High Frequency Trading: Under the Spotlight
High frequency trading (HFT) has once again found itself in the spotlight. With the release of a new book highlighting the dangers and inequities of the practice, a recent 60 Minutes lead story, countless articles in well-circulated publications, and a federal investigation into the very legality of HFT, the subject has moved back to the forefront of public discourse. We welcome the added attention the subject is now garnering. Because of the pervasiveness of the issue, we encourage investors to ensure that they are well informed of the challenges HFT can pose to transparent, efficiently-functioning markets.
What is High Frequency Trading?
High frequency trading is a form of automated trade execution. Complex strings of code enable high-powered computers to analyze markets, transactions, and quotes at an extremely rapid pace. Based on the data and market activity these processes identify, trades are then placed in order to generate profits. Though the profits are often very small, the sheer volume of transactions and the speed with which they occur means that they can add up quickly.
Although exact numbers are difficult to come by today, most estimates place the share of U.S. daily trading volume attributable to HFT above 50%. Proponents of HFT argue that it enhances liquidity in equity markets. Moreover, by reducing the bid/ask spread on trades, proponents also claim that HFT can reduce trading costs. Critics counter that while HFT may provide liquidity at times, this is not always the case. In fact, market prices can be negatively impacted in instances when liquidity is withdrawn from the market. HFT can also make trade execution more costly.
In the world of HFT, speed is the name of the game. Milliseconds can mean the difference between trades that get executed at a profit and those that end up canceled due to changes in price, or one trader getting beat to the punch by another. For this reason, HFT firms may try to locate themselves in close proximity to the geographical location of the exchange(s) where they plan to execute their trades. In a similar vein, some HFT firms and businesses that support the practice have spent huge sums of money laying high-speed cables that help them execute their trades fractions of a second faster than other market participants.
In order to better understand the significance of speed and how HFT can negatively impact markets, below are some examples of strategies employed by high frequency traders:
- Market Making: High frequency traders will quote buy and sell limit orders in an effort to capture the bid-ask spread. The traders profit by successfully acquiring shares from sellers that can then be sold to buyers at an incrementally higher price. However, in times of market stress when traditional market makers are expected to maintain order flow, and therefore liquidity, high frequency traders may simply close out their trades and shutter activity if they detect too much risk in the market. Thus, what had appeared to be a deeply liquid market quickly becomes the opposite.
- Algo Sniffing: Investors seeking to buy or sell large numbers of shares may break up one trade into a series of smaller trades using various trading algorithms in order to disguise their trading activity. A common HFT strategy involves other more complex algorithms designed to detect this sort of behavior and then buy or sell shares ahead of the remaining series of trades. For example, if a high frequency trader identifies what appears to be the beginning of a very large order, he/she will rapidly purchase shares and then fill the series of buyer orders at a slightly higher price.
- Arbitrageurs: High frequency trading systems use algorithms to detect and exploit occasions of mispricing in the market and seek to eliminate them quickly. For example, an algorithm may look at securities across a variety of trading venues and then arbitrage the slight differences between each venue to make a profit.
How can investors minimize the impact of HFT?
By and large, the presence of HFT in the market puts other investors that do not utilize these strategies at a disadvantage. The good news is that there are a variety of things market participants can do to help mitigate the influence of HFT. The following represents some of the trading practices many institutions, like Manning & Napier, employ to assist in obtaining strong execution for clients despite HFT’s pervasiveness.
- Working with institutional trading desks at reputable brokers and evaluating their execution services on a regular basis;
- Routing orders through venues designed to disguise trading activity from predatory HFT firms, and in some cases, exclude those firms from trading;
- Utilizing industry available trade algorithms that are also designed to function in ways that reduce signals to HFT firms;
- Maintaining a staff of professional traders with access to real-time market data and charging them with parsing trade orders out in a controlled manner to multiple venues and brokers so that no single entity is aware of the full trading intent.
What’s next for HFT?
The growing popularity of HFT is troubling, and surveys show that this opinion is not unique; investors, media outlets, and academics alike are expressing concerns. We applaud any and all efforts that help to shine a light on HFT and its potential threat to the fair and orderly functioning of financial markets. While it remains to be seen if action will be taken against HFT, it is encouraging that ongoing research and dialogue on the subject is catching the broader attention of regulatory bodies that are tasked with preserving the levels of transparency and fairness that all market participants benefit from.
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