High Frequency Trading – Every Second counts – trading off speed against security

Posted on : 31-03-2014 | By : richard.gale | In : Cyber Security

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History – same principles different technology

High frequency trading (HFT) is the latest name for an old trading practice; Arbitrage – identifying & exploiting the difference between two markets or prices to make money. This relies on two basic factors – differences in price of the same commodity and communication mechanisms to transmit information between the markets with that price differential.

Where there is more than one opportunity to trade the same thing and there is a slight difference in price then there is money to made. In the ‘old’ days this could be between two markets selling, say, grain in different market towns. For various reasons (difference in the number of buyers/sellers that day or even the weather) then a bushel of corn could be $10 in one town and $12 in the next. Before fast communication methods this was just the way it was. With the advent of the telegraph, clever traders could buy on one market and sell on the other so making a clear profit on the difference.

Arbitrage developed into a significant trading tool and as communications improved it became faster and more sophisticated. The time differential in price shortened and the prices themselves grew closer together. When the telegraph (ticker tape) was introduced then the time gap could be minutes or hours. With high speed networks, seconds and then milliseconds became the difference between profit and loss.

Trends – Speed is all

HFT now is a major business. It is estimated that more than 30% of trades in some markets are executed by HFT systems. Some of the profits per pair of trades are very small but the number of transactions can make a significant amount of money.

Transaction speeds are way beyond the capabilities of human traders, black box systems pump thousands of trades through a second and are constantly charging and improving their trading models.  Firms spend serious amounts of money on the fastest possible hardware and networks. Stock and commodity exchanges have now created new profitable markets in selling space in their data centres to firms wanting to reduce latency to a minimum.

Some companies are going further, to shave 3 milliseconds off the data transmission times between New York & Chicago trading firms invested over $800m to build a direct fibre optic link. It’s an amazing story so take a look at this link to read more. There was some talk of boring through the earth to remove the extra distance required for the curvature of the earth – either way, unfortunately for them, another firm then built a series of line of site microwave links which effectively took them out of the market.  We actually wrote an article a few years back about a project we heard of which is taking this to the next level of speed….

With the transaction and reaction speeds measured in milliseconds then opportunities for errors magnify – there have been a number of noticeable spikes in volatility. The infamous Flash crash of 2010 where, in an already jittery market, the Dow Jones fell 600 points in 5 minutes only to recover half of that in the next 20 minutes was perhaps due to a ‘fat fingered’ trade (where someone added too many zeros) but the movement was magnified by the algorithmic computations taking advantage or defending losses on the rapid change in price.

The market is affected immediately by news feeds. This is nothing new but as new sources of information arrive the accuracy of them often isn’t checked until after the event.

It used to be that news was researched, verified and then printed and available in newspapers the next day. Radio & then television made this process much faster but information was generally verified, rolling news channels and their constant demand for events may have increased speed to live but potentially reduced accuracy.

There are ‘instant’ market data services such as Bloomberg and Reuters where trained journalists report and publish but now public messaging such as Facebook & Twitter allow anyone to publish virtually anything instantly without any verification of its accuracy.

Most trading firms treat the noise of Twitter as an additional influencer but not sole source of the truth. There is suspicion that some traders are feeding their HFT systems with raw feed data. This is what caused another mini crash when the Syrian free army hacked the Associated Press Twitter account and falsely reported an explosion at the White House.

Security – What could happen and is it actually possible?

So what are the security implications for HFT?  There appears to be a direct conflict of security versus speed. Any attempt to verify, encrypt or otherwise secure the HFT trades will inevitably slow down the messages so disadvantaging the firm that does this.

To counter this there is a level of security in the network. These are generally partitioned from the rest of the firm and often have their own physical wires and high speed routers to minimise ‘hops’ and the impact of other traffic. Beyond this are there other ways to ensure security and protect against possible attacks or breaches that could occur?

Slowing down rivals

The competitive advantage HFT have is getting the trades in faster than the opposition. An obvious way to do this would be to slow down the rival’s speed somehow. So if network speed could be reduced by, say putting additional traffic on the network or even carrying out a Denial of Service (DOS) attack to disrupt or disable the competition, it could present a significant (if illegal) trading window. In the same way, if the network could be reprogrammed to route elsewhere (maybe falsely alerting of a network failure in the main route) then the same thing could happen and the trades would arrive (too) late.

Modification

What if these attacks could be taken a step further? If a rival managed to change the code of a competitor they could introduce additional steps to slow the processing down. An extreme would be they could modify the amounts, security or even turn a buy into a sell. Fanciful maybe but not impossible.

What is perhaps more likely is that human error will cause these issues themselves. This has happened before, most significantly with Knight Capital when the wrong software was activated in  the live environment causing a $460m trading error and the eventual demise of the firm.

 

Can this dichotomy of the need for speed versus security ever be resolved? Anything which improves one will negatively impact the other.

Bring back the Ticker

The essential ingredient of HFT is a constantly moving price in more than one location that are out of synchronisation. With demand from traders, exchanges have improved their update speeds to the pointwhere the prices are constantly changing, instantly reacting to the changes in supply and demand. Some thought has been given to publishing the price on a regular basis in the way ‘ticker tape’ used to flow from telegraphs. If this was set at say once a second it would eliminate most of HFT’s reasons to exist. A nice idea but difficult to implement now the door has been opened and the massive investment in technology has been made.

Gentlemen’s agreements

Assuming that it is not possible to introduce additional steps into the in-line HFT trading process, is there another way to sort out the inevitable errors after the event? There are always trading errors and most organisations do enough business with each other to have informal agreements in place to resolve issues. Some exchanges also provide this service. However this did not help Knight Capital and may not help others in the future. If multiple trading parties have issues at the same time then the issue may have a systemic impact on the financial services and then the ‘real world’ soon after.

Legislation

There have been many calls for the cessation of HFT as it is considered destabilising, dangerous and out of control. Traders will always look to the next way to improve profits so if a way is found of closing down HFT then you can bet a similar successor system will arise. Ensuring enough reserves, liquidity and controls to manage the bumps and issues on the way is probably the best that can be hoped for.

 

We’ve been looking at HFT for a while now and it’s a fascinating area – pulling in the best brains from trading and technology. Michael Lewis – famous for his exposes of the financial world in Liar’s Poker published a book on the subject of HFT a couple of years back – it’s a great read!