If you have wondered why the
world's stock markets behave the way they do, why the DJIA falls 150 points on one
day on news of Greece leaving the euro, then gaining 200 points the next day on
news of a bailout, then back down a day later on more news of the bailout, your
confusion is understandable. It seems that there might be nobody who actually can
predict the market's contortions and that every trade is a gamble. You would be
wrong. There is evidently a small group of elite, well-financed, well-equipped market
players who have decision advantages measured in microseconds - just enough time
to have a glimpse of the world that almost no one else has and then execute trades
based on that privileged information. It allows them to test theories of market
reactions and make nearly instantaneous adjustments to either increase profit on
good decisions or minimize losses on bad decisions. This is referred to as "high
frequency trading." Actually, software makes all the decisions, not actual humans,
but of course that software is created based on human knowledge.
According to one of many articles in the June 2012 edition of IEEE's Spectrum magazine reporting on the world's money machine,
a multimillion dollar microwave link has just been built between the New York Stock
Exchange (NYSE) and the home of Chicago-based futures traders by the company
McKay Brothers (nobody
named McKay has ever worked there). Its purpose is to exploit the lack of signal
delay inherent in fiber transmissions (about 0.7c) provided by the current crop
of connections. They take it one step farther in order to help assure that nobody
else will be able to edge them out in the future. According to co-founder Bob Meade,
a high experienced trader who has a Ph.D. in theoretical physics from Harvard, his
cascade of microwave towers is sited on a great circle path that deviates from perfection
by only 4 miles. There is some latency in the tower-mounted repeaters (as low as
100 ns for state-of-the-art equipment), but optical cables also exhibit input/output
latency. The McKay Brothers' route uses greater than normal distances between towers
in order to minimize latency, and even uses overwater shots across Lake Erie and
Lake Michigan - something normally avoided because of multipath fading phenomena.
Their justification is that their customers would tolerate occasional loss of data
in exchange for the tactical advantage normally provided. Another company, Hibernia,
is laying optical cables in the Atlantic Ocean to minimize latency between the NYC,
Boston, and London exchanges.
In reading the article, I never did figure out why the traders don't simply move
all their offices to Long Island and mutually eliminate the timing contest.
The arbitrage thing is interesting apart
from the microwave system implementation. According to Merriam-Webster, arbitrage
is "the nearly simultaneous purchase and sale of securities or foreign exchange
in different markets in order to profit from price discrepancies." Its roots are
from the early 20th century organized crime practice of exploiting an ability to
receive horse race, boxing match, and other gambling-based results via private telegraph
wires ahead of those broadcast over Western Union's standard news wires. Bookies
could accept and reject wagers from clients based on their advanced knowledge of
event outcomes. They made untold (to the IRS, anyway) million$. Recall in
Back to the Future Part II where Biff became the world's richest
(and most corrupt) man because of a copy of Gray's Sports Almanac (fictional) provided
to him by his future self. That was the ultimate form of arbitrage.
BTW, the June 2012 edition of Spectrum is chock full of stories on the world's
financial systems, with a focus on how and where electronics and software systems
play a key role. Contactless payment via near field communications (NFC) is set
to replace the venerable magnet stripe (Mag-Stripe) on credit cards, and
Bitcoin™ is successfully removing traceability from electronic
Quantum dots are set to eliminate the possibility of counterfeiting,
and we're at, "The Beginning of the End of Cash." There is also a nice story
on "A Brief History of Money."
Biff's Copy of Grays Sports
Almanac - Back to the Future, Part II
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