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An HFT Driven Market

Not too long ago, a Russian programmer was picked up by the FBI for circulating what may be Goldman Sachs proprietary HFT (High Frequency Trading) software. Essentially, much of the volume in today’s markets is entirely driven by computers making minute decisions about penny trades on the smallest of fluctuations to derive an arbitrage situation and exploit it through volume. To make it even more interesting, the software is designed to carefully layer its moves in attempts to hide its intended activity from rival HFT algorithms doing the exact same thing; this reminds me somewhat of an old school programming game CoreWar where code was designed to annihilate it’s competitor in RAM and hide what it did from that same competitor. All of this makes sense from a trading perspective, get the edge on your peers and do so in a way that makes you the most money. My problem with HFT computing is that it seems diametrically opposed to the concept of opening a company to the public for investment as a means to raise capital. With HFT, the markets are not a forum for raising capital anymore or making investment in a company, they’re simply a place to exploit mathematical trends causing the sale of what could be a fantastic organization or the purchase of crap simply based on a prediction model. Granted, according to the article on HFT there are variables allowing for human input to lean the algorithms towards certain less tangible abstracts like hunches … but at its core, it’s still a math program looking for the same thing as everyone else’s math program which makes the market react in swings.

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My problem with HFT computing is that it seems diametrically opposed to the concept of opening a company to the public for investment as a means to raise capital.

One of the more widely held ideas in economics is that ideal markets represent “perfect information”.

Essentially, they argue that the market price of a stock (under ideal conditions) reflects all the information available to the traders. In that sort of situation, it’s only possible to make relatively short-term gains through investing. Long term gains are wiped out by the law of averages.

Now, in reality, those ideal conditions aren’t realized in practice. It takes time for information to propagate through the market, and for the market to react. Because of the way communications technology has been evolving in the last few decades, that time is always getting smaller, but the laws of thermodynamics will ultimately stand in the way of getting it to zero, as needed in the “ideal conditions”.

Much of the function of the HFT systems, especially the statistical arbitraguers, is to try to exploit that propagation time. If the statarb gets the information first, and can make a valid prediction, it makes money.

The key point underlying that is that the statarb doesn’t “manipulate” the price — it just exploits the fact that it knows something the market hasn’t yet incorporated into the price. Eventually, the knowledge gap is closed and the price moves in line with that information.

None of that is really inconsistent with the traditional idea of public trading as a way to raise capital. It’s the fortunes of the company, good or bad, that dominate the “knowledge” that market price represents.

The money the company raises comes from the original stock offering, not from trading. If I sell you stock, it doesn’t affect how much capital I raised in doing so if you then sell your stock to markmcb.

The real problem with HFT is what they point out toward the end of the article. The trading done by the HFTs is a very complex dynamic system, one that nobody can study because of the secrecy surrounding it. It’s entirely possible — even quite likely — that there’s some basin of attraction in the system that causes the market to crash like it did on Black Monday.

Since the trades are automated, and account for such a large percentage of trading volume (the article gives an estimate of two thirds), that’s a disaster waiting to happen.

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