Investing

What If Speed Traders Competed on Price?


What If Speed Traders Competed on Price?

Photograph by Mario Tama/Getty Images

In high-frequency trading, speed means everything. With most firms using sophisticated trading algorithms to scour the stock market for tiny price differentials, the trick isn’t so much spotting the profit opportunity, but getting there first. Which is why HFT firms put so much effort (and money) to upgrading their computers while paying steep fees to locate their servers next to those of the exchanges. There’s even a rush to spend millions improving the world’s fiber-optic cables so HFTs can shave a few milliseconds off execution times—reducing “latency,” in industry parlance.

Some see this arms race in speed as a waste of time, money, and talent. If everyone’s continually getting faster, the relative speeds stay the same, but costs continue to rise. One former high-frequency trader has a proposal to slow things down. Chris Stucchio, a math PhD who spent a few years working at a New Jersey high-frequency trading firm, argues that if stocks were allowed to be priced in increments below one penny, HFT firms would have to compete not just on speed, but on price as well.

The Securities and Exchange Commission requires stocks to be priced in 1¢ increments, a rule that reduces the ability of trading firms to compete on price. As Stucchio sees it, if stocks could be priced in sub-penny increments—say, half a cent—then HFT firms would be forced to compete on two fronts, not just one. In theory, firms that offer better prices would be rewarded, not just the ones claiming the trade a micro-second faster than everyone else.

According to Stucchio, the benefits would be two-fold: “Trading for retail investors would be cheaper and the profits of high-frequency trading firms would be reduced,” he says. Making high-frequency trading less profitable would be a good thing, Stucchio believes, because it would encourage a bunch of smart people to leave the industry and do something of greater social use. Like making the Internet itself a whole lot faster.

It’s an interesting theory. But Ben Van Vliet, a professor at Illinois Institute of Technology and an expert on high-frequency trading, believes sub-penny pricing would put an even greater premium on speed. When the SEC reduced the pricing increments—or spreads—from 12.5¢ to a penny in 2000, speed became more important, he says, adding, “I don’t see why it would be any different this time around.”

Whether we like it or not, speed is now part of the market. HFTs need it to make their operations profitable. And the exchanges have come to count on the constant flow of high-frequency trades to create the liquidity that allows markets to function smoothly. Reducing the role of HFTs would probably require a complete overhaul in how the markets operate. Still, Van Vliet has a suggestion for how to pull back on the speed arms race: “Go back to dollar spreads and guys in funny colored coats on the exchange floor.”

Philips_190
Philips is an associate editor for Bloomberg Businessweek in Washington. Follow him on Twitter @matthewaphilips.

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