Armchair theory can sometimes look naive from the perspective of institutional detail. Case in point, my recent post on high-frequency trading in which I speculate
how best to allocate the privilege that HFTs enjoy of proximity to exchange servers and access to dark pools. In other words, what do the HFTs pay for their advantage? And who is receiving these payments? Clearly there are capital investments (a form of private sector rent seeking). But I wonder if there are forms of licensing or other “rental” agreements in place that the exchanges use to retain some of the profits earned by HFTs. If I were on the board of an exchange, I would be asking this question every minute of every day. Clearly I lack the detailed institutional knowledge to push the point further.
Tyler Cowen has just posted some of the relevant institutional details, as supplied by an anonymous “loyal reader” of Marginal Revolution.
Colocation is a practice, whereby any market participant can pay the exchange a fee which allows them to locate their trading computers in the same building as the exchange itself ( the matching engine ).
Exchanges sell access to direct data feeds to all investors. When high frequency traders subscribe to a real time direct feed in the colocated facility and they observe the order book as well as trades, they have no idea who is trading – a customer, a big bank or another HFT firm. They see the same exact trades in this feed as all other market participants. Many, if not most, HFT firms do not deal in any way with customers whatsoever. The ones that do are supposed to have a clear separation (a Chinese Wall) between customers and proprietary trading, so no customer information can flow through to the prop desk – the same thing is true of big banks and other broker/dealers.
It’s an interesting post for going into detail about how HFT works — and how it doesn’t. There is also a nice distinction between algorithms that operate on public information versus insiders who observe customer order flow and act profitably on that private information. A rationale is also offered for dark pools being regulated out of existence by requiring all equity trades to be done on public exchanges. Last but not least, it sheds some light on my naive post by describing how exchanges sell access rights.