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WTF Is HFT? What You Should Know About High-Frequency Trading

If you've scratched your head this week about all the talk around high-frequency trading, you're not alone.

High-frequency trading, a practice that has become increasingly common in recent years, has gained more mainstream attention thanks in large part to Michael Lewis, the author of popular books like Moneyball and The Big Short. His new book, released Monday, is called Flash Boys and takes a critical look at the risks of high-speed trading. It has already sparked some heated debates, as you can see in the incredible CNBC video below.

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At the same time, the FBI recently confirmed that it is looking into the practice of high-speed trading to determine whether traders are breaking the law by having access to non-public information.

To help explain what high-frequency trading is, how we got to this point and why the government is taking notice, we reached out to Charles Jones, a finance professor at Columbia Business School. Here is a lightly edited transcript of that conversation.

Mashable: First things first: Can you give us a brief explainer on how high-frequency trading works?

Jones: It's a computer program that is programmed to trade in and out of stocks pretty quickly, with holding periods measured usually in seconds to minutes, rather than in days and weeks. These guys are doing a couple of different things: They are the new market makers. They are willing to buy and hold onto the shares for a few minutes until they can find another buyer who wants to hold it longer term. They are also often trading on small imperfections where prices aren't exactly the same in two markets.

So how did we get to this point where we can speed up and automate trades?

We've been transitioning from manual markets with trading floors and people to automated markets where it's basically a computer server somewhere in suburban New Jersey. That process has been going on for really the last 10-15 years. More or less, the computers won, and when the computers won, everybody had to revamp all their processes to deal with the new ecosystem.

So that's why the high-frequency trading program has replaced the floor trader on the floor of the stock exchange. An algorithm for a pension fund for it to place its orders has replaced a broker who would spend all day to slowly buy 100,000 shares.

Who are the big players here? Would the average person even recognize the names?

All the exchanges have embraced it. The real changing of the guard here is that it used to be dominated by large Wall Street firms and their trading desks. They have been supplanted by these newer companies that are more technology companies than they are Wall Street companies. The players now are mostly names that people have never heard of: Companies like Getco, companies like Citadel [Group], companies like Tradeworx. These are typically small technology shops that have very fast hardware and good code.

What is the strongest case in favor of the practice of high-speed trading?

If we replace a lot of humans with computer code, we are going to be able to do that cheaper. It's wringing costs out of the system, and when you wring costs out of the system you can basically provide the same services to investors at lower costs... The pro case, especially if you are a retail trader, is you are actually a lot better off now because these guys are able to provide liquidity at lower cost. You will never pay more than a penny extra a share in markup. Now commissions are $7.95, or some number like that, for any size trade. The technology squeezes the cost out and the competition squeezes the profit out and the investor benefits.

And what is the case against it?

The con case is really that it's possible the markets are more fragile than they were before — that because it's all computers talking to each other and the quality control isn't always there, we are prone to maybe more breakdowns than before. There have been a few high-profile examples of that.

The FBI is currently looking into high-frequency trading. The SEC had previously proposed regulations. What's going on here?

I think it's clear that HFT has a serious perception problem even if perception is worse than the reality. So I think these guys are responding to that. Given the outcry and worry by some investors, it probably makes sense to look more closely and make sure there isn't any there there.

The new Michael Lewis book has certainly helped propel the issue more into the mainstream. What, if anything, do you expect will come from that?

I think what it means is this is elevating the discussion. It will elevate the importance of these policy issues. The SEC might not have been too keen to have looked at the overall U.S. market structure, but you can be damn sure they are going to now... My guess is that that's going to happen before 2014 is out.

Topics: Business, stocks

সোর্স: http://mashable.com

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