Thursday, January 6, 2011

98 Microseconds


98 millionths of a second – the time for a round-trip of a NASDAQ trade order to be implemented and confirmed. Electronic trading, increasingly away from the largest traditional stock exchanges, is the how the markets work today… like massive schools of fish, turning to dive and swim in a uniform and seemingly choreographed sweep. “The N.Y.S.E. accounted for more than 70 percent of trading in N.Y.S.E.-listed stocks just five years ago. Now, the Big Board handles only 36 percent of those trades itself. The remaining market share is divided among about 12 other public exchanges, several electronic trading platforms and vast so-called unlit markets, including those known as dark pools.” New York Times, January 3rd.


Outside of the N.Y.S.E. and NASDAQ, the next two biggest such exchanges, which combined handle about 20% of the 8.5 billion in such average daily transactions, are located in northern New Jersey and Kansas City, Missouri: Direct Edge and the BATS Exchange, respectively. Stakeholders in Direct Edge include Goldman Sachs, Knight Capital, Citadel Securities, International Securities Exchange and JP Morgan. The government regulator – the Securities and Exchange Commission – has fostered the use of such electronic trading in sequential rule-making that began in the 1980s, ostensibly because that such automated trading has dramatically driven down the cost for consumers when they buy and sell stocks.


But those who have the more sophisticated computer programs and state-of-the art hardware have also created tactical advantages that smaller players simply do not have. While automated “flash trading” – where sophisticated computer programs instantaneously implement buy-sell orders based on their trend analysis without the intervention of human “decider” – has been banned, the penalties for violating this rule haven’t really been established. On the other hand, with more, smaller exchanges, the competitive playing field has been expanded, and, generally, smaller traders can function with vastly less expensive commissions and per-trade costs.


But to play in this new electronically hyper-accelerated game, the truth is that if you don’t have high-speed analytical software on the fastest computers, this is anything but a level playing field: “Even the savings of many long-term mutual fund investors are swept up in this maelstrom, when fund managers make changes in their holdings. But the exchanges are catering mostly to a different market breed — to high-frequency traders who have turned speed into a new art form. They use algorithms to zip in and out of markets, often changing orders and strategies within seconds. They make a living by being the first to react to events, dashing past slower investors — a category that includes most investors — to take advantage of mis-pricing between stocks, for example, or differences in prices quoted across exchanges.


“One new strategy is to use powerful computers to speed-read news reports — even Twitter messages — automatically, then to let their machines interpret and trade on them… By using such techniques, traders may make only the tiniest fraction of a cent on each trade. But multiplied many times a second over an entire day, those fractions add up to real money. According to Kevin McPartland of the TABB Group, high-frequency traders now account for 56 percent of total stock market trading. A measure of their importance is that rather than charging them commissions, some exchanges now even pay high-frequency traders to bring orders to their machines.” NY Times.


These new exchanges have spread into commodities/derivatives groups (e.g., Globex), and some massive computer-based warehouses have chosen to locate away from New York but directly on some of the fastest fiber-linked lines in the United States. For the most part, these networks work flawlessly, even if they are providing an unfair advantage to those with special access to the systems.


But when they fail, the speed at which they can infect the entire trading community is alarming: “THE ‘flash crash,’ the harrowing plunge in share prices that shook the stock market during the afternoon of May 6 last year, crystallized the fears of some in the industry that technology was getting ahead of the regulators. In their investigation into the plunge, the S.E.C. and Commodity Futures Trading Commission found that the drop was precipitated not by a rogue high-frequency firm, but by the sale of a single $4.1 billion block of E-Mini Standard & Poor’s 500 futures contracts on the Chicago Mercantile Exchange by a mutual fund company.


“The fund company, Waddell & Reed Financial of Overland Park, Kan., conducted its sale through a computer algorithm provided by Barclays Capital, one of the many off-the shelf programs available to investors these days. The algorithm automatically dripped the billions of dollars of sell orders into the futures market over 20 minutes, continuing even as prices started to drop when other traders jumped in.” NY Times. The fact that such electronic clearinghouses are fairly centralized and obviously dependent on fiber linkage and the Web – even with safe duplicate sites “mirroring” the data stored on the main units – also makes our financial system that much more vulnerable to a terrorist attack.


On a macro-level, this electronic advantage seems to be one more piece of evidence that economic polarization is accelerating, providing further “special treatment” for those at the top of the economic ladder. We see the increasing alienation of the common man – most recently from the powerful Tea Party grassroots resentment of a government that they no longer trust giving special interests special rights and powers – and should continue to see this frustration in the coming years… a phenomenon that should provide for increasing political volatility and legislative friction.


I’m Peter Dekom, and if you are an average American, prepare for a below-average life!

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