation that exchanges have gone down the wrong route by becoming sellers of high speed data and high speed technology.
“It’s like the referees are selling to the teams” he said. “In today’s worlds, an exchange will rent you a cable for $28000 a month, when a cable costs a few dollars. They will then say that if you want an even faster cable, you can have it for $40,000 per month however in my opinion, if the market is efficient by a few more microseconds, nobody cares about that but what the exchanges are doing is saying that the price to be the fastest has now gone up so they are now incentivized to create differences in speed, and now instead of having, as was once the case, just one view of the stock market, now you have hundreds of views of the market, so now people can trade with almost guaranteed profit if they pay for speed from exchanges” – Brad Katsuyama, CEO, IEX
Professor MacKenzie considers it important to compare today’s word of automated trading, to the world that preceded it at a time when it wasn’t done by algos, but by very highly paid human beings who were also looking out for massive advantages. The cost of completely automated algo trading is less than paying humans to do it. Most economists who studied it think that the balance is in favor of the Algo approach rather than the human trading floor approach.”
FinanceFeeds spoke today to senior executives at IEX, who stated “We are not against technology in trading or HFT as a broad practice. We’re against particular predatory/toxic practices that harm investors, and the idea that exchanges should be selling advantages that enable those strategies.”
It is interesting that academics are in favor of HFT, whereas Mr Katsuyama, a trader and exchange operator, sees it as toxic. There are, clearly, two sides to every coin, just as there are two sides to every trade!
Editorial note: This article is a summary based on a live broadcast on BBC Radio 4 listened to by Andrew Saks-McLeod over the weekend, all notes and information were taken during listening.