May 8, 2014    7 minute read

High Frequency Trading: The Future?

   May 8, 2014    7 minute read

High Frequency Trading: The Future?

It’s not mere coincidence that technology is playing an ever bigger role in the banking sector. In fact, it’s quickly becoming the defining factor for the success of some banks. There is a clear correlation between having the best technology and profitability, and banks know this.

High frequency trading is just the next chapter of this book which tends to be done by specialist firms with super-advanced technology. Indeed, it might not be too long before some traders actually become a job of the past. In future, it’s likely that the success of an institution won’t rely so heavily on bankers and traders in the front office but rather the technologists with their headphones on.

One such innovation is that by Ronan Ryan (after being rejected by Wall Street) who created what is known today as high frequency trading by creating the super high-speed fibre optics and computer platforms needed to trade in financial markets at metrics measured in milliseconds. It is literally what it says it is: a platform that allows traders to purchase or sell financial instruments, usually large amounts, in milliseconds. It links in well to automated trading as many computer algorithms performing trades as programmed are often done so in a high-frequency context.

But, a massive issue with this is it allows traders to “front-run” the system and profit from millisecond delays in trades. For example, if an order is placed on a normal connection for one million shares of company x, then an algorithm set by another trader can place an order for the same amount of shares on a faster connection. Therefore, the trader buys the shares first (even though he ordered later) as his connection is faster and then sells them at an inflated price to the original order on the slower connection. All of this takes place in milliseconds. It’s one of the reasons why this technology has become both important and criticised in equal measure. It’s essentially an easy, risk-free way to make large profits, especially on large transactions, by defrauding the system – the person with the fastest connection makes the most money. The worst part of the process is often the individual at the end of the original order does not know they have been sold shares at an inflated price as the price increase per share would be miniature (which when multiplied by the size of the order creates a large profit).

As a result, the average speed of a trade in the US now stands at 98% of the speed of light.

In 2009, high-frequency trading firms accounted for 60-73% of all US equity trading volume but in 2012 that declined to 50%.

It causes big challenges for regulators as it provides a possible explanation for what are known as “flash crashes” where the price of a financial instrument randomly collapses, sometimes to near zero, for no apparent reason. Such explanations for “flash crashes” include those of automated traders; computers that run algorithms to make decisions that traders would make, only computers do it much faster and more efficiently. In fact, it was not too long ago a firm known as Knight Capital had an issue when one of its automated trading algorithms went wrong almost bankrupting the firm within 45 minutes after making a $440,000,000 loss. This situation is made much worse when it triggers other automated computer algorithms to react causing stock prices or whole portfolios to collapse as an automated mass sell-off occurs in seconds.

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For example, a flash crash occurred in Accenture shares causing the shares to be worth practically zero (worthless) for a matter of seconds. In the same way, the flash crash in New York was a prime example of how a whole market can collapse, similar to what would be experienced in a financial crisis, when things go wrong. Often, it leaves many traders completely bewildered watching in fear.

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Some argue however, that high frequency-trading is good as it helps balance markets by closing spreads between buying and selling prices. During the freak stock market crash on the Dow Jones a few years back, CME Group claimed high-frequency trading had a stabilising effect on the market. The report by the SEC and CFTC disagreed.

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That report eventually found that the freak stock market crash was initially caused by a mutual fund selling $4.1 billion in futures contracts aggressively to hedge its investment positions and then this sale was magnified out of proportion as high-frequency trading algorithms reacted. This impact then spilled over into equity markets.

There is also a risk of insider-trading as individuals holding confidential information may decide to act on it milliseconds before the news actually becomes public in order for it not to be picked up by regulators as “suspicious trading movements” while still profiting from the privileged information.

Nonetheless, any benefits of high-frequency trading by balancing markets are completely distorted by the issue of front-running. Once again, it represents a blow for people with pensions or investments, the institutions that don’t have technology running at 98% the speed of light. Despite this, various studies have demonstrated that high-frequency trading reduces volatility, does not pose a systemic risk and lowers transaction costs for retail investors. For this reason, high-frequency trading is aggressively debated.

Regulation, which inevitably will come, is likely to be done on a G20 scale to avoid high-frequency traders who abuse the market simply relocating to continue. Again, regulators have limited funding to hire skilled people to deal with the problems faced. In fact, it was not long ago that it was revealed many compliance staff who worked for regulators were being head-hunted by banks offering higher salaries – since they are in such demand. This situation leaves regulators in somewhat of a “death spiral” meaning they are always one step behind.

Today, the man who created the platform now works at IEX, a trading platform designed to be more transparent with speed being regulated to avoid market abuses which is likely to become more popular. In this way, a “speed bump” is created to avoid certain trades arriving before others making front-running impossible. It has a firm belief in equal opportunity for all investors.

A Chicago Federal Reserve letter entitled “How to keep markets safe in an era of high-speed trading” also made recommendations including a “kill switch” to stop trading all at once if something goes wrong along with profit/loss limits, limits on the maximum position a firm can take in a day as well as limits on the number of orders that can be sent to an exchange in a certain time period.

In future, we can expect to see regulators come down hard on high-frequency trading to avoid market abuses such as front-running as well as flash crashes which can leave some investors, out of pocket. Most likely, they will adopt some of the recommendations from the Chicago Federal Reserve letter. Some European countries have even gone as far as to say they may ban high-frequency trading altogether due to the unpredictable and random volatility it can cause.

Whatever way you decide to look at it, the future is unquestionably, going to be more regulated.

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