August 19, 2016    4 minute read

A Crash Course In High Frequency Trading

Too Fast For Some?    August 19, 2016    4 minute read

A Crash Course In High Frequency Trading

Recently, there has been a lot of buzz about the growing prominence of Fintech, especially in revolutionary e-payment systems and blockchain technology. However, one significant side of it has not been given sufficient attention lately: High Frequency Trading (HFT).

HFT firm Virtu Financial Inc. is set to join hands with investment banking giant J.P. Morgan Chase to boost trading efficiency in the US market. This is illustrative of financial giants moving towards Fintech and HFT to step up their game and innovate. There has been a spike in HFT firms in terms of power and influence, as illustrated below.

KCG, a HFT firm on the rise

Source: Yahoo Finance

Another HFT firm, Flow Traders, is seeing favourable times in light of Brexit (a 5% trading income boost, to be exact). This is probably due to the shock seen by financial markets and the ensuing volatility, which is the boon for HFT firms as they trade to profit from such events. This is yet another example of the growing presence of HFT in financial markets, and they warrant a closer look. But first, what is HFT?

The Definition

Essentially, HFT is a variation of algorithmic trading (AT) and utilises the power of high-tech software to execute deals at lightspeed. HFT is like a computer programme with very specific instructions (in this case, a complex algorithm). The minute a stock falls within the given set of instructions, perhaps within a price range, the software will carry out the deal.

Why is this so powerful? Due to their low latency (time in executing a transaction), HFT firms can hit sell offers much faster than an ordinary trader could, and use that opportunity for arbitrage (reselling the stock at a higher price). Clearly, their activities are at the expense of smaller traders and investors without access to such technology.

One may be asking: what is the big deal? It certainly sounds like an innovative business plan. Now would be a good time to turn to the concept of liquidity. In layman jargon, liquidity is the ability to convert a given asset (in this case shares) into cash or some other readily accepted form. For example, a short-term government bill would be much more liquid than, for example, a factory building. This is because it is somewhat easier to sell the government bond on an exchange market than it is to find a buyer for the large, expensive and possibly redundant factory building. In an exchange market, one of the measures of liquidity would be the number of buy offers (or asks). Liquidity is also sometimes measured via volume turnover ratios or number of transactions that actually took place.

Post-Crisis Lessons

Back in 2008, the global financial crisis hit hard enough for people to realise the dangers of shadow banks, but the Fed realised liquidity in the markets was crucial for financial stability and institutional robustness. It certainly would not do good to have people holding stocks but unable to convert them to cash – that would cause drastic losses following a probable panic sale. Hence, the Fed established something called Supplemental Liquidity Providers (SLPs). In essence, SLPs are a group of companies paid a rebate to provide liquidity to market participants (by buying up market orders). This will ensure people will always be able to liquidate their shares without worry of being stuck with unwanted assets.

However, the general argument against HFT is that such liquidity provided by these SLPs (which utilise HFT) is effectively false liquidity. The algorithms are programmed to buy during good times, but such generosity may not last in crisis periods. When a systemic shock hits the markets, this liquidity will vaporise (no pun intended). Obviously, this false sense of security is highly dangerous. HFTs are also considered unfair, generating profits at the expense of small traders and preventing them from trading at real prices. One other (debatable) danger is that HFT takes emotion and sentiment out of trading mechanics. This may be dangerous, as “animal spirits” or investor speculation are a core part of trading and taking that away may lead to market instability and amplification of market volatility.

What Needs To Be Done

The consensus is to regulate HFT properly and prevent such exploitation. Also, their trading patterns should continuously be monitored to check for any risky trading which might lead to the destruction of public confidence and induce a stock market crash. For instance, in 2010, the Dow Jones Industrial Average plunged by approximately 10% and then quickly rebounded. Authorities suspect HFT was behind this, and if true, it certainly is a testament to the power HFT firms hold over the markets.

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