By Michelle Lu
In January of 2021, GameStop’s market value increased from $2 billion to over $24 billion in a matter of days. Its shares rose over 1,700 percent in January compared to December 2020, though in February it plunged by over 80 percent. GameStop’s trading mania was sparked by members of a popular Reddit investing community who said they hoped to strike back against the Wall Street elites who had long dismissed them as “dumb money.” In the fallout of Gamestop’s rise and fall, many major hedge funds and retail investors have taken a great loss. Meanwhile, though, a third player that represents about 50 percent of trading in US equity markets, has consistently made profits throughout this entire duration—High Frequency Trading (HFT) firms.
The rapid-fire computer-based field of HFT developed after NASDAQ introduced a purely electronic form of trading in 1983. HFT is all about location and speed. Why? Because of latency. A delay of just a few milliseconds is enough to miss out on millions of dollars. By racing ahead for only a few milliseconds, HFT firms are able to spot emerging trends, essentially anticipating and beating the trends to the marketplace. There are a variety of reasons why speed is so important, but the most obvious one is to be able to place orders ahead of others. If you know a stock price is going up or going down before everyone else, your decision to act on it would beat everyone else’s. For a more concrete example, if you're coming in to buy Tesla and you think the price is 800, but a high-frequency trader knows that the price of Tesla has actually gone down to 790, that trader can buy it at 790, sell it to you at 800, and reap in a profit.
If you have ever used Robinhood, you probably think that when you press buy or sell, your order is placed at the moment. However, it actually takes time—though only in the scale of milliseconds—for your order signal to travel through fiber-optic cables and arrive at a trading center. Beyond all the fundamental and technical analysis, quarterly reports, and carefully curated portfolios, financial trading ultimately rests on a simple question of physics: minimizing the time light needs to travel through fiber optic cables and execute a transaction.
In this sense, HFT firms are playing an entirely different game than traditional traders, basing their business model on taking advantage of this question of physical speed. The most obvious way is to reduce the physical distance that light needs to travel. Hence, HFT firms have rerouted cables to circumvent the circuitous cable paths that telecom companies use. In 2010, a company called Spread Networks spent about $300 million to lay fiber-optic cable in a straight line from Chicago to New York, so traders could send data back and forth along the route in just 13 milliseconds. HFT firms also use colocation—a dedicated space within the data center belonging to the stock exchanges—to gain an advantage from the physical proximity between the exchanges and their own servers. The few nanoseconds that the firms gain from colocation is enough for them to execute faster transactions in comparison to those who don’t utilize colocation.
Another way to reduce travel time is through improving the quality of fiber-optics. HFT firms now use hollow-core fiber to improve their systems by billionths of a second. Instead of standard, solid fiber cables, hollow-core fiber is empty inside, with dozens of parallel, air-filled channels narrower than a single strand of human hair. HFT firms capitalized on a very simple concept from introductory physics called the refractive index: Because light travels much faster through air than glass (the refractive index of air is ~1 while glass is ~1.52), it takes about one-third less time to send data through hollow-core fiber than through the same length of standard fiber.
HFT has proven to be very controversial considering its “unorthodox” methods. Critics say that HFT firms are manipulating the market, and taking significant profits from traditional investors, and anyone else who doesn't have the myriad of speed boosts that they do. According to data from 2010, the most aggressive HFT firms made an average daily profit of $45,267 simply by front-running traditional investors. Even beyond financial implications, the amount of STEM talent we lose to HFT firms each year that could’ve done something more impactful on a societal level is astonishing. Ultimately, HFT is, on a purely technological level, a triumphant application of science to society. Its ethics and potential ramifications, on the other hand, are much more murky.