Until now it was difficult to quantify what financial impact high-frequency traders impose on regular investors. On Monday, a study by the United Kingdom’s financial regulatory body, the Financial Conduct Authority, found regular investors worldwide lost $5 billion at the expense of traders with sophisticated trading technologies and algorithms.
How It Is Possible
High-frequency traders, or HFT for short, often have access to microwave antennas or a server co-located with a stock exchange and backed by sophisticated software. This gives them the ability to execute an order in a millionth of a second. While this may not seem like much, it beats out the vast majority of individual investors and creates a “latency arbitrage tax.”
The market works on a first-come-first-serve-basis. Obviously, an HFT with sophisticated technology can make sure their order arrives at the exchange ahead of regular investors. This can be used to generate an advantage as HFT traders can grab shares at a better price and immediately flip it back to ordinary investors for a very small profit.
Once multiplied hundreds if not thousands of times a day, each day, the fractional gains add up to the billions. This creates a form of a “tax” ordinary investors have to pay although these types of trades account for just 0.0042% of total daily stock-trading volume.
Is This Fair?
The New York Stock Exchange helped HFT traders generate $1 billion worth of profits while the other two major U.S. exchanges added another $1.77 billion, according to the study. Some of the global exchanges listed include China’s Shenzhen Stock Exchange, the Korea Exchange, Deutsche Borse, and the National Stock Exchange of India.
This creates a bit of a moral conundrum that market owners worldwide may need to address. On one hand, a very small group of people legally make use of expensive and sophisticated technologies to gain an advantage against others who willingly participate in the market.
But on the other hand, others would argue the system is flawed and the only fair way to operate a market is to eliminate any and all possibilities of gaining an advantage.
“The latency arbitrage tax does seem small enough that ordinary households need not worry about it in the context of their retirement and savings decisions,” the authors wrote. “Yet at the same time, flawed market design significantly increases the trading costs of large investors, and generates billions of dollars a year in profits for a small number of HFT firms and other parties in the speed race, who then have significant incentive to preserve the status quo.”