Term of the Day
Co-location: Locating computers owned by HFT firms and proprietary traders in the same premises where an exchange’s computer servers are housed. This enables HFT firms to access stock prices a split second before the rest of the investing public. Co-location has become a lucrative business for exchanges, which charge HFT firms millions of dollars for the privilege of “low latency access.” As Lewis explains in “Flash Boys,” the huge demand for co-location is a major reason why some stock exchanges have expanded their data centers substantially. While the old New York Stock Exchange building occupied 46,000 square feet, the NYSE Euronext data center in Mahwah, New Jersey is almost nine times larger, at 398,000 square feet.
Flash Trading: A type of HFT trading wherein an exchange will “flash” information about buy and sell orders from market participants to HFT firms for a few fractions of a second before the information is made available to the public. Flash trading is controversial because HFT firms can use this information edge to trade ahead of pending orders, which can be construed as front running. U.S. Senator Charles Schumer had urged the Securities and Exchange Commission in July 2009 to ban flash trading, saying that it created a two-tiered system where a privileged group received preferential treatment, while retail and institutional investors were put at an unfair disadvantage and deprived of a fair price for their transactions.
Latency: The time that elapses from the moment a signal is sent to its receipt. Since lower latency equals faster speed, high-frequency traders spend heavily to obtain the fastest computer hardware, software and data lines so as execute orders as speedily as possible and gain a competitive edge in trading. The biggest determinant of latency is the distance that the signal has to travel, or the length of the physical cable (usually fiber-optic) that carries data from one point to another. Since light in a vacuum travels at 186,000 miles per second or 186 miles a millisecond, a HFT firm with its servers co-located right within an exchange would have a much lower latency – and hence a trading edge – than a rival firm located miles away. Interestingly, an exchange’s co-location clients receive the same amount of cable length regardless of where they are located within the exchange premises, so as to ensure that they have the same latency.
Liquidity Rebates: Most exchanges have adopted a “maker-taker model” for subsidizing the provision of stock liquidity. In this model, investors and traders who put in limit orders typically receive a small rebate from the exchange upon execution of their orders because they are regarded as having contributed to liquidity in the stock, i.e. they are liquidity “makers.” Conversely, those who put in market orders are regarded as “takers” of liquidity and are charged a modest fee by the exchange for their orders. While the rebates are typically fractions of a cent per share, they can add up to significant amounts over the millions of shares traded daily by high-frequency traders. Many HFT firms employ trading strategies specifically designed to capture as much of the liquidity rebates as possible.
Matching engine: The software algorithm that forms the nucleus of an exchange’s trading system, continuously matching buy and sell orders, a function previously performed by specialists on the trading floor. Since the matching engine matches buyers and sellers for all stocks, it is of vital importance for ensuring the smooth functioning of an exchange. The matching engine resides in the exchange’s computers, and is the primary reason why HFT firms try to be in as close proximity to the exchange servers as they possibly can.
Pinging: Refers to the tactic of entering small marketable orders – usually for 100 shares – in order to learn about large hidden orders in dark pools or exchanges. While you can think of pinging as being analogous to a ship or submarine sending out sonar signals to detect upcoming obstructions or enemy vessels, in the HFT context, pinging is used to find hidden “prey.” Here’s how – buy-side firms use algorithmic trading systems to break up large orders into much smaller ones and feed them steadily into the market so as to reduce the market impact of large orders. In order to detect the presence of such large orders, HFT firms place bids and offers in 100-share lots for every listed stock. Once a firm gets a “ping” (i.e. the HFT’s small order is executed) or series of pings that alerts the HFT to the presence of a large buy-side order, it may engage in a predatory trading activity that ensures it a nearly risk-free profit at the expense of the buy-sider, who will end up receiving an unfavorable price for its large order. Pinging has been likened to “baiting” by some influential market players, since its sole purpose is to lure institutions with large orders to reveal their hand.
Point of Presence: The point at which traders connect to an exchange. In order to reduce latency, the goal of HFT firms is to get as close to the point of presence as possible. Also see “Co-location.”
Predatory trading: Trading practices employed by some high-frequency traders to make nearly risk-free profits at the expense of investors. In Lewis’ book, the IEX exchange, which seeks to combat some of the shadier HFT pratcices, identifies three activities that constitute predatory trading:
“Slow market arbitrage” or “latency arbitrage,” in which a high-frequency trader arbitrages minute price differences of stocks between various exchanges.
“Electronic front running,” which involves a HFT firm racing ahead of a large client order on an exchange, scooping up all the shares on offer at various other exchanges (if it is a buy order) or hitting all the bids (if it is a sell order), and then turning around and selling them to (or buying them from) the client and pocketing the difference.
“Rebate arbitrage” involves HFT activity that attempts to capture liquidity rebates offered by exchanges without really contributing to liquidity. Also see “Liquidity Rebates.”
Securities Information Processor (SIP): The technology used to collect quote and trade data from different exchanges, collate and consolidate that data, and continuously disseminate real-time price quotes and trades for all stocks. The SIP calculates the National Best Bid and Offer (NBBO) for all stocks, but because of the sheer volume of data it has to handle, has a finite latency period. A SIP’s latency in calculating the NBBO is generally higher than that of HFT firms (because of the latter’s faster computers and co-location), and it is this difference in latency – estimated by Lewis to occasionally reach as much as 25 milliseconds – that is at the core of predatory HFT activity. While Nasdaq OMX Group and NYSE Euronext each run a SIP on behalf of the 13 exchanges in the U.S., Nasdaq OMX terminated its SIP contract in January 2014 and may only operate the SIP for two more years.
Smart Routers: Technology that determines to which exchanges orders or trades are sent. Smart routers can be programmed to send out pieces of large orders (after they are broken up by a trading algorithm) so as to get cost-effective trade execution. A smart router like a sequential cost-effective router may direct an order to a dark pool and then to an exchange (if it is not executed in the former), or to an exchange where it is more likely to receive a liquidity rebate.
The Bottom Line
HFT has been making waves and ruffling feathers (to use a mixed metaphor) in recent years. But regardless of your opinion about high-frequency trading, familiarizing yourself with these HFT terms should enable you to improve your understanding of this controversial topic.
‘Lady Macbeth Strategy’
A corporate-takeover strategy with which a third party poses as a white knight to gain trust, but then turns around and joins with unfriendly bidders.
A theory of macroeconomic money-supply growth first postulated by Nobel Prize-winning economist Milton Friedman. The theory states that the best way to control inflation over the long term is to have central banking authorities automatically grow the money supply by a set amount (the “k” variable) each year, regardless of the cyclical state of the economy.
The k-percent rule proposes to set the growth variable at a rate equal to the growth of real GDP each year. This would typically be in the range of 2-4%, based on averages seen in the United States.
‘Jointly and Severally’
1. A legal term describing a partnership in which individual decisions are bound to all parties involved and thus undivided.
2. A term used in underwriting syndicates to refer to the distinct responsibility of individual companies to sell a certain portion of unsold new issue.
The term Icarus factor describes a situation where managers or executives initiate an overly ambitious project which then fails. Fueled by excitement for the project, the executives are unable to reign in their misguided enthusiasm before it is too late to avoid the failure.
A bearish candlestick pattern that forms at the end of an uptrend. It is created when there is a significant sell-off near the market open, but buyers are able to push this stock back up so that it closes at or near the opening price. Generally the large sell-off is seen as an early indication that the bulls (buyers) are losing control and demand for the asset is waning.
‘Gaming Industry ETF’
A sector exchange-traded fund that invests solely in gaming companies, so as to generate investment returns that correspond to those of an underlying gaming index. A gaming ETF consists of a wide range of stocks, from casino operators and manufacturers of gaming systems to companies that accept bets on sporting events. A gaming ETF may be vulnerable to economic downturns.
Debtor: A person who takes some money on loan from another person.
Demand Deposits: Deposits which are withdrawn on demand by customers. E.g. savings bank and current account deposits.
Demat Account: Demat Account concept has revolutionized the capital market of India. When a depository company takes paper shares from an investor and converts them in electronic form through the concerned company, it is called Dematerialization of Shares. These converted Share Certificates in Electronic form are kept in a Demat Account by the Depository Company, like a bank keeps money in a deposit account. Investor can withdraw the shares or purchase more shares through this Demat Account.
Dishonor of Cheque: Non-payment of a cheque by the paying banker with a return memo giving reasons for the non-payment.
Debit Card: A plastic card issued by banks to customers to withdraw money electronically from their accounts. When you purchase things on the basis of Debit Card the amount due is debited immediately to the account. Many banks issue Debit-Cum-ATM Cards.