Is High Frequency Trading Really Such A Bad Thing?

in Investing by

In the wake of Michael Lewis’s new book on high frequency trading abuses, I’ve been reading the daily headlines shouting for more regulation in the stock market. Everyone seems to have a different agenda, and the complexity of the modern marketplace makes it almost impossible to separate truth from exaggeration or misdirection.

While the current news cycle focuses on the abuses and damage HFT creates, there is also good evidence of the positive influence it has on information flow, price discovery and tighter market spreads. In the end, it’s up to the regulators to decide which effects are most important.

WHAT IS HIGH FREQUENCY TRADING ANYWAY?

At its most basic, high frequency trading involves using a computer algorithm that responds to changing market conditions to buy or sell shares of stock extremely quickly. Since trading risk rises with the size of trade and holding period, HFT attempts to minimize both.

A computer will buy and sell stock in a fraction of a second, using small sized lots and making a fraction of a cent a share. This allows for profit in both up and down markets with extremely low risk. A hundredth of a penny doesn’t seem like very much, but remember that HFT is currently estimated as 50% of daily trades and average NYSE volume is over one billion shares a day. Those fractions can really accumulate!

No one really knows how much they add up to in aggregate, but at least we can get an idea of the lack of risk in this strategy: In the course of filing documents for their IPO, HFT firm Virtu recently announced that they had only ONE losing day in four years of trading. Just one. (Virtu has now postponed their IPO indefinitely).

How those profits accrue is a matter of fierce debate. Much algorithmic trading is engaged in information arbitrage across stocks and exchanges. A change in the market will occur, and HFT systems will race one another to trade on other exchanges before they have had a chance to adjust. This type of arbitrage has been practiced forever, and even critics of HFT generally consider these actions above-board and entirely proper.

LOWERING THE COST OF TRADING

High Frequency trading in this capacity accelerates both price discovery and the spread of information between exchanges, and it can actually make trading cheaper by shrinking the bid/ask spread.

The spread is the difference between the best price a buyer is willing to offer and the best price a seller is willing to take, and it exists wherever there is a continuous market such as the stock exchange. The wider the bid/ask spread, the more you pay to trade, and the size of the spread is not the same for every stock. If a stock is volatile or does not trade frequently, mis-pricing risk increases and the bid/ask spread will be larger.

Competition between HFT systems has had the effect of tightening these spreads by increasing the number of shares displayed and traded, while accelerating the update of pricing information in the stock market. Numerous studies have noted this effect over the last decade. At the same time, the cost for everyone to trade in the market has been shrinking.

In a 2010 letter to the SEC, Vanguard argued against blanket restrictions on HFT, in part because they had seen their transaction costs drop between 35% and 60% in the past 15 years. As one of the largest mutual fund companies in the world, Vanguard is not engaged in high frequency trading of any sort, and has no reason to defend the practice unless they see a positive outcome for their clients.

THE NEGATIVES OF HIGH FREQUENCY TRADING

Despite the lower costs of trading and support from the likes of Vanguard, there is also an uglier side. HFT can be used to discover orders on their way to market and trade in front of them, through speed-of-light information leakage. They take liquidity away at the best bid/ask, and then turn around and provide it back to the original trader at a worse price. This is possible because an order traveling through 300 miles of fiber optic cable will always lose out to an order originating across the street from the stock exchange.

When an order is large and traded in a predictable fashion, it is particularly susceptible to front-running because more information about the order can leak before it has completed. In response, many institutions have begun using algorithms that break up order flow into smaller pieces and trade them opportunistically. This type of HFT is pretty obviously a drain on the marketplace, and is much harder to excuse.

While high frequency front-running can prey upon all market participants, some are hit harder than others. The companies most affected by this speed-of-light information leakage are generally mutual funds that do a lot of large block trading and tend to trade urgently or predictably. In a word, the “active” funds. Their increased trading costs are hidden from their clients but flow through to performance, which is just one more reason why actively managed funds struggle to beat their benchmarks over the long term. It is no wonder such firms push for regulation

Front-running does obvious damage, but the true cost of HFT may actually be increased market volatility. High frequency trading has displaced many of the traditional market makers whose job it was to keep an orderly market, and who were required to step in and provide a backstop during volatile periods. Because HFT firms are under no such obligation and can enter or leave the market unbelievably fast, the odds of a sudden liquidity drain go way up.

This is what we witnessed during the flash crash on May 6, 2010. One mutual fund firm entered an ETF order incorrectly, and in a matter of minutes that information had flashed across the market and without human intervention, liquidity was instantly pulled. Some stocks were left with no bids at all and traded at $0.01! The market recovered later in the day, but the damage was done.

In another instance of machines running amok, on August 1st, 2012 Knight Capital mistakenly put a trading algorithm meant for development into the market and in a matter of an hour or two the system had racked up so many losing trades that the company almost went bankrupt. These programs react so quickly that by the time a human understands what is going wrong and pulls the plug, hundreds of millions of dollars can be lost.

Partly in response to these calamities, regulators have introduced circuit breakers into the market that automatically halt trading if a stock moves more than a certain amount. The hope is that these algorithmic halts will give human traders time to intervene and prevent widespread disruption.

CONCLUSION

As regulators and the general public look more closely at high frequency trading, hopefully they can resist the urge to throw up their hands and declare the market “rigged.” Tech advances that allow faster price discovery and more efficient markets should be allowed to flourish, while bad actors at the margins are pursued and punished. It should be possible to regulate front-running and volatility risk without placing blanket restrictions that raise costs for everyone. And rather than crying foul, the active mutual funds most vulnerable to front-running should adapt.

Personally, I like being able to trade at 1-2 cent spreads and $7 dollar commissions. It is a far cry from 15 years ago of $25 commissions per trade. If the major drawback is that mega funds trading 50,000 share blocks need to work a bit harder to avoid being sniped, then surely their fees will cover an increased investment in trading technology. And as everyone in the market is forced to become more efficient, it wouldn’t surprise me to learn that the profits of the HFT firms begin to level off or fall. Technology is more helpful than harmful. Wouldn’t you agree?

Photo credit: Financial Samurai.

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Matt Lenore

Matt Lenore

Matt Lenore is a Research Associate at Personal Capital. He left a traditional portfolio manager to join Personal Capital to be part of revolutionizing the wealth management industry. When he's not trading, he loves tracking the markets and scheming about investment strategy. He graduated cum laude with a degree in economics from Brandeis.

3 comments

  1. Barbara Friedberg

    @Matt,As an investor (of several decades) as well as a portfolio manager, I’m thrilled with the rock bottom commissions and small bid-ask spreads. I stick with an index fund approach and only trade infrequently, in order to rebalance my portfolios. Plus, I have more to worry about in my life than the “high frequency traders”. Good overview, but really, if the commissions and spreads are coming down, aren’t there more important things to worry about?

    Reply
  2. Financial Samurai

    Hi Matt,

    Nice approach to HFT. The guys who got promoted and gained power at the investment banks were the creators of black box, dark pool, algo trading at the investment banks. The traditional sales/trader fella slowly went away. But, in order to do the big blocks, you always need someone to negotiate and find the middle. It’s not worth having an algo try to find you $1 billion + of the other side.

    As a retail investor, I’m happy prices have come down. If I was a traditional trader, not so much. But, we must always be adapting to survive with technology.

    Reply
  3. ArbritRon 1000

    Part of your argument is that prices per trade have come down and that HFT is part of the reason. Can you provide any evidence of this? Prices are mostly down because technology has removed brokers and their commissions from the equation. Better technology, fewer people costs and more volume = lower prices.

    As for the company that reported only 1 losing day in 4 years… hmm, if I knew both sides of a trade and there’s any wiggle room between the bid/ask and my machines/network is fast enough, the only risk is that I beat out the other HFTs when they insert themselves between those prices. Oh, and that my profits outpace the cost of my cool tech and high-priced engineering staff.

    The only difference reason we don’t label HFTs insider trading is because the ‘tech is cool’. If you or I knew Warren Buffet and overheard he’s planning on buying a ton of Apple and we jump in and buy some the day before, we’d be headed to jail like Martha Steward; but if we see his transaction coming in and get in and out in nanoseconds, we could go IPO.

    Reply

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