Of Course It Is Rigged

High frequency trading, known as HFT, is the hot new thing for market pundits to reference when discussing the markets. They don’t know much about it, but mentioning it give them credibility. This post over at MR brought out some particularly oleaginous characters defending what is nothing more than a way to game the system. The idea is to use special knowledge to buy and sell equities in order to minimize losses and arbitrage imbalances in the market.

This has been the point of insider trading and self-dealing since knife money. In a completely honest and transparent market, the only way to make money is to buy and hold stocks. Trading, assuming fees are involved, is pointless since everyone knows what everyone else knows. There’s no chance to buy a depressed stock that is about to rebound or sell a stock that is about to collapse. Informational asymmetry, at least the belief in it, is what allows a market to exist.

What the HFT guys are up to is two things. One is they can process news that impacts share prices faster than any human. The algos can grind through a mountain of data by the time humans traders have buttered their toast. Bake in the right assumptions about how the humans will react to particular data and your algorithm will make perfect trades before anyone else in the market. Selling a stock that is about to drop 10% saves millions. Buying just as it heads up 10% and you make millions.

That’s the boy scout approach. The big boys like to play dirty. Here’s how. Let’s say there are 20,000 shares for sale at $10.00 and 10,000 shares for sale at $11.00. A buyer can have all 20,000 shares at $10.00. If you’re the guy looking to sell at $11.00, you may be willing to sell at $10.00 if you think there are no takers at $11.00. You can drop the price, but you still stand in line behind the guy selling at $10.00 until those shares are sold. That’s how it works. No line cutting.

The HFT guys beat this system by exploiting the relatively low cost to cancel. They can put sell orders out at $10 and see if demand is strong. They can cancel those sell orders, thus making the bit of the line in front of the $11 sell orders disappear. Humans can’t play this game, but robots are very good at it. In fact, cancel orders have rocketed up as more and more algorithms have sprung up in finance. Getting ten cents more per share may seem like peanuts, but not when you’re moving tens of million of shares.

The thing is, this is neither new or unexpected. A great book to read for anyone interested in the financial markets is called The Money Game, written fifty years ago. The author was a market insider when that meant something. He predicted the rise of machines in trading and the rise of crooks using machines to get an edge. Mencken, I think, said there are no new ideas, just new ways of saying them. That’s true of the HFT scams. It is just another way for sharps to fleece the squares.