High Frequency Trading Programs Questioned

Chris Lee

The High Frequency Trading or HFT programs in use by large financial institutions like Goldman Sachs, for example, generally use current market order information to execute exceptionally quick deals, known as flash orders, ahead of significant pending orders.

Thanks to modern technology, such timely order information can now be obtained from exchanges, like the New York Stock Exchange and the NASDAQ, usually for a hefty price tag.

High Frequency Trading Criticized as Unfair

Automated High Frequency Trading gained considerable notoriety in the middle of 2009 when the flash trading activity that was recently enabled to operate on exchange traded markets was first exposed to public scrutiny.

The revelations about the new technology and the resulting public outcry about these operations even prompted Senator Charles Schumer, a New York Democrat, to write to the Securities and Exchange Commission about the issue.

In his communication to the SEC, Schumer expressed his intention to introduce new legislation that would prevent high frequency trading using flash orders, if the SEC refuses to regulate the practice.

In essence, the high cost of the data feed and the associated flash order dealing technology necessary for such front running activities tends to put access to high frequency trading firmly in the league of big banking institution pocketbooks.

According to HFT critics like Senator Schumer, this gives banks like Goldman Sachs an unfair inside trading advantage in what are supposed to be public securities marketplaces that should protect investors’ interests and operate fairly.

How Front Running Works

Such so-called order front running activities by financial institutions are relatively common among market makers operating in relatively unregulated markets like the foreign exchange market, for example.

Professional forex dealers generally keep a close track on their order books containing a list of orders and call levels placed by their customers in the currency pair that they specialize in.

As a result, they know where the major order levels are located and the amounts of currency waiting to be traded there. Such market makers might also gossip amongst themselves about large orders being worked by other professional dealers.

The dealers will then often take a short position for their own account just ahead of levels where their customers have placed orders to sell a large amount of one currency against another. Conversely, they might take a long position ahead of levels at which large buy orders have accumulated.

This way, if the market reverses without triggering the order, the dealer can close their positions at a profit which will sometimes be as small as the difference between the bid offer spread. They might even do this repeatedly to enhance their profits further, while possibly stopping the market from moving to fill their customer’s order due to their front running activities.

Alternatively, if the market continues moving to then trade at the customer’s order level, they simply stop themselves out by transferring their position to the customer and taking a minor loss in the process.

In this latter case, they might even transfer their loss to the customer by charging them “slippage” and filling their order at a worse level than it was placed at, especially if it was an “at best” or “market” order triggered by a certain price level trading.

Sophisticated HFT Programs Automate Exchange Front Running

Such order front running activities have been a standard part of the professional currency trader’s arsenal of money making tactics for years, so forex market professionals used to this behavior tend to wonder what all the fuss about front running stock orders is all about.

Nevertheless, what has gotten important legislators like Senator Charles Schumer up in arms is that the sophisticated HFT computer programs developed by major financial institutions like Goldman Sachs now allows such questionable front running activities to extend to orders in exchange traded securities like stocks.

This automated front running activity has been enabled by advances in data transmission and computer trading technology. This has been further empowered by the high speed order transmission data now for sale by major U.S. stock exchanges to big spending bidders like Goldman who are well known for their profit hungry activities when operating in the financial markets.

HFT Remains Highly Questionable

Publicly traded stock exchange markets were supposed to help protect investors from market price manipulation and dirty dealing practices perpetrated by stock dealers.

Furthermore, allowing access to sensitive order information very likely seems a breach of what at least should be ethical business practice on the part of the stock exchanges that have been entrusted with this data by the retail and institutional investors who deal though them.

Thus, permitting select financial institutions with deep pockets and access to state of the art automated HFT technology to profit handsomely from such important inside information seems highly questionable at best. In fact, flash trading on stock exchange data seems even criminal to some high powered critics who have proposed legislation and even class action litigation to help control the practice.

Chris Lee

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