In May of 2010, as the nation reeled from the global financial crisis that struck just two years earlier, markets experienced a “flash crash”, with the Dow Jones Industrial Average falling 1000 points before rebounding in the span of a few minutes. In those few minutes, a total of twenty thousand trades were placed, sending some stock prices skyrocketing while others plummeted. A report by the Securities and Exchange Commission in October 2010 blamed the crash on a colossal sell order resulting from a computer glitch in a Kansas mutual fund. To fully understand the cause of 2010’s “flash crash”, however, it is imperative to analyze the rise and downfall of another company, KCG Holdings.
Founded in 1995 and headquartered in New Jersey, Knight Capital Group was for years a relatively obscure financial services firm, engaged in “market making”, that is, profiting by taking advantage of the bid-ask spreads between the buying and selling prices of stocks. By 2011, the $1.5 billion company was the kingpin of U.S. equities trading, accounting for nearly one-fifth of all trades in both the NYSE and NASDAQ. In less than an hour on August 1st, 2012, however, KCG hemorrhaged $460 million, sending the NYSE into precarious convulsions and the country into yet another brief panic. By July 2013, what remained of the company was absorbed by a scavenging competitor, Getco. Though the SEC ultimately attributed this second flash crash to “erroneous technology issues”, it again failed to elaborate, not out of confidentiality, but rather, out of ignorance.
Knight Capital specialized in the art of high-frequency trading, a phenomenon that was well-known to many of Wall Street’s most powerful banks and financial firms, but was only just coming to light in the public realm at the close of the first decade of the 21st century. Paralleled by the meteoric rise of computerized trading, high-frequency trading has facilitated market manipulation and insider trading at a vast scale; it is a systemic exploit which will be remedied only through robust legislation and changes to the current market system.
A decade after KCG’s founding, amid the abstruse tangles of newly-laid fiber optic cables and flashing monitors, the SEC ordered US stock exchanges to become public for-profit institutions, permitting corporations to be listed on multiple exchanges. Though liquidity surged, market fragmentation occurred, meaning that share orders which could not be fulfilled by a singular exchange could now be filled by channeling them through multiple exchanges, resulting in minuscule time differences in the arrival of broker bids. The exploitation of these time differences, or “latency periods”, constitutes the practice of high-frequency trading. Upon placing an online order, an investor’s order is sent to a broker—such as eTrade—which in turn electronically sends a “bid” for the shares at a certain price range to the nearest exchange, where an SIP (Security Information Processor) calculates the NBBO (National Best Bid and Offer Price) and communicates the new, higher price of the stock to all other exchanges. If the initial exchange is unable to fulfill the order due to a scarcity of “ask” (sell) offers, the order is “fragmented” and routed through a series of exchanges until all desired shares are bought. High-frequency traders—or arbitrageurs—operate by accessing an investor’s market transaction at Exchange A, deriving the resulting new price—the NBBO—using their own algorithm, and buying shares of the stock at the pre-NBBO price at Exchange B before the new price from Exchange A arrives and is disseminated to the public. When the new price from Exchange A arrives at Exchange B, electronic trading algorithms sell the shares bought just milliseconds earlier at the NBBO price, garnering a profit. High-frequency traders are able to achieve this feat by either utilizing fiber optic cables shorter and more direct than those used to connect exchanges or optimizing the “logic”—or code—underlying their trades to be faster than that of the SIP. The entire process occurs in approximately 450 milliseconds—less than half the time required to blink an eye.
Following Michael Lewis’ 2014 publication of Flash Boys, which brought high-frequency trading to light in the mass media, many have taken issue with the practice, criticizing it as a gross form of market manipulation to guarantee a profit as well as contributing to so-called “flash crashes” when algorithms go awry. That said, electronic arbitrage remains legal in the United States, and generates profits in excess of $20 billion per annum for participating firms. Proponents have argued that ballooning trading volumes resulting from increased participation of HFT firms in markets has increased liquidity by tightening bid-ask spreads, reducing transaction costs for the background investor. However, this assertion has been vigorously refuted by the authors of a 2013 paper by researchers from the University of Michigan, who claimed that rather than increasing market efficiency, electronic arbitrage “reduces profits to everyone else” due to skewed probabilities of profit leaning toward the offending arbitrageur. Most damning, simulations supported the conclusion that latency arbitrage resulted in “no countervailing benefit in liquidity or any other measured market performance characteristic.”
Indeed, HFT’s disregard for the intrinsic value of a company or its value as a viable business is troubling, as it encourages background investors to search for ways to further exploit the markets for short-term stock-holding strategies, antithetical to the ideal of a value-based market. Furthermore, the advent of high-frequency trading creates a barrier to investment, due to the exceedingly high upfront costs associated with acquiring the necessary technologies. To mitigate the advantages offered by electronic arbitrage to traders, the current stock market system should be revised from a continuous trading environment to a periodic, or “discrete-time call” market, in which exchanges delay trades until an NBBO has been calculated and disseminated to all stock exchanges. Such a system would not only prevent profit skimming via electronic arbitrage, but by proxy also protect global markets against repeats of the flash crashes of 2010 and 2012.
High-frequency trading represents a loophole in the current financial system which the SEC has thus far failed to seal, though the FBI has begun calling for arbitrageurs to come forward. To some, including New York Attorney General Eric Schneiderman, latency advantages represent a novel form of insider trading, as the practice facilitates access to critical financial information to a select few market participants before the public. In order to best achieve—or return—to the goal of an open, value-based market, perhaps the hour has arrived for the United States to revise both its financial system and its archaic legislation on insider trading to reflect the problematic trend of latency arbitrage and the realities of Big Data in the 21st century.