Time is money—and to de­feat HFT firms, it’s mea­sured in nanosec­onds

A se­cre­tive hedge fund thinks atomic clocks can fight HFT firms Dif­fer­ences in nanosec­ond trades are “too small to be per­ceived”

Bloomberg Businessweek (Asia) - - CONTENTS - Miles Weiss and Zachary Mider, with An­nie Massa

In Fe­bru­ary the U.S. Patent and Trade­mark Of­fice pub­lished Ap­pli­ca­tion No. 14/451356, a 16-page doc­u­ment that pro­poses a so­lu­tion to one of the big­gest prob­lems for large in­vestors: how to out­run the fastest speed traders on Wall Street.

The in­ven­tion uses so­phis­ti­cated trad­ing al­go­rithms, hosts of com­puter servers, and atomic clocks—cal­i­brated to vi­bra­tions of ir­ra­di­ated ce­sium atoms. If it works, one of the most il­lus­tri­ous names in the hedge fund busi­ness could gain ex­clu­sive rights to a weapon ca­pa­ble of de­fend­ing against the most preda­tory high-speed traders.

The ap­pli­ca­tion be­longs to Re­nais­sance Tech­nolo­gies, the ul­tra­se­cre­tive and highly prof­itable $32 bil­lion com­pany founded by math­e­ma­ti­cian and former code breaker Jim Si­mons. The lengths to which Re­nais­sance has been will­ing to go to build and patent its own com­puter-driven tech­nol­ogy—at a po­ten­tial cost of tens of mil­lions of dol­lars—il­lus­trate just how big a threat high-fre­quency trad­ing (HFT) has be­come to the in­dus­try’s largest and savvi­est play­ers.

Those HFT firms, vil­i­fied in Michael Lewis’s best-seller Flash Boys: A Wall Street Re­volt, have come to dom­i­nate U.S. stock trad­ing by us­ing pow­er­ful com­put­ers to make mil­lions of trades a day. Last year they ac­counted for about half the vol­ume in U.S. stocks, ac­cord­ing to the Tabb Group, a re­search firm spe­cial­iz­ing in cap­i­tal mar­kets. HFT firms say their con­stant ac­tiv­ity helps in­vestors in two ways. It cre­ates liq­uid­ity, mak­ing it easy for other traders to buy

and sell shares when­ever they want. And it low­ers costs by nar­row­ing the “bid-ask spread”—the dif­fer­ence be­tween of­fers to buy a stock and of­fers to sell it.

Crit­ics ac­cuse HFT firms of us­ing their speed to take ad­van­tage of other in­vestors. Most money man­agers route their or­ders to brokers, who send them on to var­i­ous ex­changes or dark pools—pri­vate trad­ing net­works— de­pend­ing on which has the best price. When an HFT com­puter de­tects an or­der from some­one else, it can race to buy or sell the stock at a bet­ter price on a dif­fer­ent ex­change.

Re­plete with schematic draw­ings, the patent fil­ing de­scribes a way for “ex­e­cut­ing syn­chro­nized trades in mul­ti­ple ex­changes.” It first sends an or­der to a cen­tral server, which breaks it up into mul­ti­ple smaller or­ders. Those or­ders, along with in­struc­tions on the pre­cise times they should be ex­e­cuted, are then routed to a sec­ond set of servers lo­cated next to trade-match­ing ma­chines owned by big ex­changes, in­clud­ing NYSE Group and Nas­daq.

Trad­ing com­pa­nies such as Re­nais­sance pay pre­mi­ums to put their servers next to the ex­changes’

ma­chines to re­duce the dis­tance and there­fore the time it takes for a trade or­der to travel be­tween them. The Re­nais­sance servers sync their trades so HFT firms won’t have enough time to iden­tify part of an or­der on one ex­change and then race to another to trade against it.

A cru­cial part of the patent is the op­ti­cal, atomic, or Global Po­si­tion­ing Sys­tem clocks used to syn­chro­nize or­ders. Re­nais­sance says in its ap­pli­ca­tion that GPS clocks are ac­cu­rate to within nanosec­onds, and any time dif­fer­ences among them are “too small to be per­ceived” by HFT firms. Re­nais­sance de­clined to com­ment on whether it’s us­ing the sys­tem now.

The patent is the work of Robert Mercer and Peter Brown, Re­nais­sance’s co-chief ex­ec­u­tive of­fi­cers, both of whom have doc­tor­ates in com­puter sci­ence. They over­see a team of Ph.D.s in fields from as­tro­physics to num­ber the­ory who la­bor to­gether over al­go­rithms that an­a­lyze data to pre­dict prices of stocks, cur­ren­cies, and fu­tures. Re­nais­sance uses those cal­cu­la­tions to make hun­dreds of bets in what’s known as sta­tis­ti­cal ar­bi­trage. Its flag­ship Medal­lion Fund has had av­er­age an­nual re­turns of 35 per­cent since 1989, al­most quadru­ple the av­er­age an­nual gain for the S&P 500.

With a patent, Re­nais­sance can block com­pet­ing firms from copy­ing its ap­proach for as long as 20 years. It could also li­cense the sys­tem to oth­ers to de­fray the costs re­quired to build and main­tain such in­fra­struc­ture. But it’s not with­out risk. By fil­ing a patent, “you ba­si­cally move from guard­ing your pro­pri­etary strat­egy as a trade secret to re­veal­ing the pre­cise me­chan­ics of what you are do­ing,” says Paul As­ton, founder of Tix­all Global Ad­vi­sors, which helps in­sti­tu­tions with their for­eign ex­change trans­ac­tions. “The worst-case sce­nario would be to find out that much of your in­ven­tion al­ready ex­ists.” Re­nais­sance isn’t the first firm to seek a patent for its anti-HFT tech­nol­ogy. In 2013, the Royal Bank of Canada ob­tained one for an or­der-rout­ing sys­tem that Brad Kat­suyama, the hero of Flash Boys, and his team de­vel­oped. Af­ter start­ing IEX Group, he went on to cre­ate the now-fa­mous “magic shoe box”—38 miles of fiber-op­tic cable coiled in a small box to slow or­ders by 350 mi­crosec­onds and keep ev­ery­one on an even play­ing field. IEX, which uses the sys­tem as its cen­ter­piece, will be­come a full-fledged ex­change in Au­gust.

In its patent fil­ing, Re­nais­sance cites un­pre­dictable changes in “la­tency,” stem­ming from is­sues such as net­work traf­fic, data rout­ing, and out­ages, that could leave in­vestors ex­posed to preda­tory HFT. Re­nais­sance says its own in­ven­tion pro­vides “a much sim­pler and more cost-ef­fi­cient way” to beat the speed demons.

The bot­tom line Re­nais­sance Tech­nolo­gies has filed a patent for a trad­ing sys­tem that can be used to de­fend against preda­tory high-speed traders.

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