High Frequency Trading: What’s the Big Deal?

by: Gennady Favel

There has been a lot of talk lately about high frequency trading. Journalists and media reporters have had a tough time properly presenting the subject to an already skeptical audience. Meanwhile, mutual funds and institutional investors have been quick to point at HFT as the cause for their own poor performance as well as market instability. Lastly, some politicians have steered up so much negative publicity for HFT that it seems they are likening it to Skynet – the supercomputer that destroys humanity in the Terminator movies. To dispute these rumors, workers from several prominent HFT firms have stepped away from their comfort zone of computer code and trading screens in order to present their own inside perspective into the industry. In the paragraphs below I would like to add my own views.

I would like to start with a shocking statement, “high frequency firms are there to make money.” I realize that in the current climate of anti-Wall Street sentiment, admitting to wanting a make a profit is dangerous, but I think honesty has to count for something. I find it fascinating that a fairly young industry such HFT has come under so much pressure, while, the mutual fund industry which continuously and meticulously underperforms the major indexes all while charging enormous fees has somehow been able to paint itself as a victim of the “sneaky” and “shadowy” algorithms. So yes, just like the mutual funds, the hedge funds, the retail investor, the pension funds, the preparatory trading firms, and everyone else who has ever placed a trade in the market, HFT firms are there to make a profit. So how do they do it?

The answer is, “very fast”, hence of course the term high frequency. Contrary to some reports however, HF firms do not have special access to order flow, news, or other information that is kept away from the average investor. That being said, HFT firms do try to be as close to the information as possible in order to be able to react to the market with the utmost precision. This is really no different than the idea of subscribing to a live market feed instead of using a 15 minute delayed one that can be found on most free finance websites. Similarly, by subscribing to news sources such as Bloomberg or Reuters, HFT firms can react to news faster than someone who reads the Financial Times or the Wall Street Journal. But in both instances it must be stressed, HFT firms trade on information that is public and readily available to everyone.

HFT firms use algorithms to scan the market for trading opportunities and this I believe is what makes some people skeptical of their intentions. Fundamental analysis - the traditional way of analyzing companies, and technical analysis - the study of chart patterns are fairly simple concepts to get your head around. But trading with algorithms is something different all together and therefore is sometimes misinterpreted as deceptive, which it isn’t.

To understand HFT better, it is best to look at two main reasons why it has become such as fast growing sector. After pondering those reasons I think we will be able to conclude that HFT is not only a benefit to the markets but to the economy as a whole. The first reason for the growth of high frequency trading was the phasing out of human intervention in the matching of orders on the stock exchange floors. For example, on the floor of the New York Stock Exchange specialists would match buy and sell orders received from broker dealers around the country. By making markets in stocks, specialists would try to make sure that buyers and sellers arriving to the market at different times did not cause extreme price shocks. In order to do that, specialists would need to take on positions and risks, and just like everyone else on Wall Street they needed to get compensated for it. And compensated they were. To say that specialists were on the side of the retail investor would be a gross overstatement. Unlike HFT firms, specialists DID have access to information and order flow that was not public and they used every bit of it to their advantage. Since the specialist took positions in the stock he was making markets in, he had every incentive to make sure the stock moved in his the desired direction. In order to help him do that, the specialist had special privileges such as being able to manipulate the order book and freeze orders in order to not let a trader cancel them. Additionally, specialists had an incentive to create large bid/ask spreads because that it how they made much of their profits.

With the proliferation of ECNs (Electronic Communication Networks) trading moved toward computerized order matching and away from the specialists. Because it was now possible to place and cancel many orders without being concerned about specialist interference it became possible for traders to use their computers to trade.

The second accelerant for HFT is the ability of modern computers and communication networks to process more and more data at faster speed. Because HFT firms need to process vast amounts of data to make trading decisions and then be able to send the result of those calculations to the exchanges they have to use the fastest possible hardware and software available. Only recently have advances in computing and communication made it possible for high frequency firms to thrive the way they have.

So who benefits? Naturally, successful HFT firms that were able to adapt to the new market structure and best utilize the latest technology have benefited. But what about the rest of us, are retail investors footing the bill? I don’t believe so. For starters, I believe that HFT firms place orders into bid/ask spreads that would otherwise be left unfilled. So, if traditional market makers are only willing to provide a five cent spread, HFT firms will likely narrow it down to one cent on most liquid stocks. HF firms are able to do this because they offset their risk of tightening the spread by either quickly getting rid of the position or simultaneously hedging it somewhere else. As a result of these tight bid/ask spreads, retailer investors who are more likely to use market orders instead of limit orders get lower execution costs.

Besides improving the structure of the markets HFT firms are also investing hundreds of millions of dollars into computer and telecommunication equipment boosting certain sectors of the economy. Established tech companies such as Intel and Cisco have seen increased sales to HFT firms, and new tech companies have sprung up to cater to the unique needs of the HFT industry. These new companies create thousands of well paid jobs and add to the growth of America’s high tech industry. Finally, because HFT firms are working to create cutting edge algorithm technology I believe that there will be a beneficial spillover into other industries. For example super computers built for HFT can be used by scientists in the study of physics or chemistry and perhaps low latency computing that is being developed by HFT firms can in the near future help in creating biomechanical devices that will require fast interactions between computers and the nervous system.

The Chicago Mercantile Exchange has recently released a report stating that HFT was not responsible for the May 6th, 2010 market crash. Yet, some people, perhaps with good intentions but incomplete information want to seriously limit HFT or ban it altogether. For the reasons I outlined above I believe that would be a big mistake. So, to the regulators and investors who think that tough measures against HFT will somehow improve the markets or the economy I want to paraphrase the poet John Donne, “Don’t ask for whom the bell tolls, it tolls for thee.”

Disclosure: No positions