Financial marketsHow are Quants Ruling the World?

Kennnedy MuturiDecember 6, 20218113 min
source: freepick.com
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Since buy and sell orders do not appear in the market simultaneously, traders who buy from the seller and sell to the buyer act as a middleman. Assume you wish to purchase a significant amount of stock XYZ, such as 10,000 shares. You place a buy order with your broker, who then attempts to fulfil it by purchasing shares on the stock exchanges. The transaction is if a seller has 10,000 shares to sell. The seller sells, the buyer buys, and the buyer’s and seller’s brokers receive their commissions. If only smaller lots are available across many exchanges, the broker will purchase these smaller lots to fulfil his customer’s order for 100,000 shares.

What if your broker tried to purchase shares of XYZ stock that looked to be available for purchase on one exchange, but the share lots unexpectedly vanished when he submitted his purchase offer? The duplicate share lots then surfaced on a different exchange—at a more excellent price? What if this happened on a regular basis, making the stock market your broker observed and the “real” market—what you could buy—two different stock markets?

source:freepick.com

This situation is known as “front-running,” in which high-frequency traders pay public and private exchanges for access to their incoming orders. When high-frequency traders noticed the order on one of the exchanges, they rushed to acquire all of the stock that was available elsewhere, then offered to sell the shares they’d bought at a higher price. If you learn about the orders ahead of time, you can use them to your advantage. High-frequency traders operate in this manner.

Here’s an example explaining how high-frequency trading works: Let’s say you want to buy tickets for a show with a large group of pals, so you call the ticket vendor. The ticket seller then contacts a scalper, informing him that you and your friends are looking to purchase many concert tickets. The scalper orders the tickets at the current price but does not pay for them. The scalper then resells your tickets for a higher price, pays the ticket seller for the tickets he ordered, and keeps the difference. Because he has the sellers in hand, the scalper never needs to worry about having tickets he can’t sell. He never has to worry about ticket prices rising since he buys them before anyone notices that demand (and thus the price) is increasing.

That’s how high-frequency trading works, except that the buying and selling stocks happens in microseconds. The name of the game is speed: the faster your trading algorithms are, the easier it is to take advantage of the slight time difference between when an order is made and when it is filled. It entails being faster than the competition. High-frequency traders pay to have their servers located as close as possible to stock exchanges. The speed at which electronic impulses move across cables is the only physical constraint. A microsecond advantage can mean billions of dollars in annual revenue. As a result, the closer a trader is to the exchange, the more significant his speed advantage. And therefore high-frequency traders spend to have their systems installed inside or as close to the exchanges as possible.

In another way, a high-frequency trader sees a market that a typical investor does not: They have access to stock orders just a fraction of a second before they are filled, and they use this information to profit from the trade. They also participate in “spoofing,” which involves placing anonymous bids and then withdrawing them in a matter of seconds to temporarily raise a stock’s price, entice others to buy it, and then sell at a more significant profit. They pay Wall Street banks for access to their internal “dark pools,” which allow them to see stock orders and profit from inside knowledge. To put it another way, they paid Wall Street banks for the privilege of exploiting their clients.

It might surprise you to learn that “front running” or “trading ahead of the market” is entirely allowed.

Financial services executive Brad Katsuyama relates a meeting with Securities and Exchange Commission agents in Michael Lewis’ book ‘Flash Boys’. They discussed a system he devised to route buy and sell orders such that they arrived at the exchanges at the same time. What happened was eerily Kafka-like: Some SEC workers contended that Katsuyama’s actions were unjust because they stopped high-frequency traders from using false bids and offers on exchanges to acquire data from precise investors without having to stand by them. Forcing these traders to honor their bids and offers, they said, was unjust. Others on the SEC staff disagreed, claiming that if these traders don’t intend to honor their offers, they shouldn’t be there at all. At the meeting, nothing was decided. However, since 2007, more than 200 SEC employees have departed to work for high-frequency trading businesses or firms that lobbied Washington on their behalf, according to Michael Lewis.

Brad Katsuyama, a financial services executive, describes a meeting with Securities and Exchange Commission agents to discuss a system he created to route buy and sell orders so that they arrived at the exchanges at the same time in Michael Lewis’ book Flash Boys. What happened was genuinely Kafkaesque: Some SEC workers contended that Kitayama’s actions were unjust because they stopped high-frequency traders from using false bids and offers on exchanges to collect information from real investors without risking having to stand by them. They claimed that forcing these traders to honor their bids and offers was unjust.

Others on the SEC staff disagreed, claiming that if these traders don’t intend to honor their offers, they shouldn’t be there at all. At the meeting, nothing was decided. However, since 2007, more than 200 SEC employees have departed to work for high-frequency trading businesses or firms that lobbied Washington on their behalf, according to Michael Lewis.

There have been two reactions to this possibly fatal issue so far. To begin, Katsuyama established his stock exchange with the primary goal of ensuring that purchase and sell orders arrived simultaneously. The remedy was simple: slow electrical signal transmission by looping cables (similar to winding up a garden hose) so that they had to travel long distances to reach their destinations. They were slowing down the signals took away the advantage that some traders had by being physically closer to the exchange. These tactics, while not illegal, are immoral and, as Katsuyama and others have correctly pointed out, pose a long-term threat to the stock market’s stability.

The other is that, in reaction to the uproar sparked by Lewis’ book Flash Boys, the Securities Exchange Commission, the Financial Industry Regulatory Authority (FINRA), the FBI, and even Congress have initiated investigations into high-frequency trading. The question is whether they will adequately comprehend the need to hire their own “quants” to probe and follow high-frequency traders’ “algobots.” I wouldn’t put my money on a lawyer or a politician knowing what “quants” are.

Money is at the heart of everything we do, and whoever controls the flow of money controls the domestic and global economies. And that is how the world is ruled by “quants.”

Kennnedy Muturi

Ken is a Quantitative Trader with experience in investments, quantitative finance, financial modelling and algorithmic trading in Global Investable Markets (GIM). He enjoys using Bayesian Statistics, Time Series and Machine Learning in developing Robust consistent Alphas in Equities Market, FX, ETPs and Derivatives instruments. He enjoys deep dives in understanding High Frequency Trading infrastructures and improving how the African financial markets work. He holds a Bachelor's in Actuarial Science from Strathmore Institute of Mathematical Sciences : An Executive Program in Algorithmic Trading (EPAT) certificate in Algo Trading from QuantInsti : A current MSc student in Financial Engineering at World Quant University.

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