I love a good tech story, but this one is downright scary.
For some reason I went down a bit of a rabbit-hole with high-frequency trading and robo stock traders this week.
I thought I’d share a bit of that with you here, not to make the point that the stock market is rigged (you knew that already), but just because the way it is rigged and the way the robot traders work, is just kind of mind blowing.
So yeah, money and tech. Two of my favourite things.
Ok, so I’ll admit I had no idea how robo-traders worked. When I first heard about them, I imagined a robot like Dexter from perfect match, going through stock-picking newsletters and picking the ones it liked.
But I then learnt it had something to do with algorithms, which again I thought was about mathematical ways to pick stocks, or pick market momentum – technical analysis on steroids.
But the truth is much scarier.
And we have a Hedge Fund guy named Brad Katsuyama to thank for that truth.
He noticed that his capacity to execute trades was falling. That is, on the computer systems traders use, they have something on their screen that tells them the stock price, and how many stocks are being offered at that price.
So say, Westpac, WBC at $2 a share, with 100,000 shares on offer.
In 2006, if Brad saw there was 100,000 stocks on offer, and he wanted to buy them all, he’d get them.
But in 2007, if there was 100K on offer, he’d be lucky to get 80K.
In 2008 it was down to 70K. And by 2009 it was down to 45K.
The screens would tell him that there were 100K, on offer but if he tried to buy them, he’d get less than half of what he wanted.
That was a problem.
At first he thought it was just the market moving at the same time as he was trading. But even in slow moving stocks, where trade was thin, he’d get the same problem. He realised some sort of event was shifting the market, and he was that event.
So he went digging. He discovered a few very interesting things.
The first is that that 100,000 shares was not housed at a single exchange, but was rather distributed across 13 different exchanges. (This is America we’re talking about).
And when you executed a trade, you didn’t put your order in with an exchange, you sent it to a ‘Smart Order Router’. The router would then split it up and send your trade on to the relevant exchanges to complete the trade.
Thing was though, the trades didn’t arrive at all of the exchanges at the same time. The further away the exchanges were, the longer it took.
(I ripped these images from a talk he did recently).
This created a window of opportunity for the robo-traders.
When Brad looked into it he found that there was about 2 milliseconds between when the trade arrived at the first exchange and the last exchange.
He thought, wow. That’s pretty quick. It takes 300 milliseconds to blink your eye, so 2 milliseconds (0.002 seconds) was fast, right?
Actually no. When he looked into it, the robo-traders could get their trades to the exchanges in 476 micro seconds. A micro second is a millionth of a second. So that’s like, 0.000476 seconds.
That’s insane right?
How does time even make sense at that level? It is beyond human comprehension.
But the robots got it. And the robots were using their speed to their advantage.
What they would do is ‘front run’ Brad’s trade.
So when he says, buy 100K WBC and hit go, the robots get in front of his trade. They would withdraw their sell offers and buy up WBC for themselves to sell on to him at a profit.
And so while there’s 100K on offer when he hits his button, by the time the robots have run ahead of him and done their thing, he’s lucky if he gets half of what he wants.
He calls this latency arbitrage – using the time lag between servers to your advantage.
I still find it mind blowing. This is how lots of people make money these days. By getting super fast robots to run ahead of people’s legitimate trades and mess them up.
And I mean a lot. On some days, 75% of trading volume is done by robots.
It gets worse. Brad reckons that stock exchanges don’t make money on helping people execute trades any more. (They actually offer billions of dollars in ‘rebates’)
Rather they make their money by selling super-fast tech and super-fast data to the robot masters.
That is, they are enabling latency arbitrage. They are creating a class of people who have more info than others, and who then use it to their advantage.
Stock exchanges are enabling insider trading.
Just balls-out madness.
Seriously. Why would you?
Until a robot shows up to auction one day, I think I’ll stick to property.