One of the most controversial topics in trading today is High-Frequency Trading (HFT).
HFT uses computerized algorithms to rapidly open and exit trades as close to the speed of light as possible. HFT firms use all sorts of up to date technologies, including computer algorithms, microwave data cables, and servers located near exchanges, in order to minimize the amount of time required to execute trades.
The doors were originally opened to High-Frequency Trading in 1998 when the US Securities and Exchange Commission authorized electronic exchanges. Since then, HFT firms have increased their proportion of US equity trades from 10% in 2000 up to an estimated 70% in 2013, as is displayed in this HFT infographic.
Furthermore, while HFT firms make up roughly 70% of all US equity trades, they also make up 90-95% of all market quotes in the form of the bid and offer. In other words, HFT firms control the market prices and trade volume of US equities.
THE TECHNOLOGY BEHIND HFTS
HFT firms need to use the latest technologies and hardware if they want to remain profitable. The thing about HFT technology is that absolute speed is irrelevant, all that matters is the relative speed i.e. that you’re faster than your competitors.
As such, HFT companies such as GETCO spend millions of dollars each updating their technology, server and hardware. In 20012 alone, GETCO reportedly spent $37 million upgrading its new trading strategies.
HFT firms and banks also keep their trading formulas closely guarded secrets, to the extent that traders who have tried stealing these formulas from banks such as Societe Generale and Goldman Sachs have been prosecuted and received numerous years in prison.
Examples of the type of technology that HFT firms invest in include: specialized quote platforms such as OpenBook and TotalView (which run along 40 Gig data lines which cost $60,000 per month); internalization of order flows from major retail brokerage houses such as TD Ameritrade and E-trade; server farms located as close as possible to exchanges that shave milliseconds off execution times (up to $5,000 per month); hundred million dollar transatlantic cables between London and New York; specially designed computer chips which can prepare trades in one billionth of a second; and wireless microwave transmission services which can transmit data a few milliseconds faster then fiber-optic cables.
WHAT ARE THE RISKS AND ISSUES WITH HFT?
The main issues surrounding HFT are its lack of regulation, its unfairness to individual traders, and its ability to cause massive drops in the market at uncertain times.
While HFT firms generally add the bulk of liquidity to markets on a day-to-day basis, at times of uncertainty (or when algorithms go out of control and submit unanticipated orders, as in the case of Knight Capital) HFT firms tend to abandon all of their position, which can cause rapid crashes in the markets. The 2010 May Flash Crash was a perfect example of this.
The problem with HFT technology is that it is inherently about speed. As such, regulatory measures aiming to add “kill switches” to HFT orders aren’t very practical.
UNFAIRNESS TO TRADERS
The other main argument against giant HFT firms such as GETCO and Citadel is that they hurt individual traders and day traders. The fact that computers can react to news and execute trades at the speed of light often means that limit orders placed by individual traders get picked off by HFT firms. Individual traders will almost always be stuck behind a queue of thousands of HFT firms before they can withdraw their limit orders.
For example, if the Bank of America (BAC) is trading at $12.93 bid and $13.94 offers the retail investor or trader has very little chance of actually being able to buy on the bid at $13.93. According to a recent article in Forbes on “adverse risk” selection, this largely removes the incentive for individual traders to place limit orders based on imminent news release.
CHANGES TO THE REGULATION OF HFT TRADING
In response to the significant risks of high-frequency trading, many countries and exchanges have begun implementing new regulation to combat the issue.
Italy became the first country in the world to regulate HFT in September 2013 by charging a levy of 0.002% on all transactions that last less than 0.5 seconds.
France imposed a tax on high-frequency trades last year; Germany imposed the German High-Frequency Trading Act in Spring 2013; while EU policymakers have also confirmed plans to curb HFT trading going forward.
Many of Europe’s largest HFT firms saw profits slump by nearly half last year. According to Hans Pieterse, a European Managing Director at Optiver: ““If you split the world into the US, Europe and Asia, Europe is by far the most challenging region for the industry right now. Volumes and volatility are down, costs are rising and there is a great regulatory burden on us. It is a very difficult environment to operate in, and I would expect further consolidation.”
While many people see high frequency trading as a natural development in the marketplace, the risks it has posed in the past have certainly awoken policymakers across Europe. The EU Commission’s latest Mifid regulations are expected to be announced by January and come into effect in 2016.
