High-Frequency Trading (HFT), also called algorithmic trading, is a method of trading securities in the capital markets by using supercomputers and complex algorithms. This method gives the skilled HFT trader the ability to make a trade in microseconds, according to a 2010 Duke Law and Technology Review.
Algorithms used by HFT traders allow the computer to look for a temporary imperfection in the market and trade before it disappears. The trader must trade thousands of stocks and be ahead of competitors by constantly investing in new and more advanced computer technology before making a decent profit.
“High frequency trading appears to be an irreversible trading trend in the U.S. and at its current pace will only expand its share of the U.S. stock market in the next few years,” the Duke Law Review states.
There are many advocates of the HFT method and probably even more who oppose it because of how it developed over time.
Even the assumed father of HFT, Thomas Peterffy, founder of the Connecticut brokerage firm Interactive Brokers, has second thoughts about high-speed trading.
“The man who built what was possibly the first stock-trading robot now worries they have too much sway over the market. In other news, Victor Frankenstein is starting to rethink that whole reanimating-the-dead thing,” according to an Aug. 28 article on the Huffington Post website.
Pros of Algorithmic Trading
“The potential benefits of high frequency are that it adds liquidity to the markets, speeds execution time, and narrows the price spreads between markets and exchanges. HFT firms may even be better liquidity providers than the specialists of the past because they do not have a conflict of interest,” according to the Duke Law Review.
Algorithmic trading benefits traders who buy the latest computers and algorithms, which in the long run equates to “survival of the fittest,” the Duke Law Review states.
“The benefit of this electronic execution framework is the efficiency and the cost,” suggested Larry Tabb, CEO of the TABB Group, in his Sept. 20 testimony before the Senate Subcommittee on Securities, Insurance, and Investment, published on the Senate Committee on Banking, Housing, and Urban Affairs website.
According to Tabb, HFT lowers trading costs for institutional investors, costing 1.08 cents per share for simple orders and 2.05 cents per share for orders that need some hand-holding. It costs retail traders $8 to $10 a trade, without any regard to the number of shares being traded.
Tabb suggests that using automated trading tools increases the efficiency and effectiveness of the market system.
“In addition, the electronic marketplace has made the marketplace overall more efficient, measured by volume traded. High-speed computers are continuously analyzing millions of quotes a second and looking for incorrectly priced assets, buying the theoretically cheaper ones, and selling the more expensive ones to bring prices in line,” Tabb testified.
Cons of High-Speed Trading
Some opponents of HFT are more vocal than others. Some see the practice just as an irritant, while others believe it takes advantage of momentary market imperfections that can’t be discovered by a small-time trader or an individual without the funds to invest in complex computer systems.
The Duke Law Review gives a more sedate evaluation of the cons of HFT: “High frequency trading is worrisome because of the lack of information available on its potential uses, the possibility that it could be used to manipulate the markets or obtain an unfair advantage, and its potential to lead to another financial crisis.”
The Duke Review states that the firms using HFT technologies are not transparent and rather guarded in what they are actually doing. The major problem is that these technologies are employed without anyone being able to control them and in the long run could hide some illegal activities.
“Other criticism is levied at the low barriers to entry to becoming a HF trader and the degree to which exchanges court HFT firms with the use of rebates,” the Duke Law Review suggests.
The question remains whether the rebate gained by the HFT trader drains liquidity from the markets and adds an additional cost to those who are not astute in the practice and do not participate in high-speed trading.
What is of concern is that a stock bought or sold through high-speed trading may change in value from 10 to 15 cents despite its market price, and someone has to bear the cost.
The Duke Law Review warns: “The lack of regulation on naked access allows a reckless high frequency trader to conceivably pump out hundreds of thousands of faulty orders in the two minute period it typically takes to rectify a trading system glitch.”
An Oct. 11 article on the Wall Street Insights & Indictments website is quite blunt in its criticism: “High-frequency trading is a scam. It should be outlawed. … The game, known as HFT, isn’t arbitrage, isn’t fair, isn’t consistent with the keeping of ‘fair and orderly markets,’ and so should be illegal.”
David Lauer of Better Markets Inc. testified before the Subcommittee on Securities, stating that it was a wake-up call for him when on May 6, 2010, the market crashed, losing $1 trillion and then regaining that amount within 20 minutes.
The next year, in August 2011, there was a computer-driven volatility that moved the market up and down for four days. Small crashes occur almost on a daily basis, and over 2,000 have been recorded since August 2011. All these types of volatility carry a certain amount of economic cost that as of this date has not been assessed.
“I witnessed something unthinkable: the market simply disappeared. … While complex systems can often provide elegant solutions to intractable real-world problems, they can also spin out of control in unexpected ways,” Lauer testified.
According to Lauer, mistrust of HFT trading and the publicizing of crashes resulted in a significant downswing in initial public offerings (IPO) and smaller investors have moved out of the stock market. An annual average of 530 IPOs was listed between 1990 and 2000, but the number has decreased to an average of 125 annually since 2001.
“Investor confidence is non-existent, with only 15% of the public expressing trust in the stock market in the latest Chicago Booth/Kellogg School Financial Trust Index. … Since the Flash Crash in May 2010, over $283bn has flown out of the U.S. Equity markets. Over that time period, the S&P 500 has risen by over 21%,” Lauer testified.
SEC Actions Missing
“While the SEC (U.S. Securities and Exchange Commission) deliberates extensively on any rule change and regulation, the hurdle is far lower for new order types. It is extremely rare to have the SEC refuse an exchange’s request for a new order type,” according to Lauer.
The issue is that the SEC requires proof that any change will have positive consequences in the market. But it has not implemented this requirement in regard to HFT, despite mounting evidence of the possible manipulative nature of this tool.
The SEC has hired a well-known HFT firm to develop a ticker plant, a software program that collects and distributes to traders the pricing and transactional data on particular trades.
“This is reminiscent of the fox guarding the hen house. This HFT firm is not in the business of building ticker plants,” Lauer testified.
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