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”
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.