Joe Weisenthal: Hello and welcome to another episode of the OddLots podcast. I'm Joe Weisenthal.

Tracy Alloway: And I'm Tracy Aloway. Tracy, one of the things that I think we like to do on this podcast is sort of deabstract the things that we take for granted in the world. And there are various processes. We always say this when there's like a blowup or something like that where it's like, oh, if we're having to pay attention to X or Y, there must be something going on. But we don't always have to wait for blow-ups. But like we live in this world where like you click buttons and things happen and you have some intuition of what happens after the button is clicked, but you don't really have a great intuition of like what happens between the button clicking and the thing happening.

Joe Weisenthal: Absolutely. I actually don't know how the process of like inputting an equities trade actually works like where it kind of shows up. So that's a big question. And I suspect a lot of people, even people who are in markets, probably don't know like the entire sequence of events. Partly because it's gotten more complicated over the years with like regg NMS. Do you remember that and stuff like that?

Tracy Alloway: The other thing I've been realizing about trading, obviously the big trend here is high frequency trading, right? And it's just getting faster and faster and faster. When we first started writing about HFT, I guess in the sort of like mid 2000s after the financial crisis, I remember thinking that it was all about the actual algorithm and finding like a really smart pattern in financial markets to exploit. But the more I learn about it and the more I read about it, I kind of realize it's not really that. It's about exploiting the market structure.

Joe Weisenthal: Yeah. Yeah. Totally. And there are so many, you know, we we had that I forget who we were talking to recently. Oh, it was the guy from Hudson River trading and you know, there were the famous like wire wars where it's like, no, I want to be one inch closer to the main server, etc. It's like, god, this is like a good use of brain power. So, like we're going to solve the market because one more nancond faster, etc. But, you know, the other thing, you know, sort of related to this, one of my long-standing questions is, you know, a jobs report will drop at 8:30 on a Friday and the market immediately moves. And I'm like, how did that happen? Because it didn't happen because someone was staring, they had their like fingers above the buy or the sell button, but also had something had to be programmed such that that data could instantly be ingested and then some sort of like directional trade was made based on that. But I don't know how that happens. I don't know how that works. There's also of course the overall question of what all this electronic trading actually means for the market itself.

Tracy Alloway: Yes.

Joe Weisenthal: And people talk about things you know with the multistrat funds getting these feedback loops and maybe increasing volatility in the market and things like that. So we should discuss

Tracy Alloway: and I would just add one more thing. You say what does it mean for the market itself? What does it mean for society itself that so much effort is being placed on like getting a meter closer to the server room or whatever and why is this a good use of time and is this improved capital allocation? I'm really excited to say we do in fact have I think truly the perfect guest to talk about this someone who has a sort of an extraordinary body of life's work in a range of areas that is very distinct from almost any other academic or researcher that I can think of. We're going to be speaking with Donald McKenzie. He's a professor of sociology at the University of Edinburgh in Scotland. I first came across his work. He wrote a fantastic book called An Engine Not a Camera, which is sort of about finance and the original birth of quantitative finance and the use of advanced models and how these models didn't just reflect what was going on in the real world, but how the adoption of these models then created this feedback loop, the engine effect such that it actually started to drive markets themselves. More recently, he wrote a book called Trading at the Speed of Light, all about highfrequency trading. He's also written recently a book about digital advertising. And so truly a a polymath in the world of thinking about this relationship between industry and the sort of technological substrates that drive them. Professor McKenzie, thank you so much for coming on OddLotss.

Donald McKenzie: Well, thank you very much for inviting me to do that.

Joe Weisenthal: Absolutely. Why don't you start off by telling us the gestalt of your life work? What is your core underlying interest such that it's produced books in these various realms?

Donald McKenzie: Yeah, I mean fundamentally I'm a sociologist of technology. So I'm interested in the technical systems that affect or could affect all of us you know so over time uh first major project in that area was on nuclear missile guidance technology.

Joe Weisenthal: Amazing.

Donald McKenzie: Then I moved on to safety critical computing technology. Then the work on financial models that you've just mentioned. Then high frequency trading. Then digital advertising, you know, because as well as driving us all insane by or ads that we don't want to see appearing on our screens, that's also of course the big funding source for much of the everyday digital world. And then most recently of all I've started working on AI and large language models. So you can see that you can see the picture. They're all highly technical areas. One way or the other they all affect all of us.

Tracy Alloway: The other reason we wanted to talk to you is because you come at everything from this sociological perspective and I absolutely love it when like anthropologists and sociologists go to Wall Street and write about it. Why did you take that approach especially with your highfrequency trading book?

Donald McKenzie: Yeah. Well, I don't do kind of like quantitative social science, you know, I can leave that for example as far as markets are concerned. I leave that to economists. What I do I like talking to people. I like going looking at stuff to the extent that you can look at it. I like tracing how things have developed through time. you know, my work's often got a kind of, you know, something of a historical dimension to it. But the most fun bit isn't writing the books. The most fun bit is talking to people. And that's the bit I've always enjoyed most.

Joe Weisenthal: One interesting thing in this book, Joe, I don't know if you noticed, but Donald writes down like all his numbers of sources and who they are. So like, you know, people from the exchange, people from high frequency trading firms, what their seniority is, which is something I hadn't really seen before. That is a really cool thing. By the way, as Donald says, the fun part is talking to people, not so much the writing of the book. As two people who talk to people every day and have never written the book, I feel already, now granted, we never actually went through the process of writing the book because the talking part is so much more fun. I don't want to ever take a pause from the talking. So, I already feel like to some extent, Donald is a kindred spirit. It's like it's fun to talk to people, isn't it? Talk to us about how you find them. you know, it's like, okay, HFT is interesting to you and like you just want to have some conversations. What is the sociologist's toolkit here for knowing who to talk to?

Donald McKenzie: Yeah. Well, it's always difficult and it's always very ad hoc. There's always a lot of luck involved in it. And with a financial market topic, I will typically start reading the Financial Times, finding names in the Financial Times, approaching those people, and then maybe they pass me on to other people. But, you know, there's also, as I said, dumb luck involved. like crucial moment in the work I did in high frequency trading was going to interview someone at the start of it and framed on his wall was the front cover of an issue of Forbes with the headline of the article free enterprise comes to Wall Street and I thought oh that sounds kind of interesting and I checked that out and it was to do with a new electronic stock exchange called Ireland And it turned out that Ireland the story of Ireland was completely interwoven with the story of of high frequency trading.

Tracy Alloway: Before we get into exactly what high frequency trading is and how it fits into, you know, placing orders for equities or futures or bonds, I have a cultural question which is whenever you go into an HFT firm's office, it always looks like a tech company. Yeah. Right. with the chess board and the mach and very modern like why do you think they've taken that approach? How did that aesthetic become the norm?

Donald McKenzie: Yeah, that's a really good indicator of cultural change because of course previous to that the sort of dominant image we might have of a financial market would be the trading floor of the New York Stock Exchange. You know, folks in colored jackets. They're typically televised when even nowadays when you know so there's been a a big drop in the market or something so the the camera has tried to catch somebody who's looking kind of glum and and worried. So we think of that as what finance is.

Joe Weisenthal: Or we think about like the Bud Fox in Wall Street of a bunch of guys and slick back hair sort of, you know, on the phone and boiler. Yeah. Yelling at each other looking at a green screen, right? Sorry, I didn't mean to interrupt that, but those are I suspect the two things people imagine.

Donald McKenzie: Yeah. Yeah. And you know there's was a transition involved but by and large the high frequency trading firms hire people who know how to code often you know with higher degrees in mathematical kinds of subjects and even the people who refer to themselves as traders often have that kind of background. And you know, I'm I'm sure when the visitor isn't there, there'll be a fair bit of swearing at the screen when something goes wrong and and that kind of stuff. But you you're right that the normal experience of those trading rooms, they're quiet, they're orderly, and you could indeed make mistake them for a Silicon Valley startup.

Tracy Alloway: Yeah. And if you see people in jeans and I I visited one and like I think I saw the CEO and he was just like wearing his like college t-shirt or uh something like that.

Donald McKenzie: Yeah. With strong memory I've got because you know in the previous work they work for an engine not a camera and some follow on stuff. I would often go to investment banks and in investment banks you know I kind of had to wear a suit and a nice shirt and a a tie and so on. So when I started interviewing in high frequency trading, I turned up at one firm dressed like that and the owner of the firm sort of snarled at me. You're overdressed.

Joe Weisenthal: Wow.

Tracy Alloway: You mentioned Island. Why don't you tell us that story? You know, I want to get more into the tech, etc., but you're like, okay, this turned out to be an exchange. What was distinct? What is Island? I've heard of it, but it's again one of these things that I've heard of it and then I moved on. What was distinct about this and why is it so interwoven into the history of HFT? How is it different from other exchanges that have existed for hundreds of years?

Donald McKenzie: Yeah. Yeah. You know, I'm going to oversimplify of course because there were predecessors to Ireland that you know were a little bit like it and so on, but that would take us too long to go into. I mean, fundamentally, trading on Ireland was organized around an electronic order book, which was is a list of all the bids to buy or offers to sell the shares in question. And that electronic order book is managed by something called a matching engine. And as the name implies, that looks for a match. In other words, a bid to buy and an offer to sell at the same price. And when it finds that couple, it consummates the trade and the trade is done. So it's all done electronically. There's no direct human negotiation involved. You just enter your orders into the order book and the matching engine either executes them or fails to find a match. There were exchanges prior to Ireland that worked in that kind of way. But what was distinctive about Ireland is that its matching engine was blisteringly fast by the standards of the day which were the you know was essentially the late 1990s. So the closest analog was a system called instant and it might take a couple of seconds the matching engine to find the match and execute the trade. And of course for a human being sitting there even if they're impatient 2 seconds is not a very long time. Island improved on that a thousandfold. So it could execute trades in 2 milliseconds 2000th of a second. So that was the opening for highfrequency trading that with exchange I mean strictly Ireland was not exchange it was what was called an electronic communications network or ECN but I'll call it an exchange for simplicity. If you've got an exchange like that and you've got an automated trading system it's a marriage made in heaven. The two things the exchange and the trading firm fit each other very very well and amongst the consequences of that is that liquidity in Ireland. It traded NASDAQ stocks. This is the time of the dotcom bubble of course where there's a lot of trading of NASDAQ tech stocks. Ireland brought a lot of liquidity to that market. So that's you get a kind of feedback loop where you get automated trading bringing liquidity to exchanges that have the kind of technical features that make high frequency trading attractive and feasible. So the established exchanges started to have to change how they did things because otherwise they were going to lose out to the new exchanges. And that's basically the feedback loop that's created today's electronic markets.

Joe Weisenthal: Joe, whenever I hear terms like millisecond and nancond, I just it's so hard to wrap my head around what that actually it's. It's faster than that.

Tracy Alloway: Oh, yeah. For sure.

Donald McKenzie: I I can actually help there. And I'm going to hold my fingers. I'm holding them 30 cm apart or since you're in the US, I'll say one foot apart at the speed of light in a vacuum. It takes a nancond to get from one finger to the other finger. And that's an indication of how fast automated trading specifically high frequency trading has become. That when I started working on the topic in roughly 2011, people were still talking about milliseconds or thousands of a second. Two or three years later, it had become microsconds or millionth of a second. And by the time Ed was finishing the research, nanconds were starting to account. So light traveling that 30 cm traveling that foot that mattered to high frequency trading by you know roughly 2018 2019 2020 round about then

Joe Weisenthal: that's very helpful. I do have questions about the physical realities of how fast we can actually go with all this stuff. But before we go any further, can you talk about the process of let's just focus on the equity market for now. Someone places an order to buy or sell a stock. What actually happens in the ecosystem between traders and market makers and the exchange that makes that happen and what does it mean to actually make that happen and execute the trade?

Donald McKenzie: So what happens is your order via the broker your user I mean in the brokerage system is no longer a human being via the brokerage system gets placed in the exchanges order book and then one of two things happens. The first is if the matching engine can find an existing order in the order book that matches the the price of your order, it executes the trade and the the trade then happens, not quite instantly, but you know, very very very fast and you're done. You're that's it. It's over. If on the other hand there is no match as the order book stands your order rests in the order book and it stays there until either you cancel it or a matching order comes along and then it's executed at that point. So that's the basic process

Joe Weisenthal: you know so it occurs to me like gains of speed in trading have been happening forever long before we were talking about you know anything electronic I'm sure yeah other technologies exist technological evolution is a long time thing is pretty benol statement I suppose but what I'm curious about is the sense in which a change in degree becomes a change in kind essentially so that like when you go from 1 second to a thousandth of a second to a nancond. How does that change say like the types of strategies that can then be employed or the types of skills that might be required to be a successful trader in the nancond era versus the 1 second era like talk to us about like that relationship.

Donald McKenzie: Yeah. Yeah. Well, there's a wonderful book by the historian of technology Jima Canales which is called a tenth of a second a history and the significance of the tenth of a second is that's the generally accepted lower threshold of the human perceptibility of time. You know, basically we just can't mentally process time intervals that are less.

Joe Weisenthal: So Tracy, don't feel bad about not being able to build an intuition for a nancond.

Donald McKenzie: less than a tenth of a second, you know. So what essentially happened is that we've moved from that kind of you know the tenth of a second or longer from from that kind of epoch into an epoch where human beings I mean they can still be in overall control of the system but they can't actually execute the actual trading decisions fast enough not to be outrun done by an algorithm. So we moved from a a kind of human- centered form of trading to a machine centered form of trading and the you know the actual threshold of the change is probably around that tenth of a second amount.

Tracy Alloway: I have another cultural and I guess market structure question. But one thing that I always thought was interesting about high frequency trading was that the banks didn't really get into it which you know

Joe Weisenthal: there's one big reason why which is the ban on prop trading after 2008 but even before then they just never seemed to be able to compete with independent firms. Why did that happen?

Donald McKenzie: Yeah, it's I've asked people that and there's I think complex sorts of reasons and I let it be said some banks have been more successful than others. Banks are not always bad at this though most banks are bad at it. One way of thinking about it is is that typically a bank will have an IT department that's separate from the other functions of the bank like trading like market making and so on. So if you you know if you're a trader you got to persuade the IT people to give you a fast enough system which involves them you know maybe writing some new software buying some new kit. So you need to get higher level management sign off on it and it all takes time whereas the high frequency trading firms are typically pretty small. you know 50 people is a decent size firm. 150 people is you know is a reasonably big high frequency trading firm. Very often those firms are owned and run by the you know the people who founded them. So that there is a boss or bosses but you know other than that it's a relatively flat organizational structure. If for example, at least this was the case in the early days of high frequency trading, it's not quite as simple as this now, but in the early days of high frequency trading, you know, if some IT firm came out with a new, better, faster server and you were a trader in a firm like that and you okay, well, let's get this new server. You could just use your own personal credit card to buy the server, get it delivered to your office, and then get your engineers to take it out to whatever data center that they were trading in and and get it installed straight away. And you know, that could maybe that would be a week or 10 days or something. Whereas in the bank, you'd be doing pretty well if you could achieve that within 6 months.

Joe Weisenthal: Yeah, that's amazing. Purchases,

Tracy Alloway: we don't know. We don't know anything about long waits for computers to arrive.

Joe Weisenthal: No, we surely don't. Um, that's sarcasm. By the way, actually, this reminds me of something that I wanted to ask, which is we know there's competition between firms, highfrequency traders for the fastest connections to um, exchanges and things like that. There's also competition I imagine within the firm itself because setting aside the credit card anecdote these can be expensive and there's also limited supply you know only so many servers can be colllocated where they want to be

Tracy Alloway: in your research how did you actually find executives at HFT places how did they actually allocate the fastest connections to which team

Donald McKenzie: yeah what I found was the high frequency trading firms fell into two different camps, so to speak. In some of them, there were separate trading teams that didn't really communicate with each other and indeed by design didn't communicate with each other. In some cases, the the office was actually laid out in such a way that somebody in one team was not very likely accidentally to overhear something said by someone in the in another term. I mean in those in those firms yes I mean they are essentially in competition and I think that in that kind of firm then the results of each trading desk the P&L the profit and loss the little trading teams that are doing best would get the available bandwidth on the microwave links that are crucial to high frequency trading and and so on and maybe they would get the fastest machines first and and so on so forth. Earth. The other kind of trading firm was and is operated as a unified entity in some cases even without individual profit and loss in individual P&L accounts for traders and there's a lot of shared infrastructure um in that kind of firm and indeed there's also shared infrastructure in this you know the segregated kind of trading firm because if you're the boss of such a firm there's obviously simply economies in not having completely separate IT systems for each each trading for each each trading team. But there's that kind of divide. Does the firm operate as a unified entity or does the firm operate as a sort of aggregate of competing trading teams?

Joe Weisenthal: So actually let's just you know on the subject of who is the closest or where who gets to have their server located where tell us a little bit more about the timeline. So island emerges in the late '9s. When did it start to dawn on people in the trading industry that given this new physical reality given the speed we need to start thinking about who is going to have collocation. we need to start thinking about sort of like microwave radio line of sight. Where did that speed war was the genesis of it?

Donald McKenzie: Yeah. Yeah. I mean a kind of crucial date was 2005 where Ireland which had already been bought by Instanet was acquired by NASDAQ and the New York Stock Exchange uh acquired another of the pioneering electronic trading exchanges. This one was called Archipelago. And

Tracy Alloway: is that just a coincidence that island and archipelago? That's kind of like

Donald McKenzie: Yeah. No, I'm sure it's not a coincidence. Yeah. And they technologically reorganized themselves. The New York Stock Exchange and NASDAQ technologically reorganized themselves around this new insurgent technological approach to trading, so to speak. And 2005 because of the acquisitions in that year is is a kind of noteworthy year. But even before 2005, people in trading firms started to become aware that you couldn't just do automated trading with the machine sitting in your office. For example, there's a Kansas City trading firm called Tradebot whose owner Dave Cummings has written a really rather nice autobiography. And one of the things that Cummings came to realize is that trading an island while having your machines in Kansas City was placing him at a disadvantage. So firms like that started to move their machines either directly into the island computer room or they couldn't do that into the offices of another firm in the building to shorten the distance and that kind of thing was already in place by 2005.

Donald McKenzie: Two things then happened for a period. There was a kind of wild west so to speak where there are lots of stories of high frequency traders like drilling holes in walls so as to shorten the distance between their servers and the exchanges matching engines. That has by and large generally come to an end. What happens now in the in the data centers of all the major exchanges is there is a rule about equal cable length. So if you happen to have if a trading firm happens to have its servers physically close to the exchange matching engines, the fiber optic cable that connects them is coiled so that there's exactly the same cable length for each of the trading firms within that data center. The other thing that started to happen is that getting the signal from one exchange's data center to another exchanges data center started to become a technological speed race. Back to 2005, by and large it would just be sent by fiber optic cable, but the exact route was not under the control of the exchanges or of the trading firms. So there's a lot of sort of randomness. The crucial link here is actually between the Chicago Merkantile Exchanges data center then um in downtown Chicago. It's it's now in in in the suburbs of Chicago. The link between that and the data centers that trade shares in northern New Jersey. And there was a kind of triple evolution there.

Donald McKenzie: The first evolution was that the particular trading firm, and since it's no longer directly in business, I can actually name it Gecko, um, managed to, as it were, stitch together existing fiber optic cables to get the fastest route on the Chicago, New Jersey link. And that actually in the business was known as the gold line. gold because of the money that you could make by having the fastest route. Then in 2010, if memory serves me right, a new firm, Spread Networks, actually dug an entire new cable from Chicago to Northern New Jersey. Uh, you know, drilling, you know, sort of underneath car parks and, you know, just really trying to be as close to what a geographer would call the geodisic. In other words, the the fastest route on the surface of the earth from point A to point B. Then third phase that was trumped by the arrival of microwave because light in a fiber optic cable I mean the core of fiber optic cable is essentially a specialized form of glass and that glass slows the light down to only 2/3 of its speed in a vacuum. Whereas if you can shoot your electromagnetic signal through the atmosphere, it's not exactly at the speed of light in the in a vacuum, but it's very very close to the speed of light in a vacuum. So that was the third phase when people moved from exclusive use of fiber optic cable to supplementing the fiber optic cable by microwave links between Chicago and northern New Jersey.

Tracy Alloway: That was incredible.

Joe Weisenthal: I have another cultural market structure question which is along with this intense competition to be faster than anyone else there was a narrative around that time that this was a bad thing Right. Um, and one of the interesting cultural things is you saw the highfrequency trading firms kind of divide themselves into good guys and bad guys. So there were some that were saying, "Well, we make liquidity, right? We're good for the market." And then there were others, I mean, they wouldn't describe themselves this way, but they were accused of being liquidity takers in the market. How should we think about that particular tension?

Donald McKenzie: Yeah. No, that's a very fundamental thing because you're quite right that there's a degree of differentiation between trading firms and indeed in the more segregated firms also within those firms you different desks fall on others on different sides of that. I mean the the way to think about it is to remember that in all these exchanges trading is organized around an electronic order book. As I said, a list of the bids to buy and offers to sell the instrument in question. What a market making firm does is it places lots of orders into the order book at prices that can't immediately be executed, but those orders then populate the order book. So if somebody else comes along, an individual investor or maybe an asset management firm, somebody else comes along and needs to trade, they find an order book that's populated with lots of existing bids and offers that they can execute against. So the market making firm is providing liquidity and most people reckon that that's a good thing.

Donald McKenzie: The other kind of firm, the one where, as you say, there tends to be more controversy, they don't do that. They don't constantly populate the order book. Their systems constantly monitor the order book. And then when they detect what they think is a profitable opportunity, they execute against the orders that are already in the order book. And that is called liquidity taking because of course the execution removes the order from the order book. And in in practice, a lot of this is actually going on between high frequency trading firms because most of the orders in the order book are placed by market making high frequency trading firms. And a lot of the executions against those are by the high frequency trading firms that specialize in taking liquidity. And this is the core of what gives the business its characteristic as an arms race in speed.

Donald McKenzie: So for imagine for a moment that your algorithms are trading equities in one of the data centers in northern New Jersey and the relevant stock index future traded in Chicago changes in price or even you know there's a big shift in the order book for that stock index future and then let's say the price of the stock index future falls that's very likely to lead within a tiny fraction of a second to falls in the price of the underlying shares being traded in New Jersey. And in that tiny little fraction of a second in that intervening period, a lot of the market making firms orders in those order books become stale as people in the markets would put them. So the making firms rush to try to cancel their stale orders and the taking firms race to execute against those stale orders. And that's a race that nowadays can literally be played out in nanoseconds.

Joe Weisenthal: That's interesting. I hadn't appreciated that dynamic at all to be honest. You mentioned that these highfrequency trading firms, they're all sort of like they're run and operated basically by the employees or the owner or something like that. What is it that sort of distinguishes a highfrequency trading firm from say a hedge fund that would have limited partners and make distributions etc. You know, you never hear about like oh I have an investment with Jane Street or something like that. They I don't think that's what I think. What is it about the nature of the business such that essentially they trade their own capital?

Donald McKenzie: Yeah, I guess that's just you know in a sense it's one of those things that's historical evolution. I mean in many cases those high frequency trading firms were initially set up by successful floor traders particularly floor traders in the Chicago markets the futures markets and if you were successful in that you could you might not become a billionaire but you know you could make decent amount of money tens of millions of dollars and that was enough to enable you to start an initially small automated trading firm and you often didn't need any external capital to do it. You just had to buy the necessary technical kit and hire technically savvy people and so on. But you could start really quite small. You could start, you know, 10erson firm or something like that. Now the business has got a lot more expensive since then because in good part of the speed race that we've just been talking about but by and large those firms made profits the owners reinvested the profits in the firms so that you know the the capabilities of the firms grew to meet the growing demands on them.

Donald McKenzie: And then another thing that should perhaps be said is that those founders would have the majority of their net worth invested in the firm. And so their risk control was often, you know, pretty good. You know, risk management for those firms was not a sort of, you know, a separate bureaucratic department that the traders had to try to outwit, so to speak. the founder would quickly detect if you were trying to do something like that. Now, some automated trading firms have blown up ne nevertheless, but it's actually quite interesting how few of them have blown up. Yeah. because of you know for example because of classical software bugs and that's I think because the relatively small structure the handson involvement of the founders etc etc has created a kind of technical culture that actually works pretty reasonably well better than I would have expected it to work at the start of this research

Tracy Alloway: so one thing I wanted to ask is this idea of physical limitations to how fast we can actually go. I'm pretty sure people always say that you can't go faster than the speed of light. There's probably some caveats there about like quantum entanglement and stuff like that, but surely we must be getting close to how fast things can actually go. What's your sense of how long the speed race can continue?

Donald McKenzie: Yeah. Well, we can never get to zero.

Donald McKenzie: Mhm. Of course, I think Einstein is basically correct. You can't get faster than the um the speed of light in a in a vacuum. And similarly, a computer system, there's always going to be a nonzero processing time of the system, but you can get ever ever closer to that. So in mathematics speak, zero is an asmtopical limit. Um that's to say you can always get closer to it, but you're never actually going to get right there. And I think that's the nature of the business. You know, we're still in the nancond regime. If I remember correctly, the next lowest time interval is the picoscond. um you know we I could imagine this continuing in a in a domain of picos seconds. So that's the way I would see it that there's a hard limit but we're never actually going to get to the hard limit. We're still going to race to get as close as possible.

Tracy Alloway: But your understanding as of the time of your work is that the race is not over. that for these firms and I'm sure they have many different projects on their plate including various things with AI which we haven't gotten to and I guess we won't but the speed race is not and will never be done.

Donald McKenzie: Yeah, I think that's correct. Now, of course, there is an economic process, yeah, at work here, which is to say that the investments that you make in speed have to be recoupable from the trading profits that you make from your trading. And I think Tracy I think said at the very beginning what essentially is going on here is that structural features of financial markets are being exploited like the relationship between the stock index future and the underlying equities. The amount of money to be made by exploiting those kind of structural features is not trivial. It's been nicely measured by the um Chicago economist Eric Suffort and colleagues. It's not trivial, but it's perhaps singledigit billions of dollars. So, you know, suddenly deciding you're going to invest $50 billion in the technology of speed would be a dumb thing to do because you wouldn't be able to recoup it. So there is that economic factor that is I'm pretty certain slowing you know the speed race is still there but it's it's you know and you know things are getting faster but the rate at which they're getting faster is certainly not accelerating and I think that economic factor probably explains it.

Joe Weisenthal: That makes sense. So, we should talk about the impact of HFT on the overall market a little bit more. And one of the things that caught my eye in your book was you cite a previous study, I can't remember by who, but basically saying that the efficiency of financial markets has not improved between the 1880s and 2012,

Tracy Alloway: which is very counterint. But what does that mean? Yeah.

Donald McKenzie: Yeah. So that is work by Thomas Filipon or his French pronounce it in the American way. It's Thomas Filipon. What he means by efficiency there is really rather different from what I've been talking about. What he means by efficiency is what he calls the unit cost of financial intermediation which essentially is you know basically putting it crudely how much it costs to do the kind of thing that investors want to do that asset managers want to do and so on and it you know it's very striking finding that from the 1880s to I think his most recent data got up to 2015 that there was no really clear-cut tendency for that cost to decline despite all the advances in information and communication technologies over those many decades. And the explanation to put it simplistically and crudely is the capture of those efficiency gains in the form of high pay in the financial sector. You know, typically through the form of fees. So the fees that you pay for an index fund, say for example, those have really gone down. But people have also been moving their money into private equity and the like hedge funds which have much higher fees and so on. So those kind of effects seem to have sort of canceled themselves out in the 1940s.

Donald McKenzie: A professional in finance was basically paid roughly the same as somebody with equivalent educational qualifications in a different line of business. And then from the 1970s onwards the gap has got bigger and bigger and bigger. Now these days of course you can make a lot of money by being a technologist in AI for example but by and large those sort of exceptions aside finance is an extraordinarily well-paying professional at least for those in the central roles in it. And that's essentially the explanation of of that finding by Philippon.

Tracy Alloway: Well, this is a good opportunity to ask about AI because I suppose it's inevitable as a sociologist who examines the tech industry or looks at how tech is impacting things. Your next project must be AI, right?

Donald McKenzie: Yes, it is.

Tracy Alloway: And what's what's the particular angle or what have you been discovering so far?

Donald McKenzie: Yeah, it's very early days. But the thing I'm most interested in so far is the question of scaling a I because of course it's no secret to anybody who reads reads a newspaper subscribes to Bloomberg or or whatever. I mean the huge trillions of dollars are being thrown at AI infrastructure and absolutely there is a sort of logic there that's you know repeatedly stated that you know these systems are all built around neural networks and the effectiveness of a neural network grows with the size of the network the size of the training data the number of parameters in the model and so on and there are well-known scaling laws but and this is the thing that interests me is the the but there's a very nice little statement from Sam Alman in February of last year that the intelligence of a system is roughly the log the logarithm in other words of the resources devoted to training it running it to computation at inference time and so on. Now, of course, what Alman meant was basically give the industry more money and you'll get more intelligence. And that's of course indeed the giving the more money to the industry is exactly what what's going on. But a logarithmic function, there's a bit of maths here, a logarithmic function, at least of the kind that Altman is referring to, is a diminishing returns function. You can draw its graph and it very clearly demonstrates diminishing returns. It'll you can always get better and better, but each increment costs you more in terms of the resources deployed. And we're dealing here where the horizontal axis in the graph so to speak is denominated in trillions of dollars of financial input or hundreds of megat tons of carbon dioxide emitted by the electricity generation needed to power the data center.

Donald McKenzie: So the question becomes on a diminishing returns curve how far do you go? When do you decide we really got to stop? Can you decide we really got to stop? Do you have kind of quasi magical beliefs so to speak that at some point the diminishing returns something qualitative will happen that artificial general intelligence or super intelligence will suddenly appear? So that's the core of what I'm interested in um right now. How far do you go along a diminishing returns curve?

Joe Weisenthal: Joe, I just want to state for the record if you give me more money I get more intelligent. There's no diminishing returns just for the record,

Tracy Alloway: you know. Um, noted first of all, and it's interesting, you know, hearing this in the context and it suddenly makes so much sense how this fits into your work and this idea of like the arms race, right? Because yes, it's true like maybe there's only so much extra profit available for the firm and maybe that pool of profit is shrinking and maybe it gets more and more costly to sort of exploit the remaining profit that's available. But on the other hand, you can't fall behind. You can't let and this is so there it's true in HFT and it's clearly true in AI where okay like it spends more and more money to improve the model but you can't fall behind even if the economics look worse with each iteration.

Tracy Alloway: Anyway, Professor McKenzie, lovely conversation. I really enjoyed that. We really learned a lot. Really appreciate you coming on to OddLots and uh yeah, thank you for

Donald McKenzie: Thank you both. Thank you both for inviting me like I said and you know thanks for a a really great conversation.

Joe Weisenthal: It was fantastic. Thank you.

Tracy Alloway: We'll have to have you back on when you publish your AI book.

Donald McKenzie: Absolutely.

Joe Weisenthal: Tracy, I love that conversation. Really interesting. I love like encountering people who are like actually understand the tech, actually can articulate what the tech is doing for especially it's always impressive someone with a sociology background to just sort of be like that comfortable and I think that's like the throughine of his work is like he gets it

Tracy Alloway: right. So in the book there's lots of like field trips to data centers and looking at cables and things like that but then also as you stated just talking to people and getting anecdotes and there's funny stories about like the battle of the asterisks and things like that that's at the very end but people should go and read it. The other thing that stood out to me from that conversation was towards the end when we discussed AI, you made the point that you get this similar dynamic between HFT and AI now where because everything is framed as existential.

Joe Weisenthal: Uh you just can't stop, right? You always have to keep going.

Tracy Alloway: Totally. And look, I mean, I suppose the high frequency trading is not sort of like existential in the broad sense, but it's existential at the firm level. At the firm. Yeah. Yeah. at the firm level. So it's like and I hadn't really thought about okay you like have this like pool of theoretical profit which is the gap between where the futures are trading in Chicago and where the stocks are trading in New York that's fixed right there that's not going to get that big but again like someone gets faster at exploiting that and I had never really heard quite until your question and his answer this sort of make taker dynamic of okay I have these orders and now I'm quickly rushing to cancel them and you're quickly rushing to fulfill them and if you and I are both in the market we can't slow if you get faster I must get faster cuz you're going to then snipe me every time or vice versa etc. But, you know, they still make a lot of money. It seems like unlike the AI firms, they make a lot of money. Yeah, exactly.

Joe Weisenthal: That was a funny dynamic in HFT world, the like accusations of Taker versus Maker. And I always think of the, you know, the Spider-Man meme where they're all kind of pointing at each other. It felt very much like that. But it was really great to catch up on HFT again. This was sort of a blast from the past because you used to hear about it more and now it's become so normalized that people just don't talk about it that much. Well, you know, we heard about it a lot and especially post 2008. Yeah. That was the ultimate fingerpointing era, right? The Michael Lewis because you just have like everyone had some, oh, it's the naked short sellers, it's the credit rating agency, it's the uh, you know, the law that forces banks to be equitable in who they distribute mortgages to, etc. Like, there was a million fingerpointing. Oh, maybe it's the HFT firms, maybe it's the short sellers, whatever. So I mean part of the reason we don't hear about it as much is because there hasn't been a crisis etc. But as you said the race continues and of various flavors.

Tracy Alloway: You can never get to zero but you can always get closer.

Joe Weisenthal: You know it's like you know I always think about some lines they go like straight up you know it's like the they ever like curve back around instead. You get like negative space like can we do even better than line go up like line go up and backwards? I guess Einstein would say no. Um, if only we could have Einstein on as a guest to talk about trading

Tracy Alloway: to talk about high frequency trading.

Joe Weisenthal: Shall we leave it there?

Tracy Alloway: That would be a perfect guest. Let's leave it there.

Joe Weisenthal: All right. This has been another episode of the OddLots podcast. I'm Tracy Aloway. You can follow me at Tracee Alaway.

Tracy Alloway: And I'm Joe Weisenthal. You can follow me at the stalwart. Check out Donald McKenzie's book, Trading at the Speed of Light. And of course, follow our producers, Carmen Rodriguez at Kerman, Dashel Bennett at Dashbot, and Kell Brooks at Kellbrooks. And for more OddLots content, go to bloomberg.com/odlots. We have a daily newsletter and all of our episodes. And you can chat about all these topics 247 in our Discord. discord.gg/odlots.

Joe Weisenthal: And if you enjoy OddLots, if you like it when we look back at the HFT boom and how it continues, I guess, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely adree. All you need to do is find the Bloomberg channel on Apple Podcast and follow the instructions there. Thanks for listening.