The popularity of high-frequency trading (HFT) has boomed in the past decade as hedge funds and proprietary traders have made astounding sums of money exploiting network technology to execute trades a few milliseconds faster than their competitors. High-frequency trading is a form of high-speed arbitrage where traders capitalize on small discrepancies in the prices of financial products. Essentially, traders will search for situations in which two investors have different valuations of a stock. When they find such a situation, the HFT traders will buy the stock from the person who values the stock at a lower price, and simultaneously sell the stock to the investor with the higher valuation. For example: if the price of a stock is lower on the U.S. exchange than it is on the British exchange, the trader will simply buy the stock in the U.S. and sell in Britain, pocketing the difference. This strategy (Arbitrage) has been around for centuries, but high-frequency trading is steroid charged version that delivers unheard-of risk-adjusted returns for investors. Professional traders and finance specialists use a risk measurement called a “Sharpe ratio,” which is defined as the return of the portfolio minus the risk-free rate (such as the interest rate on U.S. treasury bonds) divided by the volatility (standard deviation) of the portfolio. To put things in perspective, typical real-life daily trading strategies generate Sharpe ratios in the 1-2 range, but well-designed HFT strategies typically produce double-digit Sharpe ratios, which means a trader can generate risk-adjusted returns that are high multiples of the typical trader’s returns.
While many have been fearing HFT because they worry about the volatility that it can potentially create, such as during the “flash-crash” of 2010 when the Dow Jones Industrial average plunged over 1000 points (around 9%) only to recover a few minutes later. Professor Kimball wrote in his quartz article about the perceived unfairness of HFT traders having the ability to exercise their trades faster than ordinary investors. Although many of those concerns are worrisome, as the Wall Street Journal reports, investors may have to worry about HFT traders getting another advantage: information.
Many HFT traders have now begun to capitalize on small time lags between press-releases of financial information on different websites. This direct access subscription to financial news and data gives HFT traders a split-second advantage over other investors. For example, on December 5th of last year Ulta Salon Cosmetics and Fragrance Inc. released its earnings statement that missed analyst’s forecasts. They released the information to the public over a number of sources, but each distributed the earnings at slightly different times. Traders that paid for an ultra-fast subscription to BusinessWire, a financial reporting company, received their information 242 milliseconds before Bloomberg news published the results and 464 seconds before Dow Jones published the results. This meant that anyone who paid for BusinessWire got a legal, split-second advantage in getting the information. As a result, at only 50 milliseconds after the initial press release, over $800,000 worth of Ulta’s stock was sold in a series of rapid-fire trades, even before investors using Bloomberg and Dow Jones received the same information.
This discrepancy between the time different investors receive information brings up important questions about the efficacy of current regulations of financial reporting. As Scott Paterson of the Wall Street Journal writes:
The Securities and Exchange Commission’s fair-disclosure rule, Regulation FD, requires that public companies issue material information about their businesses to the broader public at the same time it is disclosed to market professionals. The SEC passed the rule in 2000 amid concerns that companies were selectively revealing material information to Wall Street analysts and certain privileged investors. The rule, written before the era of high-speed trading, doesn’t address whether fractions of a second matter in terms of when information is distributed.
Essentially, this could end up being looked at in a similar way as a typical insider trading case, since these HFT traders are able to get their information before (even just by a few milliseconds) the public receives this information.
Despite the worries about the impact that HFT is having on the financial industry, I remain cautiously optimistic. First, with regards to the rate at which individuals can receive company information, this is hardly a new phenomenon. In a range of packages, Bloomberg has for years offered investors stock price information at different lags and different prices. If you want to get the freshest information at 1 second intervals, you have to pay a higher price, but those willing to use stale information at lagged 10 minute or 1 hour intervals can get it cheaply. This is simply a faster version of an old practice. Second, as the price of up-to-the-millisecond information increases due to increased HFT demand, these HFT traders are slowly eroding the profits they can earn (more expensive information = smaller profits), so there might be smaller advantages to using this information in the future. Furthermore, as more and more investors jump on the HFT game, it might become standard practice for all to be able to execute trades within a few milliseconds; in this case, there’s no advantage to driving a Ferrari if everyone on the street is driving a super-car. Finally, the problem with this technological arms race with HTF is that it’s bound by the laws of physics. What I mean is, there’s a physical barrier to increasing the speed of information transfer: the speed of light. Even if you had magical fiber optic cables that prevented any lag in the light signals traveling down the cable (light typically slows down in a medium compared to a vacuum. You can see this in the childhood optics experiment by putting a pencil in a glass of water and watching the refraction of the light “bend” the pencil. This occurs because light travels slower through water than in air), the fastest you could ever send that information is at the speed of light. Eventually, the technological limitations to how fast you can send information will plateau, everyone will be able to access the high speed networks (for a fee), and the advantage of HFT will be erased. Overall, my opinion is that HFT is simply a high-tech version of the arbitrage game that has been going on for centuries, and the fact that there’s a physical limitation on the rate at which you can transmit financial information will ultimately erase the advantage of these traders.