Two years have passed since the Federal Reserve Bank of Chicago asked the SEC to look into the dangers of HFT (high frequency trading).

The SEC, so far appears to have been studiously avoiding the whole issue.

As is well known by now, the SEC has good reason to avoid looking too closely at the behavior of the W$ MOTU because they are invariably involved in doing things that if done by you or I are considered illegal.

In particular, the SEC expressly forbids front-running, trading on information that is not available to the public and thus Traders are forbidden to trade ahead of their un-informed customers.

In order to insure a fair market, traders are forbidden to trade on inside information, they are expected to trade on market information available to the public, which in practice would mean watching the news coming out of stock exchanges and making decisions on trades that have already been transacted, and are thus considered public knowledge.

Proponents of high frequency trading would have us believe that they are simply analyzing the news faster than the rest of us and that our only disadvantage in the market is our slower ability to understand what’s going on, and to react in such a way as to profit from that understanding.

They also encourage us to believe that the advantages of HFT mostly involve a very special species of programmed trading, whose essential features are complicated computer programs that analyze data from trading as it happens, and execute tactically advantageous, and complicated trading strategies based on that analysis.

This far from a complete picture, this is also far from the truth.

IOW, this is a lie.

Rather than analyze market data as completed transactions are reported, high frequency trading firms leverage their direct access to the exchanges OMSs (Order Management Systems) to analyze the whole stream of orders as they are coming in to the exchange, this is possible because exchanges allow certain investors access to a system called DMA (Direct Market Access) which gives them a ‘window’ into the OMS itself, which, coupled with the HFTs’ high-speed analysis and direct access to the execution desk, a sort of ‘fast track’, effectively allows them to front-run the market.

A slight digression;

Just so I don’t get deluged by remarks by my more informed readers, I have to add that because exchanges are more and more allowing HFT firms to co-locate their servers in extreme proximity to the servers that house the exchanges OMS, the HFT can achieve what they call ULLDMA (Ultra-Low-Latency Direct Market Access) which makes their communication so fast they can figuratively turn off the lights and be in bed before the room is dark.

Now some people are going to say that this sort of thing has always happened, and they would be correct, up to a point, but what HFT systems allow traders, is an almost absolute ability to front run the market by virtue of the fact that their computer systems have replaced the human relationships that underpin the traditional vectors of insider trading.

HFT technology creates the virtual effect of slowing down the stream of incoming customer trade instructions to the point where they can be analyzed wholesale, all of this before the ‘normal’, retail investors transactions are completed.

The effect, at street level, is that no matter what electronic platform that cute TV-baby investor subscribes to, and no matter how well informed he, and his friends are, he is trading blind and in slow-motion in comparison to HFT firms.

There are even more complicated systems imbedded in the HFTs bag of tricks, some of them are the ability to confirm the efficacy, and assess the risks of their system-generated trading strategies by automatically backtesting them just prior to executing their trades, against historical trading data housed within their systems’ data bases.

With the information gleaned from this analysis, they can make trading decisions, backtest, and execute them via their own direct access to the execution desk, all of this happening while the ‘retail’ customers orders are still awaiting execution back in the slower-moving OMS.

To help you see how all this works, I want you to understand a couple of very helpful analogies that illustrate the practical effects of the technologies involved in high-frequency trading.
The first analogy involves the way that computers communicate in order to make trading work, in particular how orders for stock trades are communicated from the customer to the exchange where the trades are actually executed.

1. The Railroad analogy;

Computer communication over the internet is accomplished by dividing the message you wish to send into IP packets, which can be thought of as individual rail cars which are then put together to form a train, the complete train being understood as the whole message you wish to send to another computer, say a computer at an exchange where you have an account that allows you to trade stocks.

One of the important details that you must understand, is that the IP packets that make up your trade request are not sent grouped together like the real train, they are split up by the function of the internet, and when they are all received at the other end, ‘the train’ is re-assembled and your message/ trade instructions are sent to the OMS server that executes the trade you requested.

I’m not going to go into the technical description of how the ‘train’ is disassembled when it leaves your computer and re-assembled when it arrives at the exchange other than to say this work is accomplished by thousands of routers, one at your end of the trip, on your network at home or at your employer, thousands in the fabric of the internet, and ultimately one or more on your broker’s network, where the OMS server lives that executes your trade request.

It is sufficient to say that each packet in your trade message contains the IP address it came from and the IP address it is being sent to and the routers get all the packets to the right place in any which way they can.

So when you send your trade instructions to your broker, it is in the form of a bunch of IP packets, analogous to a train whose cars are split up and ‘routed’ individually to your broker’s network where they are reassembled as they arrive, passed on to servers where your trade instruction ‘train’ enters the OMS to be executed.

Now we’re ready to consider the second analogy;

2. The Bullet Time effect;

We’re all familiar with the Bullet Time effect, it received its’ name because of its use in movies like The Matrix;

Our hero is attacked by gunmen who fire hundreds of bullets which suddenly slow down and remain seemingly motionless, floating in space leaving our hero unscathed.

Within this ‘reality’, our hero remains able to move normally, he could, for instance reach out and gather the bullets and examine them minutely, and toss them aside as harmless if he wanted.

We sometimes see the same sort of time-warping effect employed in hand-to-hand movie combat, where our hero finds himself attacked by numerous villains, whom he manages to defeat by supposedly warping time in such a way as to slow them all down to the point where he has the advantage.

Now I want you to consider the possibilities that this skill would present if it actually existed outside the movies.

What if a pick-pocket could stop all movement on the street long enough to pick everybody’s pockets for instance?

The HFT systems employed by trading houses allow them to create a virtual environment where they can leverage the speed differential between the OMS employed by the exchanges to control trading by retail investors, and the HFTs much faster systems, to slow down the ‘normally’ confusing light-speed flow of information in order to permit rather detailed analysis, and base their own trading upon that analysis rather than guesses born out of the relative confusion that passes for ‘news’.

Let’s put these analogies together so we can understand the reality surrounding HFT.

I’m going to show you a virtual rail yard that includes the exchanges’ routers, and OMS servers, where you can imagine all the incoming IP packets (rail cars), are coming into the exchange and being assembled into stock transaction requests, (trains) before being sent into the OMS server for execution.

It is at this point in the system, that the exchanges allow the HFTs (HFTraders) access to their OMS (Order Management System), via what is known as DMA (Direct Market Access) and the HFTs use their own super fast computers to create the Bullet-Time effect in their own virtual copy of the yard where the trains are pulled off the main line, and parked on side tracks.

The time-warp effect is employed by HFTs to allow inspection of all the trade instruction ‘trains’ contents minutely, that is, open up and analyze every trade request.

All of this happening while the ‘real’ transaction ‘train’ is virtually motionless back in the OMS of the exchange.

Now comes the good part.

The HFTs systems employ this ultra-highspeed analysis to generate trading strategies, that of course include passing all the trains it has ‘stopped’ with its’ time-warp machine, with its’ own transaction trains containing trade instructions based on the information it found in the transaction trains belonging to ‘retail’ investors.

The railroad analogy explains the basis of the technique that allows for high-speed analysis that HFT affords, and the Bullet Speed analogy explains the effect of the resulting time manipulation so the average person can grasp the obvious possibility of abuse.

It is the fact that the HFTs’ rail yard exists in virtual time, prior to the trains reaching their destination, that is; trade execution, that should make it illegal.

All of the retail investors’ orders are presumably based on information that is public knowledge, however, the trading done on the part of the HFTs who have analyzed the contents of all the exchanges’ retail investors trade instructions prior to execution is based on ‘inside information’ by definition.

The brokers encourage us to think that their HFT systems are based on news analysis, that is, after-the-fact analysis of trades already executed, whereas they are actually cheating us by analyzing trades that are not-yet-executed/reported.

They’ve created a time-warping machine, a virtual environment where they observe trading before it occurs to give themselves an incredible advantage. It’s as if they created a virtual world where they have ESP, and the rest of us are dull-witted, a world where they profit from fore-knowledge, and they think we’re too stupid to figure it out.

So, you might ask, how do I know this is true?

I know it’s true because the guys who design and build the systems’ software have explained its effect;

From Rueters;

Andrew Van Hise managing director at SEQA Capital that designs algorithmic trading programs for hedge funds has described the operation, and impact of these systems like this;

“By the time a standard retail or institutional order reaches an exchange, it’s been looked at in essence by a number of algorithms which have cherry picked it,” said Van Hise. “What finds its way to the traditional exchanges is viewed by market participants as exhaust.”

And, the guys at the SEC understand, but, as usual can’t be bothered to care;

Also from Rueters;

Gregg Berman, who is one of the SEC’s leading experts on stock market structure, said regulators found most of the complaints from the public and money managers about high-frequency trading to be anecdotal.

“I’ve heard many suggestions for how we might slow down the markets. But I think some ideas have ignored the fact that we have markets in which investors demand the ability to trade on an immediate and continuous basis, not at discrete intervals,” said Berman.

He continued: “It’s like saying ‘let’s use the rules of train travel, in which every train is on a specific track, to try to dictate how cars should behave, even though cars can drive between the lanes and on the shoulder.’“

W4B;

Mr. Berman is telling us that as far as he knows, what the HFT firms are doing is not against the law.

Mr. Berman says it’s all just anecdotes, but his use of the train analogy suggests he understands more than he lets on.

There’s also a lot of evidence that retail investors agree with my analysis, they have withdrawn hundreds of $billions from the stock market since 2008, confirmation they think the game is rigged.

Now think about this;

By some estimates, 84% of all equity trading is the product of HFT;

From the Financial Times.

“The proportion of US trading activity represented by buy and sell orders from mutual funds, hedge funds, pensions and brokerages, referred to as “real money” or institutional investors, accounted for just 16 per cent of total market volume in the form of buying, and 13 per cent via selling in the final quarter of last year, according to analysis by Morgan Stanley’s Quantitative and Derivative Strategies group.”

Between the specters of flash-crashes rooted in botched programmed trading, and wholesale front-running rooted in HFT, we can start to understand why we have a market that behaves as if it was the exclusive domain of HFT houses and institutional investors.

So next time that baby in the TV add starts acting all superior and suggests you use his trading software, ask him how it feels to be such a rube?