High frequency trading – how worried should retail investors be?

24th April 2014

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They say time is money, and nowhere is this more the case than in the world of high-frequency trading. But how worried should you be about the allegations of a stockmarket rigged against the ordinary investor outlined in Michael Lewis’s best-selling Flash Boys: Cracking the Money Code?

Lewis’s book has caused a storm in investment circles for its exposé of the way high-frequency trading firms, peopled by computer nerds instead of Gordon Gekko-style alpha males, are using computer algorithms to push up share prices and make money out of the trades made on our behalf through our pension and investment fund managers.

For high-frequency traders it is not the speed of the computers that counts, but the speed and even the length of the wires connecting the computers to the stockmarket.

By connecting with exchanges before the rest of us, high-frequency traders sound out when buyers are in the market, buy stock and then sell it on to these unwitting buyers at slightly increased prices. The increases in share price may be small on their own, but operated day-in day-out, they can make high-frequency trading firms hundreds of millions of pounds every year without taking any risk at all.

With so much money to be made, high-frequency traders have been going to extreme lengths to shave fractions of a second off the time it takes to connect to stock markets. Investment and pensions journalist John Greenwood considers the issues.

One high frequency trading outfit had spent hundreds of millions of dollars connecting markets in Chicago and New Jersey with a cable that had gone under rivers and through mountains, in a bid to cut milliseconds off the data journey time.

Another company, Hibernia Networks, is reportedly spending $300m dollars laying a fibre-optic cable under the Atlantic in a bid to shave a few milliseconds off the time it will take to connect Wall Street to the City of London. To put that in context, this massive project is expected speed up the transfer of data between the two financial centres in a small fraction of the time it takes to blink your eye.

Lewis’s book has provoked much outrage – so how concerned should ordinary investors be?

Lewis himself reports that around $1bn a year is being taken out of the market through one of the main high-frequency trading strategies. IBISWorld, a market research firm, estimates high-frequency trading is worth $29bn a year. This is a significant sum of money seeping out of the market.

For buy-and-hold investors, the increased cost of buying shares is likely to be minor. A £20 share could cost a fraction of a penny more, which, over the long term is likely to make a negligible difference to the investor’s return.

Defenders of high-frequency trading say it creates liquidity in markets, and is a continuation of the age-old practice of buying from one person and selling to another at a higher price.

Hedge funds on the other hand are likely to see high-frequency traders acting as a noticeable drag on performance. It is telling that Lewis’s book includes complaints from asset managers, banks and brokers but not from consumer groups.

But the idea of markets being constantly manipulated by computers should be a concern for those charged with ensuring they are functioning properly. On May 6, 2010 the so-called ‘flash crash’ saw high-frequency trading computers chasing each other in a downward spiral that saw the Dow Jones fall 600 points in a matter of minutes and then recover again, momentarily wiping billions of dollars off the stock market before putting it back on again.

Last year saw our own Financial Conduct Authority take its first action in the field when it fined a high-frequency trader £600,000 for a strategy that saw it placing false orders for shares.

But most high-frequency trading activity is within the letter of the law, even if some think it is not in the spirit of fair play. For the present there is nothing we as ordinary investors can do about high-frequency trading other than hope that our regulators can keep pace with the flash boys.

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