Welcome to the world’s most intense electronic battle. It’s waged on world stock markets and the ammunition is tiny fractions of pennies, fired through super-charged computers. The object is to wipe out the opposition.

The theatre of war is a long way from the raucous bear pit of baying stock traders. Instead, capital is unleashed in a cavernous space, lined with banks of computer servers and chilled by air conditioning. Rather than the shouts of traders, orders to buy and sell come in electronic pulses; processed instantly in near-silence.

‘It’s high tech war,’ explained a City computer expert working for an investment bank. ‘When they’re doing a trade, they can blast it with full volume so you can’t get up.’

It’s become a technological race for traders trying to exploit quirks in human behaviour. So what’s at a premium is the timing and getting hold of the data as quickly as possible.’- former banker

Buy low, sell high remains the market’s mantra. But the age of computer-driven trading has ushered in speed and processing power. Trading times have accelerated exponentially. Markets are so fast today, a trade is now measured in microseconds – millionths of a second.

Allied to speed is staggering computer processing power. Now processors can assimilate transactions made on virtually every single exchange and assess who made the trade, all in the blink of an eye. This gives investors more ammunition in their battle to outmanoeuvre and second-guess rivals.

At this level, humans are out of the game. Instead, investment banks, fund managers and traders put all their trust on complex algorithms run by computers to buy and sell shares, with varying degrees of human involvement. And the fastest players of all are a new and evolving breed of market participant: the high frequency traders.

In the past five years, high frequency trading (HFT) has stormed the citidels of finance. Today it accounts for more than a third of activity on European markets and 70% in the US. Its dramatic rise to prominence has polarised opinion. Exponents say it has reduced trading costs and increased activity on markets – but critics point to two devastating US market collapses in which HFT played a central role. And now European policymakers are debating whether to impose severe limits on HFT. Influential figures are even calling for it to be banned.

The cash/time continuum
HFT takes place at speeds more commonly associated with particle physics. In the quarter of a second it takes you to blink, an HFT computer can carry out over 5,000 transactions.

Computers are locked in a permanent race against one another, and against the wider market, to perform millions of tiny, rapid trades, each yielding a tiny profit. There is no interest in actually owning a company’s stock. The game is to sell it on at a fraction of a penny’s profit very, very quickly. The tiniest delay is the difference between profit and loss.

So HF traders pay to place their servers close to an exchange’s, and invest in ultra-high speed feeds of market data. The reason? Whittling microseconds off ‘latency’ – the time it takes their message to reach the exchange and return.

them within microseconds, with the intention of slowing down the markets and profiting from the price differences. Or ‘smoking’ or ‘layering’: entering fake trades at artificially low or high prices, to mislead other market players. American regulators have already sanctioned at least one firm for this HFT strategy.

Prepare for takeoff
It was an arcane European Union directive that effectively launched this new era in financial trading. Called the Markets in Financial Instruments (Mifid) directive, it abolished the monopoly enjoyed by stock exchanges in each EU country in 2007 – although some, like London, had already started introducing competition. New exchanges opened and a wave of merger activity ensued.

Mifid’s aim was to force stock exchanges to compete. The theory went this would make transactions cheaper and more transparent. Its introduction incentivised exchanges to increase the amount of trading providing the perfect conditions for HFT to take off. With transactions ostensibly cheaper, HFT could profit on a huge number of transactions that yielded small margins.

The industry argue it’s not just HFT which benefits. Investors now enjoy reduced spreads – the gap between bid and offer prices, and trading fees have fallen. Most importantly, they claim, HFT boosts liquidity – the willingness of the market to buy what you’re selling and sell what you want to buy.

But storm clouds are gathering for HFT. It is also blamed for making markets more predatory and volatile, causing sudden spikes and dips as black boxes bet against one another at frenetic speeds.

The critics are becoming more vocal. Last weekend a senior European Central Bank policymaker called for the trade to be banned outright, while Andrew Haldane, the Bank of England’s head of financial stability, used a speech last year to call for ‘grit in the wheels’ to slow trading and ‘forestall the next crash’.

The complaints are the sound of vested interests at work, says Remco Lenterman, chairman of HFT industry body the European Principal Traders’ Association (Epta). ‘Initiatives to try to stop our members [are] because we make the market so efficient that it becomes less profitable for the financial industry,’ he said. ‘Clearly it’s a very disruptive technology.’

The price of progress?
Concern on the potential for market harm that HFT could bring is mounting. HFT’s reputation was severely dented by the ‘flash crash’ of May 6 2010, in which already choppy US stock markets dropped by 600 points inside five minutes – wiping nearly $1 trillion off share prices at a speed only possible with quantitative trading, before rebounding just as quickly.

Two years on, many in the financial markets are still shaken by the event.

‘It was Chernobyl for stock markets,’ said one observer.

‘It was a near-death experience,’ said another: had the fall happened at the end of a trading day, markets would have closed mid-crash, sparking panic on the international markets.

‘The Flash Crash was a near miss. It taught us something important, if uncomfortable, about our state of knowledge of modern financial markets,’ Haldane said in his speech.

The flash crash could happen here: it wouldn’t be as dramatic, but we could still have a 10% drop before the circuit breakers kick in’- Kay Swinburne MEP

A SEC investigation into the events found that the fall was triggered by a mutual fund trying to shift a large amount of stock in edgy markets using an algorithm. But it gathered momentum as HFTs took advantage and drove the prices down.

If this wasn’t bad enough, last month a malfunctioning algorithm in the US saw trading firm Knight Capital lose $440m in half an hour, causing market chaos in the process.

European stock exchanges say such events couldn’t happen here: they have safety features such as circuit breakers, which halt trading on a stock when prices move too sharply. On the London Stock Exchange (LSE), they kick in around 35 times a day – although during market stress last August, this rose to 170 times a day.

But such European measures may not, according to some, be enough. Only luck has prevented major crashes in the UK, several market observers have told the Bureau.

‘The flash crash could happen here: our system’s automatic stops would kick in automatically so it wouldn’t be as dramatic, but we could still have a 10% drop before the circuit breakers kick in,’ said Kay Swinburne, a former banker and Conservative MEP on the British government’s Economic Affairs Committee.

Certainty at a premium
The trouble is that getting clarity as to whether HFT harms Europe’s markets is not an easy task. The debate is characterised by apparently contradictory studies, claims and counterclaims.

‘A lot of the research is biased,’ an informed source said: many studies are commissioned by investment banks, who count HFT firms among their clients and use HFT strategies, and others with vested interests.

The markets haven’t got worse since the advent of HFT, but they’re not much better either, a government study found

There are huge technical barriers to researching HFT’s impact on markets and trades – the raw datasets are massive, complex and scattered across multiple exchanges and trading platforms.

The lack of any conclusive evidence has allowed HFT to thrive with only limited regulatory understanding. There is not even a commonly accepted definition of what HFT actually is. ‘With the regulator understanding we are in a similar situation to how they handled off balance sheet and debt markets. The regulators are starting to realise that they know fuck all,’ said the City IT manager.