High-frequency traders are getting closer to the action, moving nearer to global exchanges, which improves their connection speeds and as new research shows, it’s a profitable shift.

According to new research from Monash Business School, high-frequency traders (HFTs) are capitalising on their close proximity to global stock exchanges.

While they make larger profits when they are situated closer to stock exchanges, it can boil down to a matter of just milliseconds, giving share trader’s a new mantra – “I feel the need, the need for speed”.

This proximity is being investigated by Monash Business School’s Associate Professor Paul Lajbcygier along with co-authors Joshua Prameswara, Dr Huu Nhan Duong and Dr Imon Palit. Preliminary findings in their paper The Influence of Co-location on High-Frequency Trading show that technology may give split-second advantages to some traders, enough to propel their trades to the head of the queue and potentially translate into huge profits.

“There is a lot of money in speed when it comes to the stock market,” says Associate Professor Lajbcygier. “All the high-frequency traders are fighting to get their servers closer to global stock exchanges. This is because co-location gives these HFT time advantages over other operators in executing their trades.”

Co-location is a service offered by exchanges which allows HFT firms to place their trading servers physically close to the exchange’s servers. This gives HFT access information more quickly and enabling them to execute trades at higher speeds than their competitors.

The exchanges often cater to the demands for co-location by HFT because they are paid on a per-trade basis, as HFT make up a large proportion of trades.

But the advantage for close proximity traders is not just in terms of information.  Improving speed through co-location also provides more efficient inventory management and lower inventory costs.

“The exchanges have a direct incentive to entice trading,” says Associate Professor Lajbcygier. “A substantial portion of the Australian Securities Exchange’s (ASX) revenue is derived from these traders so it has a direct incentive to cater to them.”

However, these co-location arrangements have the potential to give HFT an unfair advantage.

In 2012 the ASX offered co-location services for the first time through a new data centre – the Australian Liquidity Centre.

Study results revealed

Associate Professor Lajbcygier explains that the study reviewed trading three weeks prior and three weeks post the introduction of the Australian Liquidity Centre using the Securities Industry Research Centre of Asia-Pacific order book, market depth and news announcement dataset.

Although large institutions may have high-frequency trading desks, it is impossible to tell which trades are from the HFT desk, hence only proprietary HFTs were considered in the study.

“The research shows that this new faster trading speed allows for a quicker reaction to new information and sharpened ability in searching for valuable trades,” says Associate Professor Lajbcygier.

“This leads to more profitable aggressive trades and a higher level of adverse selection imposed on their slower trading counterparts.”

Faster reactions boost profits

What this speed means is that HFT can react faster to news announcements and gain price advantages by using the old share price quotes of slower, passive traders.

The study shows that HFT in Australia are twice as likely to aggressively trade than place passive orders (that may or may not be actually traded). HFTs were also found to live up to their reputation of placing a large number of smaller-sized trades and tended to trade in very liquid stocks.

Compared to global HFT traders which have been shown to close their positions off entirely at the end of the trading day nearly 70% of the time and hold zero overnight positions – Australian HFT are less focused in closing off their positions and maintaining zero inventory overnight.

Yet the improvement in speed through co-location is also used to benefit passive profits as well as aggressive profits.

The study showed co-location to better predict order flow for HFT, allowing them to reduce excess inventory thereby cutting inventory holding costs.

 

*Joshua Dharma Prameswara graduated in 2017 from Monash Business School with a Bachelor of Commerce (Honours in Banking and Finance).