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On May 6th, 2010, in the space of one-half hour, the Dow Jones Industrial Average (DJIA) dropped almost 1000 points. Two DJIA component stocks, Procter & Gamble and 3M, lost over 30% of their value in 15 minutes, while shares of Accenture went from $40 to a penny before recovering. What happened? Several theories were promulgated, from the “fat finger” trader error to “multiple erroneous trades.” The common denominator? Advanced technology: computerized, high-frequency trading (HFT) that allows for the buying and selling of millions of shares in a matter of milliseconds. Completely automated trades made by super-computers, absent human interaction.
Computerized trading has been around for forty years. In 1971, NASDAQ became the first electronic stock market, allowing dealers to offer price quotes for securities. In 1976, the New York Stock Exchange (NYSE) initiated the use of its “designated order turnaround” system (DOT), which facilitated the routing of buy and sell orders previously handled by buyers and sellers standing next to each other on the exchange floor. In the 1980s, markets become fully electronic, and a new strategy called “program trading” was instituted. Program trading is defined as “any trade involving fifteen or more stocks with an aggregate value in excess of $1 million,” and many people are convinced that it was the principal culprit or a substantial contributor to the October 1987 crash, where the market lost 22.6 percent of its value in one day.
In the ’90s, electronic communications networks (ECNs) emerged, allowing traders to conduct business outside the boundaries of traditional exchanges and traditional business hours. This was made possible when the Securities and Exchange Commission (SEC) approved a regulatory framework for “alternative trading systems” due to the “important role of technology, and the increasing competition, in today’s securities markets.” ECNs spawned the growth of computer systems which use algorithms to facilitate trading.
In 2001, algorithm trading was further buttressed when markets began quoting stock prices in decimals instead of fractions. Thus the minimum size of a stock price went from 6.25 cents (one sixteenth of a dollar) to a penny, leading to increased liquidity. Finally in 2005, the SEC enacted a series of rules called the “Regulation National Market System,” which facilitated the emergence of high frequency trading. High frequency trading may now account for as much as 60-70 percent of the volume on major U.S. stock exchanges. Some speculate it may be even higher than that.
“This is where all the money is getting made,” said former chairman and chief executive of the New York Stock Exchange William H. Donaldson back in 2009. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.” Joseph M. Mecane of NYSE Euronext offered a vivid assessment of reality. “It’s become a technological arms race, and what separates winners and losers is how fast they can move,” he said.
Speed is indeed the name of the game. A two-tenths of a second advantage can be the difference between success and failure, allowing traders to buy or sell millions of shares, milliseconds ahead of the pack. The profit or loss on each trade may amount to tenths of pennies, but when those trades number in the millions over the course of a single trading day, tens of million of dollars can be won or lost.
Speed is so critical that a 40,000 sq.ft. facility in Mahwah, New Jersey — a location chosen due to its proximity to Wall Street, but away from nuclear power plants, geological fault lines and flight paths — was constructed so trading firms could “co-locate” their super-computers next to those of the trading exchanges in order to gain microseconds worth of speed over their competitors. “We’re getting down to, you know, ‘How fast can the electrons travel at this point?’” said Larry Leibowitz, chief operating officer of the New York Stock Exchange, who has spent time promoting Mahwah to NYSE clients. And then there’s the advancement of computer technology itself. Vendors such as Hardcore Computer and Supermicro® UK, sell “submersion cooling technology,” which enables them to “over-clock CPUs,” allowing those processors to run faster, cooler and longer.
HFT has its proponents and detractors. Proponents believe HFT adds liquidity to the market and lowers the spread between the bid and ask prices. “High frequency trading has introduced a massive amount of competition, and competition is the only mechanism that can and will keep it honest,” contends Eric Falkenstein, former portfolio manager and author of Finding Alpha (2009). “All it takes is ten smart people competing with each other to whittle profits almost down to nothing, all the while increasing the depth and lowering the spread to retail investors.”
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