Light Reading
Financial traders are using low-latency high-speed fiber links and collocation to their advantage - but is it legal and is it fair?

Is Technology to Blame for Rigged Trading?

Carol Wilson
3/31/2014
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Using telecom technology to cheat Wall Street investors? I'm shocked, shocked, I say. But is the technology at fault, or the way it's being used? And what will this mean for the future of collocation and low-latency services targeting the financial services community?

Having repeatedly written stories of how financial services companies and traders were driving telecom network operators to deploy more high-speed, low-latency fiber-based services to gain an advantage, often calculated in milliseconds, in the trading of stocks, I wasn't entirely surprised to hear the 60 Minutes report Sunday that some of the high-speed high jinx weren't exactly fair… though not illegal. It's not clear to me whether what is unfair is not the speed of the trade or the information being obtained.

In an interview of author Michael Lewis, on the show to promote his upcoming book, Flash Boys, the CBS news program showed how some traders buy high-speed services and collocate their servers in the same data centers as financial exchanges in order to gain faster access to trading than the average investment company or investor.

Those high-speed traders are trying to gain millisecond advantages in the timing of their trades, and are able to detect incoming orders and essentially place their own orders in faster, thus jumping the line and driving up the cost of at least part of an original trade.

As one of those interviewed, Brad Katsuyama, who once headed the Royal Bank of Canada's investment team, explained it, the process would be like ordering tickets online and having someone able to see your request for four tickets, jump in line ahead of you and drive up the cost of two of those tickets before your order is completed.

Interestingly, Katsuyama -- who was the hero of the 60 Minutes piece -- got fed up and left the RBC to create his own exchange, IEX Group Inc., which literally uses long lengths of spooled fiber-optic cable, contained in its trading platform, to inject 350 microseconds of delay into all trades, thus eliminating the high-speed trader advantage.

So, using technology to combat a technological advantage -- quite clever.

As this Bloomberg BusinessWeek article notes, New York State Attorney General Eric Schneiderman is looking into whether it's legal to sell products and services which offer faster access to data and richer information on trades than is available to the public.

It's this "richer information" part that has me a little confused. If anyone who wants to buy faster high-speed links and pay for collocation space can do so, bearing that not-inconsiderable cost, that isn’t an unfair advantage. But if, by doing so, companies are able to gain access to information from those exchanges on other incoming orders, and to short-cut their way in front of those orders, that hardly seems right or legal.

The impact of Lewis's book and any resulting investigations on the sale of low-latency and collocation service to the financial trading industry -- a very lucrative target market and anchor tenant for many telecom players -- will be fascinating to follow. Of course, the bigger impact will be on the American equity markets. As Bloomberg notes, the volume of trading on the major US exchanges is three times as great today as it was in the go-go '90s, and that's a lot of money changing hands and a lot of income being generated for traders in the process.

— Carol Wilson, Editor-at-Large, Light Reading

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Mitch Wagner
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Mitch Wagner,
User Rank: Lightning
4/7/2014 | 2:18:11 PM
Michael Lewis says
And now I've heard an NPR Fresh Air interview with Lewis. He argues that these flash traders are parasites. They're not value investors. They're taking profits from value traders, including pension funds that pay for workers' retirement.

An independent stock exchange has been founded that circumvents flash trading. That's an argument that no additional regulation is required -- not only will the market solve this problem, it's already doing so.  
Mitch Wagner
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Mitch Wagner,
User Rank: Lightning
4/7/2014 | 2:15:42 PM
Re: Where's the damage
ethertype - Good metaphor -- particularly since, in your metaphor, the guys hanging around the counter are parasites, providing no value. 

Somewhere up the supply chain, there's a manufacturer making delicious mustard. The shops are bringing the mustard to our fair city and making it available. The buyer is adding the mustard to delicious sandwiches. 

But the guys hanging around the counter don't provide any value, and they simply drive up prices for everyone. 

They're like ticket scalpers. 

And I'm getting hungry -- 45 minutes until lunchtime. 
mendyk
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mendyk,
User Rank: Light Sabre
4/1/2014 | 6:01:51 PM
Re: Where's the damage
Post of the month. And it's only the first day.
ethertype
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ethertype,
User Rank: Light Sabre
4/1/2014 | 5:07:39 PM
Re: Where's the damage
Here's the analogy:  you look at websites of several gourmet shops (exchanges) to see who has your favorite mustard in stock and at what price (bid/ask quotes).  Three shops have stock at very similar price, but none of them has all 60 jars that you need.  So you send out three bicycle couriers (messages on a "slow" IP network) at the same time to the three shops with instructions for each of them to buy 20 jars of mustard at the advertised price (buy orders).  The closest shop (BATS) is 3 blocks away, the other two shops are 6 and 10 blocks away.  When your first courier arrives at the first shop and asks for 20 jars of mustard, a guy standing near the counter (one of the high-frequency trader's servers) hears your order and sends a text message (low-latency message via direct fiber connection) to his friends (servers) at the other two shops telling them mustard orders may be coming so they can buy all the mustard and offer it back for sale at a slightly higher price, all of which occurs before your orders arrive. By the time the other two couriers get to those shops, the price is slightly higher than when you sent them out.  Your couriers call you to tell you the bad news, but you need the mustard so you tell them to go ahead and buy at the higher price.

This all works for the mustard traders because the shops let them hang around by the counter listening to what everyone else is doing and do things like buying all the mustard in the shop and then selling it right back.  If you want to compete with them, or avoid having them trade in front of you, you could hire your own people to stand at the same shop counters and send in your orders to them via text (i.e. joining the low latency tech arms race).  But if you're just ordering mustard now and then, that's really expensive.  Or you can tell all your couriers to synchronize their watches and buy at the exact same time, so the courier at the first shop just sits around and waits until the right time before placing his order, and the other guys place theirs before anyone can learn about the first one and jump in front of them.  (That's what RBC's THOR system did at first.)  Or you can say, "Hey, let's open our own shop and don't let any shady guys with cell phones hang around the counter, because once people realize how these shops are favoring the shady guys at their expense, they'll prefer to shop with us."  And that's exactly what the RBC crew did by leaving and starting IEX.
Carol Wilson
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Carol Wilson,
User Rank: Blogger
4/1/2014 | 2:24:48 PM
Re: Where's the damage
I'm defnitely not saying there's no harm done - it's the "inserting" part that's confusing me. How is that happening and doesn't that go beyond faster transmission speeds and colocation near the exchange?

The tax idea is a good one, until the guys who can afford to spend money finding loopholes find one for that. 
Phil_Britt
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Phil_Britt,
User Rank: Light Sabre
4/1/2014 | 3:12:28 AM
Re: Where's the damage
I like the tax idea, too. The high-frequency traders are not subject to FICA taxes, unlike employees or self-employed contractors.

The other problem with high-frequency trading is that it can cause issues like the "flash crash" a few years ago. If machines drive the markets down (or up), then not only consumers, but even larger traders iwth established trade triggers -- like automated sells if a stock price drops by 10 percent -- can get caught buying or selling at prices that leave them holding the bag.
smkinoshita
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smkinoshita,
User Rank: Light Sabre
3/31/2014 | 8:05:21 PM
Re: Where's the damage
@Mitch:  I think the one-cent tax per trade is an excellent idea.  It's the same principal that MMO's use to regulate player abilities by causing diminishing returns.

I think the case of damage is a matter of creating artifical economic barriers however.  I'm not sure which way I feel, because on one hand it seems like it could cause an infinite loop of richer companies preventing others from ever being able to compete, while on the other hand it doesn't seem like it would nessecarily lock others out because I'm not convince its impact is that big.
ethertype
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ethertype,
User Rank: Light Sabre
3/31/2014 | 7:21:59 PM
Re: Where's the damage
Read Michael Lewis' article or book and then tell me there's no harm done.  The guys with the best colocation and lowest latency are inserting themselves between buyers and sellers.  It's not that they see a trade occur and then decide to trade very quickly based on that information. They actually see a trade BEFORE it happens, interrupt the trade, increase the price that the buyer thought he was paying and profit from the difference.  Your mutual fund, for example, paid more for the stocks they bought and that lowered your return.  It's fractions of pennies for each one of us, but they make billions in this fashion.  Surely in any concept of a fair market this should not be legal.
Carol Wilson
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Carol Wilson,
User Rank: Blogger
3/31/2014 | 6:57:14 PM
Re: Where's the damage
I don't think trying to get your trades done faster is the part that bothers me - hence the headline. I think having access to information about other traders is what is concerning and that goes beyond gigabit fiber and data center colocation, or at least I think it does. 
Mitch Wagner
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Mitch Wagner,
User Rank: Lightning
3/31/2014 | 6:49:15 PM
Where's the damage
That kind of flash trading bears a lot of the blame for the Wall Street crash of 2008. That particular problem could be solved by charging a tax of $0.01 per trade. This would be negligible for conventional investors, but would end the practice of flash trading.

However, the phenomenon Lewis describes in 60 Minutes is a different matter. What's the case to be made that it's a bad thing, and requires regulating against?

On a less serious note: I'm a stone science fiction fan, and I'm tickled by the thought that when some genius invents a way to travel faster than lightspeed, it won't be to travel to the stars, it'll be to get an investment advantage of a few milliseconds.
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