What sbehind high-frequency trading

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What sbehind high-frequency tradingWhat's Behind High-Frequency Trading

Scott Patterson and

Geoffrey Rogow

Updated Aug. 1, 2009 11:59 p. m. ET

High-frequency trading, long an obscure corner of the market, has leapt into the spotlight this year. Wildly successful in 2008, high-frequency traders are the talk of Wall Street, attracting big bucks and some unwanted attention. Concerns that some traders are taking advantage of less fleet-footed investors has drawn the attention of regulators and members of Congress. The following is an explanation of the core issues, based on interviews with industry participants and regulators.

Q: What is high-frequency trading?

A: Definitions differ, but at its most basic, high-frequency trading implies speed: Using supercomputers, firms make trades in a matter of microseconds, or one-millionth of a second. Goals vary. Some trading firms try to catch fleeting moves in everything from stocks to currencies to commodities. They hunt for signals, such as the movement of interest rates, that indicate which way parts of the market may move in short periods. Some try to find ways to take advantage of subtle quirks in the infrastructure of trading.

Other firms are market makers, providing securities on each side of a buy and sell order. Some firms trade on signals and make markets.

Q: How do players make money in high-frequency trades?

A: Many high-frequency traders collect tiny gains, often measured in pennies, on short-term market gyrations. They hunt for temporary inefficiencies in the market and trade in ways that can make them money before the brief distortions go away.

Market-making, high-frequency firms hope to make money on the difference between how much investors are willing to buy and sell a stock, or the bid-ask spread. They do this by selling and buying on both sides of the trade. Many exchanges offer rebates of about one-third of a penny a share to outfits that are willing to step up and provide shares when needed.

Q: Who are the big players in high frequency?

A: They range from well - to lesser-known firms. Goldman Sachs Group Inc. GS -1.23 % and Chicago hedge fund Citadel Investment Group LLC have high-frequency operations. An innovator in superfast trading strategies is hedge-fund firm Renaissance Technologies LLC.

Privately held Getco LLC, a Chicago high-frequency firm founded in 1999, is a registered market maker with operations in markets around the world. Other high-frequency outfits include firms such as Jane Street Capital LLC, Hudson River Trading LLC, Wolverine Trading LLC and Jump Trading LLC.

Q: Why is everyone talking about high-frequency trading?

A: In the trading community, high-frequency has drawn interest because it was a wildly successful strategy last year. More recently, it made headlines when a former Goldman Sachs employee was charged by federal prosecutors with stealing trade secrets from the firm's high-frequency platform.

Also grabbing attention are the volume numbers. High-frequency trading now accounts for more than half of all stock-trading volume in the U. S. It also generates more revenue for exchanges. NYSE Euronext, owner of the New York Stock Exchange, is building a data center to cater to high-speed traders.

Q: What are flash orders, and what is the controversy surrounding them?

A: Typically on trades, exchanges pay rebates to traders who post shares to buy or sell and charge fees to traders who respond to those offers. This setup creates an incentive to earn rebates. That is one place where flash orders come in.

With a flash order, a trading firm can keep its order on a certain exchange for up to half a second without matching an existing buy or sell order on another exchange, a move that puts it in a position of poster, rather than responder. The hope is that another trader who needs to buy or sell quickly steps in on the other side of the trade. This dynamic boosts the chance the flash-order trader will complete the trade on the exchange and get the rebate. Exchanges offer flash orders to keep market share.

Regulators worry that certain unscrupulous participants in the market with ultrafast computer technology could game these orders, trading ahead of them and affecting the price of the security.

Q: Who will be hurt if flash orders are banned?

A: A ban on flash orders, under consideration by the Securities and Exchange Commission, could hurt the profits of high-frequency traders who use flash extensively. Some flash-order advocates said a ban could cause trading volume to drop on the exchanges as traders look for better execution in alternative, less-transparent venues.

Q: What is naked access, and why the controversy around it?

A: Many brokers allow high-frequency outfits to trade directly on an exchange using a broker's computer-access code. Most brokers closely monitor the activity, but some allow the traders to interact with the exchange largely unchecked, according to regulators such as the SEC. In the industry, this is known as naked access. Critics worry that a rogue firm's system could destabilize parts of the market, even leading to a broad-based market selloff, without proper oversight and risk controls.

Q: How does it impact mom-and-pop investors?

A: Proponents said high-frequency provides a constant, ever-ready flow of securities when investors need them, making trading cheaper for everyone. When a mutual fund wants to buy 10,000 shares of Google Inc. odds are a high-frequency shop will be ready to provide the shares.

Critics worry that traders could use quick-draw capabilities to drive up prices, selling them back to investors at an inflated level. Another concern are rebates that exchanges pay to high-frequency traders, as the costs could be passed on to investors.

Q: Am I a high-frequency trader without realizing it?

A: Most online brokers that cater to individual investors and nearly all full-service brokers have servers at the stock-trading platforms to cut buying and selling speed down to milliseconds. This ensures orders are disposed of quickly and efficiently at high speeds. However, brokers generally don't use the highly sophisticated strategies plied by dedicated high-frequency traders, such as trading off of obscure signals in the market.