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A simple explanation of why HFT is rigged
04/04/2014Posted by on
High Frequency Trading ( HFT ) is finally being openly debated in the media , ( mainly thanks to Michael Lewis and Bloomberg News) and there are on-going investigations by the FBI currently in progress.
Traders and Bank Insider are protesting like snarling lions at any suggestion that the market is ‘rigged’ in favour of High Speed Traders. However, anyone who has read Michael’s new book, Flash Boys, and has taken the time to understand the consequences of absorbing HFT’s into the fabric of the Exchanges themselves, will clearly see that their arguments are founded on very dubious grounds.
The main contention from the HFT lobby is that the ‘system’ currently operating gives beneficial liquidity to the Market and has lead to a significant fall in trading costs to “Joe Public” . This is certainly correct, and on the face of it does not seem to indicate a “rigged” market. (ie falling transaction costs and substantial capital fluidity usually indicate a free and un-rigged Marketplace )
Their second contention is one of “free market innovation” ; by which they mean that the mechanisms that have brought about this liquidity – the nanosecond buy/sell order book transactions – have come about as a natural result of their own capital investment in new trading technologies, algorithmic-driven bots and advanced computerization etc. They contend that it is “natural’ for major players who invest heavily going forward to have a competitive edge over others who fail to adapt and invest. This all sounds very plausible.
But …. and its a very big but … The assertion by High Frequency Traders that all they are doing is essentially benefiting from their own shrewd capital investment and innovation-driven practices and policies is a fundamental deception, because – in reality – it is allowing them to bypass the regulations that are in place to protect the operation of a free market.
A level playing field, everyone knowing and abiding by the same rules, are essential for on-going public confidence in any activity. Insider trading, benefiting from prior knowledge obtained secretly, or let’s not be prudish “Cheating” , is quite rightly outlawed and a criminal offence.
So, here is a simple sporting analogy that explains why High Frequency Trading should be seen for what it rightly is .. a rigging of the game. Or more accurately, a knowing deception to cheat against ‘Joe Public’ by those HFT players over non HFT players. All trading is essentially ‘placing a bet’ that your chosen option will win over somebody else looking at the same set of circumstances. High Frequency Traders merely say they can predict the market results better, and act sooner, because of their advanced technology and investment. So let’s examine that claim.
In NASCAR, – or say Formula One Racing outside the USA – huge capital investment is needed to run successful teams. The winning teams almost always are those with the biggest innovation budgets, most up-to-date technologies and RD development. The drivers are of course part of that mix, but if you put a top driver in a third rate car, he isnt going to win The Race.
We all can accept that variation, because that’s part of a capital and investment-driven free market activity. But there are “rules and regulations’ that are put on The Race. The most important being that ALL drivers race on the same track, all start at the same time, and the “winning post” is at a universally pre-determined point.
So, if HFT’s were watching their screens and betting on a NASCAR race they would have no advantage over a ‘Joe Public ‘ Punter watching the same Race on his own TV screen. But what is actually happening is that they are on a more rapid “cable feed”, than anyone else, so their information on the Race is arriving ahead of the “Joe Public” punter.
What makes this even more ‘rigged’ is that the HFT players are in fact actually associates in the betting office, so not only do they know the result of the Race in advance of Joe Punter, but they know which bets all the other “Joe Punters” have placed and are able to cream off the odds by placing their own “winning odds” bets, as they know already know the result.
Now, explained like that, everybody would say that was “cheating” and “rigging the market”. So I would love the HFT’s themselves to try and explain why this isnt actually what they are doing ?
Oh, and by the way, does the FBI watch NASCAR ?