Behavioral Finance

How Much is a Billion Pennies?

Ron Gambassi
June 17, 2014

A Few Things to Think About

If you figured out in your head in less than 10 seconds that a billion pennies equals 10 million dollars perhaps you qualify as a “Quant”. The quants are the super geniuses employed by Wall Street firms to come up with new algorithms, ways to make money, finding a decided edge, and, in fact, finding ways to make billions of pennies. In your high school class these were the nerds, the people so far “off the grid” they practically levitated. Today they are the Masters of the Universe on Wall St. But this is not an article about the quants. If you’re interested in that subject I encourage you to read, “The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed it”, By Scott Peterson.

This article is about the furor unleased by Michael Lewis’ new book, “Flash Boys”. The quants play a role in the phenomenon he writes about in the book. It’s called High Frequency Trading (HFT). The high frequency trading crowd seek an advantage on large block institutional stock trades by taking advantage of Physics, in particular, the speed of light. By locating their data centers as close as physically possible to one of the twelve stock exchanges in the U.S. (did you know there were 12 exchanges in this country?) they are, in effect,  “gaming the system”, literally by taking advantage of the speed of light.

By receiving a stock order in a building, say, across the river (in New Jersey) from the NY Stock Exchange, the HFT company’s computer systems see that order fractions of a second before it reaches, say, central New Jersey, maybe 10 miles inland. The HFT can adjust the price of a stock by fractions of a penny and then execute a trade to some other institutional investor, thus, keeping the fractions of a penny as their profit on the trade.

Since we’re talking about investments, and benchmarks are important in investment analysis, let me share some time related benchmarks for purposes of our discussion.

It takes 10 milliseconds (10 ms) to blink your eye. When I was a young engineer building radar systems our aircraft computer would take 10 milliseconds to scan the space around the aircraft. In exactly 10 milliseconds it could “see” the radar signal of objects, in 360 degrees and tens of miles away.  If all that could be done in 10 ms, imagine how much can be done with modern day computers in 210 ms? Two-hundred-ten milliseconds is the amount of time HFT  systems have to manipulate a stock price. That is, buy it from “party A” at a fraction of a penny less than what they sell it for to “party B”. Doing this over hundreds or thousands of trades per day and making fractions of pennies (on millions of shares of stock) eventually gets you to a billion pennies (or billions of pennies) of profit. Carl Sagan might have found this an interesting topic if he were still around.

And so, this is where all the controversy arises; the “everyday” institutional traders are being taken advantage of by high frequency traders and are now shining a light on the whole practice.  It’s true, the HFTs have pulled-one-over on the large financial institutions, but, the latter complaining seems a bit like “the pot calling the kettle black”, don’t you think? Wall Street firms have been legally “gaming” each other and individual investors since stocks were traded underneath the Buttonwood Tree in lower Manhattan (the site of today’s NYSE).

Wasn’t Goldman Sachs taking advantage of investors when they were creating “junk” level Collateralized Debt Obligations while at the same time (in another part of their firm), selling-short these same investments? It was all very legal though not very ethical. Is the practice of high frequency trading unethical, probably; immoral, could be; deceitful, undoubtedly; illegal, nope. We should probably expect a Congressional Hearing to address the “outrage of it all”.

Should we as individual investors care, nah! This is just another creative use of technology that Wall St. has derived to gain an edge on the competition. Other technological advances in the last thirty years have brought us discount brokers, $8 trade commissions, minimal bid-ask spreads and other reductions in cost to investors. We have benefitted far more from these cost reductions than we are being hurt by the system of price manipulation by institutional investors amongst themselves.

The activity of high frequency trading seems just another example of exploiting market inefficiencies over the short term. Well, it doesn’t get any shorter-term than trading in milliseconds.

There are plenty of reasons why I lose sleep at night but the effects of high frequency trading is not one of them. I think I’ll stick with doing my investing over a slightly longer time horizon than 210 milliseconds, say, a lifetime.

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