Forget stockbrokers. Forget financial advisers. Today’s stock market, where your 401(k), pension or mutual fund is invested, is dominated by high frequency traders. They now account for more than half of the 7 billion shares of stock, worth $275 billion, that are traded in the U.S. every day. High frequency trading — which happens in a fraction of a second — is turning the U.S. stock market upside down and has sparked investigations by regulators and law enforcement officials, who are now asking if these traders have an unfair advantage over everyone else.
Most of the 20,000 trading firms in this country use fast computerized programs to buy and sell stocks — that’s not new. But in the past decade, high frequency traders working out of just 400 firms have taken this type of computerized trading a quantum level higher, leaving traditional trading in the dust.
High frequency traders and their complex computer formulas, operating near the speed of light, have turned what happens on the floor of the New York Stock Exchange (NYSE) into little more than theater. In fact, according to Bloomberg Businessweek, the NYSE handles only about 20 percent of all equity trading volume in the U.S., while the other 80 percent is spread out among 12 other exchanges with names like BATS Y-Exchange and EDGA Exchange, as well as over 40 private trading exchanges known as “dark pools.” High frequency traders execute a majority of the trades at these exchanges. And those transactions take place not on stock exchange floors but rather on servers in five data centers (buildings that house massive computers), located in suburban New Jersey.
Sen. Carl Levin (D) Michigan
If you want a few milliseconds of high frequency trading advantage over your competitors, you’ll need to get as physically close to these server farms as possible. It’s called “co-location” — high speed traders pay to put their servers in the stock exchange’s data center buildings. And that shorter distance to the exchange servers matters — even if it’s only a few feet. According to one estimate, having a connection that’s just one millisecond faster than your competition could mean an extra $100 million a year for a high frequency trader.
Critics are especially alarmed, because high speed algorithms are causing “flash crashes” with growing frequency. A flash crash is the sudden evaporation of hundreds of millions, sometimes trillions, of dollars in capital in the blink of an eye.
On May 6, 2010, a flash crash caused the Dow Jones industrial average to fall by a shocking 1,000 points in five minutes, briefly erasing $1 trillion in market value, only to recover fully a few minutes later. It was the largest single-day point decline in Dow Jones history and was blamed, in part, on the amplifying effects of high frequency trading. On Aug. 1, 2012, Knight Capital’s newly installed high frequency trading algorithm went haywire, costing the company $440 million in a matter of minutes. And on April 23, 2013, high frequency trading algorithms reacted to a hacked Associated Press Twitter account that said President Barack Obama had been injured in an explosion. The report was false, of course, but high speed trading fueled a flash crash of several minutes that removed $121 billion in value from the S&P 500. The real fear is that next time the market won’t recover from a flash crash, and hundreds of billions of dollars will be wiped out in minutes.
Perhaps the biggest irony is that the sheer volume of such trades continues to be high — 50 percent of the market — but the actual profits are down, from a peak of $5 billion in 2009 to just over $1 billion in 2013. Nevertheless, the industry is under increasing scrutiny. In the last few months the New York state attorney general, the FBI and the U.S. attorney general have all announced broad investigations into the practices of high frequency traders. In Washington, both the Securities and Exchange Commission and the Commodity Futures Trading Commission have announced that they’re investigating preferential treatment that some traders receive from exchanges, which puts smaller investors at a disadvantage. And in early June, Senator Carl Levin (Democrat – Mich.) spearheaded a hearing on high-frequency trading in the Senate Permanent Subcommittee on Investigations. At that hearing Levin said that, “Americans are understandably suspicious when technology can be turned against them and their families’ financial interest.”
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