Advantage goes to high speed traders
Mark Twain once wrote a story about a man who caught a shark in Sydney Harbour.
The shark was an unusually large one, and after disemboweling it the man found the remains of a German, along with a 10-day-old copy of the London Times.
It was 1870, when the event supposedly happened, and it usually took 50 days for the fastest ship to deliver news from England, so 10-day-old news could confer a neat advantage on whoever had the means to exploit it.
Luckily for the man, this edition of the Times brought news that France had declared war against Germany, and that as a consequence the price of wool had risen 14 per cent in London "and was still rising".
(It's reasoned that the German must have been swallowed along with the paper in the Thames before the shark swam to Australia).
So the man took the paper to the richest wool broker in Sydney and convinced him to stump up £100,000 to buy the entire wool crop of the colony, to be deliverable in 60 days. When news of the war finally arrived by boat both men made a pretty fortune.
Twain reckoned it was the first time that this story of the shark had been published anywhere, so you can be sure he made it up.
But it does carry a useful economic lesson. It provides an example of what economists call an "adverse selection" problem - when uninformed traders (the wool growers) suffer at the hands of informed traders (the man and the wool broker).
Traditionally, being "informed" meant that one had a better informed view than others about the direction of economic fundamentals such as interest rates, profits, or commodity prices. And in developed economies, cultures of regulation and oversight have been put in place to prevent such imbalances in information.
But global sharemarkets have recently begun to witness a new form of adverse selection, and it is a consequence of the growth of high-frequency trading.
In a speech entitled "The Race to Zero," the Bank of England's Andy Haldane drew attention to this in mid-2011. Given the publicity that high-frequency traders (HFTs) have received in the past 12 months, it is worth a re-read.
Haldane explained at the time that since advances in computing power had shifted the frontier of electronic and algorithmic trading, being "informed" now had more to do with speed than being smart.
That's why HFT firms, and big investment banks such as UBS, pay a premium to sit their servers as close as possible to the trade-matching engine of a stock exchange (a practice called "co-location").
When your trading advantage comes from being able to execute trades faster than your rivals, and when your speed is increased by limiting your physical distance from the matching engine, it pays to sit as close as possible - even if that distance is measured in millimetres.
That's why the Australian Securities Exchange rents out "co-location facilities" in its new data centre at Gore Hill, and why the distance between those facilities and its matching engine is strictly measured to ensure no firm's server is closer than its rivals'.
But it is a controversial practice. Some traders say that, given the speeds with which HFTs operate, co-location facilities allow HFTs to see and act on market prices before anyone else, so by the time their low frequency rivals make a trade they're "stock-picking based on yesterday's prices", as Haldane put it.
It is that practice that is breeding the new kind of adverse selection.
UBS's co-head of equities, Gary Head, said in October the practice was no different from the time when traders used to rent a booth closer to the chalkboard on the trading floors of the old stock exchanges.
"You paid a premium for that so you could yell out your orders and execute quicker than the guy four booths back. It's exactly the same thing. So it's really consistent with the way markets have always operated," he said.
But I'm not sure the analogy holds. It assumes that every trader on the floor has the same information and that the advantage goes simply to the trader who can act on it first. Fine.
But the difference today is that in a world where trading times can be divided into nanoseconds (billionths of a second), HFTs can both read and respond to market prices before anyone else, and that means they're able to make their trades before those prices have even been seen by their rivals.
For his part, Head said he could see both sides of the story.
"Now we've got technology - we don't have booths and blackboards - there's no reason for anyone to have an advantage. That's actually something which we can now eliminate, so why haven't we?" he asked.
But it is a competitive world, and UBS still uses the ASX's co-location facilities to execute orders for some of its clients. Head said the investment bank pays money to do that, but he can see why it places others at a disadvantage.
"For other brokers that can't afford to do that, then they're at a disadvantage for their client orders. And then you come down to the same old argument about the blackboard and the booths," he said.
It's a contradiction that ought to be settled.
Ross Gittins is on leave