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High Frequency Trading in the Current Environment
In 2009, 73% of all US equity trading volume was not initiated, executed, or monitored by human traders.[1] Rather, it was performed by High Frequency Trading (HFT) firms that used advanced hardware and software to trade large volumes of stock in nanoseconds. HFT needs to act so quickly as the average bid-ask spread has moved from 1/8th of a dollar to an average of less than 2 cents in 2012.[2] These firms trade extraordinarily large volumes over the course of one trading day and have been able to make billions because of their efficient speed. They do not trade based on fundamentals or with any regard of what they are trading. These supercomputers use algorithms to control all trades and operate based on predictions of market signals that may influence extremely short term movements in the market,[3] which can extend insignificant patterns into something significant. These movements are extremely difficult to track due to the sheer speed and complexity of HFT. HFT firms sometimes even make money on the sell side and buy side of exchanges simultaneously, by buying and selling at the same time. Firms do this because there is no regulation in place that has a significant effect on the behavior of HFT. HFT costs are indirectly passed onto investors who have to then buy shares at an inflated price after HF traders increase the price.
These firms have been able to continue business due to their ability to hide under the umbrella of phantom “liquidity.” There is no question that the electronic exchanges in the U.S. have brought a remarkable opportunity for individuals to profit and businesses to raise capital and expand. However, with the opportunity provided by electronic exchanges, colossal challenges have followed into financial markets. Currently, the financial market is becoming dominated by HFT as the justification of liquidity has allowed HFT to grow far bigger than it should have been. The major firms range from small firms that are relatively unknown to major Wall Street firms such as GETCO and Goldman Sachs. These firms have been able to influence how exchanges operate to make huge profits from almost nothing. A vast amount of money is at stake with HFT. Nearly $2 Billion was spent in 2010 on trading infrastructure – high speed servers and fiber optic cables to increase the rate at which information could be transmitted.[4] This $2 Billion exemplifies what a drain of resources HFT has created in the global economy.
HFT firms have spent millions to move their computers closer to the data centers of stock exchanges all over the world as digital information takes longer to reach some places than others. This technology has fueled a strategy known as latency arbitrage. It may take a few milliseconds more for trades on the Nasdaq’s servers in New Jersey to be crunched by America’s Clearing house for stock trades and reflected in the National Best Bid and Offer.[5] HFT uses a combination of hardware and software to see how much someone else is willing to buy or sell a given security for fractions of a second before the competition does. In the world of HFT, these fractions of seconds make all the difference when it comes to millions of dollars being made. This strategy means HFT trading firms can make money based on information that the competition essentially does not know yet. Latency arbitrage capital investments is not just being utilized in the U.S. from Chicago’s CME to the NYSE or NASDAQ, it is being utilized all over the world: London to Frankfrut, Sydney to Toyko and so forth. This has resulted in a technology arms race in hardware and software. HFT is no longer a distraction, it is a fundamental problem exacerbated by the poor business model of stock exchanges.
Exchange models allow firms to make money on the sell side and buy side of exchanges, by buying and selling at the same time. Firms do this due to a fundamental flaw of the exchanges that pays traders rebates to post shares to buy or sell[6]. The more postings firms can provide, the more they can collect from the rebates that are fractions of a penny. These quotes are not liquidity, they are quotes. These rebates are passed onto investors who have to then buy shares at an inflated price after HF traders increase the price. HFT firms only need to break even on trades due to these rebates, which increases the volume of trading. Markets are no longer nonprofit organizations owned by its trading members. Now, they’re businesses focused on making money, not funding the most efficient projects the economy has to offer. If HFT firms sought to help raise capital for businesses they would consider fundamental valuation techniques and make markets more orderly; not destroy confidence in the financial system as they have done on many occasions.
The flash crash has been well publicized in the media but its root cause has not received as much attention. The flash crash in May 2010 erased $862 billion in equity value within 20 minutes.[7] Individual investors who had stop orders in could have potentially been severely disrupted by such an unnecessary drop in market pricing. Individual Investors who were invested in large institutional funds also felt the wrath because of such a temporary rapid drop in equity valuation. The SEC and Commodity Futures Trading commission have not publically condemned HFT for the flash crash. Their report concluded that HFT didn’t “uniformly flee during the meltdown.” However, official reports suggested they helped fueled the uncontrolled selling.[8] According to John Bates, CTO of Progress Software, mini flash crashes happen all the time as a result of algorithms interacting with each other and forming an infinite loop. This is very concerning as HFT firms do not have the responsibility of being buyers of last resort.[9] Although HFT wasn’t the root cause for the Flash Crash, there are frequent examples of its responsibility for market dysfunction. When the AP Twitter account was hacked, the DJI fell 143 points[10] instantly, this is the opposite of reassuring. The NASDAQ is frequently being halted, and was halted for over 3 hours in August 2013. Knight Capital, a former HFT firm lost $440 Million in less than an hour due to a “software malfunction.”[11] The BATS Global Markets Exchange Inc. (Ironically, a leading HFT exchange) IPO flop was so damaging that an initial listing of $15 dropped to pennies on the day of its IPO due to technical issues, leading the company to withdraw its initial public offering of shares.[12] A firm that specializes in HFT can't pull off a successful IPO and that is concerning. These risks are real in IPOs. In BAT’S S-1 Filing the risks of HFT are limited to “regulatory changes” and “competition.”[13]
Proponents of HFT justify this cancer by arguing that investors are not affected by everyday price swings. They believe HFT increases liquidity and actually benefits markets. While Investors should not be concerned with small price swings, they should be concerned because these small price swings can become very volatile and turn damaging when they have limit orders in. Additionally, they are constantly at a disadvantage due to latency arbitrage and pay more for stocks due to inflated prices by HFT. Investors do not benefit from HFT firm’s increased liquidity as there is no increase to liquidity itself. Any liquidity HFT adds to markets does not last as it can be instantly removed and HFT firms can exit all of their positions. HFT switches from actively buying and providing liquidity to actively selling and taking liquidity from markets in nanoseconds.[14] These actions are all based on algorithms that can take action based on anything from a change in simple moving averages to economic data. HFT does not help markets fund new projects, reduces confidence in the financial system, and drains resources from the economy. The average investor most likely does not know about high frequency trading, so it is true that they might not be affected by HFT in their personal financial life. But, it is true that average individual investors have their money in mutual funds that are managed by large financial firms who are greatly affected by the behaviors of HFT. The bottom line is that the downside presented by HFT far outweigh any type of benefit HFT firm’s bring to the markets.
In order to restore the health and order of financial markets there needs to be a cultural shift on Wall Street and a fundamental shift to the business models of the exchanges that make HFT so lucrative. A ‘60 minutes’ special and an overwhelming amount of information supporting an overhaul of HFT exemplify the insufficiency and potential future damage to financial markets. There are a number of possible solutions that could end HFT such as limiting the amount of rebates a firm can collect, regulating how long stocks are bought and sold, or eliminating the use of latency arbitrage. Regardless of the solution to the problem, the regulatory agencies need to advance HFT on their list of priorities in order to protect the public from to the corrosive behavior HFT brings to markets as well as the economy. No matter how many circuit breakers exchanges install, HFT will continue to act faster and outsmart anemic regulatory mandates.
[1] Michael McGowan, “The Rise of Computerized High Frequency Trading: Use and Controversy” (Law School Dissertation, Duke Law School, 2010)
[2] The Economist, The Fast and the Furious, http://www.economist.com/node/21547988/print (February 2012)
[3] Richard Finger, High Frequency Trading: Is it A Dark Force Against Ordinary Human Traders and Investors? http://www.forbes.com/sites/richardfinger/2013/09/30/high-frequency-trading-is-it-a-dark-force-
against-ordinary-human-traders-and-investors/ (September 2013)
[4] Jerry Adler, How Wall Street Got Addicted to light-speed Trading, www.wired.com/business/2012/08/ff_wallstreet_trading (August 2012)
[5] See footnote 3
[6] See footnote 3
[7] Nina Mehta, Trading Rebates on Exchanges Should End, ICE’s Sprecher Says, http://www.bloomberg.com/
news/2011-10-11/trading-rebates-on-exchanges-should-end-ice-s-sprecher-says.html
[8] See footnote 2
[9] See footnote 3
[10] Heidi Moore, AP Twitter hacked and causes panic on Wall Street and sends Dow Plunging, http://the
guarding.com/business/2013/apr/23/ap-tweet-hack-wall-street-freefall (April 2013).
[11] Francesco DeLuca, “High Frequency Trading,” Review of Banking & Financial Law Boston University 32; 62-74.
[12] Dan Beucke, Bats: The Epic Fail of the Worst IPO Ever, http://www.businessweek.com/articles/2012-03-23/
bats-all-folks-the-epic-fail-of-the-worst-ipo-ever (March 2012).
[13] See Footnote 12
[14]Matt Levine, “High Frequency Traders Are a Little Too Slow” http://bloomberg.com/news/2013-11-05/ high-frequency-traders-are-a-little-too-slow (November 2013).
