Who Benefits from High-Speed Trading?

Speed is a virtue in most competitive pursuits; the combination of speed and accuracy is almost always the ultimate advantage.  No one knows this better than the purveyors of high-speed trading technology, who have profited mightily –not only by executing rapid-fire algorithmic trades, but also by exploiting the arcane rules that govern the stock exchanges.  But at whose expense are they profiting, and how long is their advantage likely to persist?

Seeking to answer these important questions, Scott Patterson, a staff reporter for The Wall Street Journal, has authored a new book, Dark Pools: The rise of A.I. trading machines and the looming threat to Wall Street, which pulls together his superb investigative reporting on electronic communication networks (ECNs) and high-frequency trading. Patterson’s book offers a clear explanation of the inner workings of rapid-fire electronic trading and the networks that sustain it, and it’s an absorbing read from start to finish.

“Dark Pools” also draws a surprising conclusion. The huge profits accrue to high-frequency traders not because they can buy low and sell high at lightning speed; the high-frequency market is too competitive for that now. Rather, skill and insider knowledge allow them to exploit arcane order specifications and a fee-sharing arrangement commonly called the “maker-taker fee.”

In a nutshell, if a trader – or rather, his trading program – knows how to place orders so that it is always defined as the maker of the trade while the counterparty is duped into being the taker, the trader will share the fees paid by the counterparty to the ECN.

Patterson’s topic is timely; high-frequency trading has triggered growing concern about a range of its less-understood effects, including how such trading could negatively impact ordinary investors’ portfolio values and liquidity and whether it might one day bring down the entire financial system.

As with many corrupt practices involving a small band of elite insiders, high-frequency trading began with a rebellion against the corrupt practices of another small band of elite insiders. It is classic Animal Farm (George Orwell’s 1945 allegory for the takeover of Russia by the Communists): first the masses overthrow their rulers amid cries of equality for all; then, a small subset of the masses becomes “more equal than others”.

Electronic communications networks, or ECNs, were created by quants and computer jocks who viewed floor traders at the stock exchanges – the NASDAQ and the NYSE – as an oligarchy that perpetuated their high fees by hoarding information. In Scott Patterson’s account, the anti-NASDAQ rebels’ mantra was “information wants to be free.”

The revolution for transparency was not only against the exchanges, NASDAQ and NYSE, but also against Instinet, the off-exchange system that matched buy with sell orders originated by large institutional investors (“whales,” in Patterson’s parlance). Instinet was the original Dark Pool; its bid and offer prices were not visible to outsiders. But when rebels shined a light on its prices, the doors were thrown wide open to swarms of ECN-based piranhas feeding on the lumbering whales, as well as on other dumb traders.

Thanks to their computer skills, these renegades succeeded in eclipsing the floor traders, creating ECNs with names like Island and Archipelago that made all posted prices transparent and let buyers and sellers connect with each other electronically, without human intermediaries. This spectacularly reduced the time it took to match buyers with sellers and close trades, so that literally thousands of trades could be completed in the time it once took to complete one.