The upsurge of investor interest in high-frequency trading (HFT) important for industry professionals to come up to speed with HFT terminology. A number of HFT terms have their origins in the computer networking/systems industry, which is to be expected given that HFT is based on incredibly fast computer architecture and state-of-the-art software. We briefly discuss below 10 key HFT terms that we believe are essential to gain an understanding of the subject.
KEY TAKEAWAYS
Co-Location Advantage: High-frequency trading (HFT) firms often place their computers close to exchange servers to reduce latency, giving them an edge in accessing stock prices faster than the public. This proximity allows them to exploit small arbitrage opportunities.
Flash Trading Controversy: Flash trading is a debated HFT practice where firms receive access to buy and sell orders milliseconds before this data goes public. This can advantage HFT firms in executing trades ahead of others, often criticized as unfair.
Latency's Role in Profitability: Latency, or the time delay in transaction execution, is critical in HFT. Firms invest in top technology to minimize latency, such as advanced hardware and strategic server locations, to maintain a trading edge.
Liquidity Rebates as a Revenue Stream: Exchanges often offer liquidity rebates to those who add liquidity through limit orders. HFT firms design strategies to maximize these rebates, which, despite being small per transaction, can accumulate large sums.
Predatory Trading Practices: Some HFT firms engage in predatory trading strategies, such as front running and rebate arbitrage, to secure nearly risk-free profits, often at the expense of other investors seeking fair stock prices.
Explaining Co-Location in High-Frequency Trading
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 Michael Lewis explains in his book "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 data center in Mahwah, New Jersey, is almost nine times larger, at 400,000 square feet.1
Michael Lewis. "Flash Boys: A Wall Street Revolt," Page 173. W. W. Norton & Company, 2014.
Understanding Flash Trading Controversies
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.2
Latency: The Race for Speed in HFT
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 to 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 per millisecond, an 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.3
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.
Demystifying Liquidity Rebates in Stock Exchanges
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.
How Matching Engines Drive Exchange Efficiency
The software algorithm that forms the nucleus of an exchange’s trading system and continuously matches 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.
The Tactic of Pinging in High-Frequency Trading
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 a 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.
Maximizing Connectivity: Point of Presence Explained
The point where traders connect to the market 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.”
Identifying Predatory Trading Practices in HFT
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 practices, 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.”4
How Securities Information Processors Work
The technology used to collect quotes 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, it has a finite latency period.5
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.5 The Consolidated Tape Association oversees the SIP for NYSE securities, while the UTP Plan does the same for Nasdaq stocks.67
Navigating Order Flow With 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 a market 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.
Could you be getting more from your CFD trading? Pepperstone gives you the edge with razor-sharp spreads, low commission and deep liquidity. Choose from MT4, MT5, TradingView, cTrader or Pepperstone’s own platform and app, all with super-fast execution and dedicated local support.
