The U.S. stock market conjures an image of adrenaline-fueled traders, yelling. That image is a memory. Now computers do most of the trading, silently — and very, very quickly. American equities change hands on about 50 mostly automated markets that exist in data centers in New Jersey and elsewhere. Microsecond reaction times have lowered investors’ costs and bestowed an advantage on trading firms that are primed for speed, while increasing the risk of errors that paralyze trading and shake investor confidence. But even as concern has grown over so-called flash crashes, high-frequency trading companies have gone from disruptive newcomers to established players in futures, currency and Treasury markets as well as stocks and even bitcoin. The future is not likely to be slow.
The new problem facing high-speed traders is that when everybody’s fast, there’s less profit to be made. Despite a chorus of critics arguing high-frequency trading firms have an unfair advantage, the traders face new challenges in less turbulent markets with low trading volume. Market makers in U.S. stocks earned $1.1 billion in revenue in 2016, compared with $7.2 billion in 2009, according to estimates from Tabb Group LLC. The pressure has forced them to branch out. Virtu Financial Inc. purchased rival KCG Holdings Inc. for about $1.3 billion, adding a company with more than five times as many as employees, including a salesforce that Virtu plans to use to persuade other traders to license its technology. Global Trading Systems LLC bought a business on the floor of the New York Stock Exchange, which it expects to use as a jumping-off point to sell services directly to companies whose stock they manage. Others are retreating from the proprietary trading business altogether. Teza Technologies LLC swiveled to focus on its hedge fund, selling some assets to Quantlab Financial Inc. A broker that helped invent electronic trading, Interactive Brokers Group Inc., sold its options market-making business. Chopper Trading LLC sold assets to DRW Holdings.
Although computers entered the scene in the 1960s, the modernization of stock trading really began in 1975, when the U.S. Congress mandated the creation of a “national market system” linking exchanges around the country. The advent of the internet and lower-cost computer hardware fueled the emergence in the 1990s of upstart all-electronic equity trading platforms with names like Island and Archipelago, which offered better technology than the incumbents at a lower price. The New York Stock Exchange ultimately bought Archipelago and Nasdaq bought Island. The 2001 shift to pricing stocks in one-cent increments eroded profits for human traders, with speedy automated trading firms stepping in to fill their traditional role. The final major shift came in 2007 with Regulation NMS, which requires that a stock be traded on whatever market has the best price at any given time. There have been some spectacular glitches: The flash crash of 2010 erased more than $800 billion from the value of U.S. stocks in a few minutes; five years later, an obscure London trader was arrested and charged with contributing to the disaster through market manipulation and fraud. In 2015, NYSE blamed a 3 ½ hour closure on a computer malfunction.
Critics, including Warren Buffett, argue that markets have become too beholden to cutting-edge technology. They say that the risk of disruptive breakdowns has grown to dangerous levels and that speed traders, with their focus on short-term returns, hurt investors with a stake in the long-term success of companies. Others say that the worst abusers may be guilty of illegal manipulation, pointing to the payment of $154 million by Barclays and Credit Suisse to settle charges that they misled customers about the way they handled high-frequency trading. Defenders of the practice say it has reduced trading costs for ordinary investors, and a growing body of research backs that claim. One effort to retain the benefits while preventing manipulation got the backing of the Securities and Exchange Commission in 2016, as it approved the dark pool IEX as a full-fledged exchange: IEX says its model dulls the advantages of some high-speed predators by slowing orders down with a “speed bump.” Still, the arms race continues: Renaissance Technologies, a hedge fund, is developing an ultra-fast trading system based on atomic clocks to keep a step ahead of the speed demons of Wall Street.
The Reference Shelf
- The Securities and Exchange Commission’s Concept Release on Equity Market Structure.
- Bloomberg Businessweek article on high-frequency trading and electronic markets and on the nuts-and-bolts infrastructure that supports the trading arms race.
- The SEC’s dedicated Market Structure mini-site.
- Senate Banking Committee page has transcripts and webcasts of testimony at a December 2012 hearing on electronic markets.
- Michael Lewis’s 2014 book, “Flash Boys,” argues that speed trading hurts ordinary investors.
First published Dec. 3, 2013
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