PRIMER: high frequency trading
This edition of IFLR’s free-to-read primer series looks at high frequency trading (HFT), exploring recent trends in the space and discussing assertions levelled against certain strategies
High frequency trading (HFT), or systematic trading, is an automated trading platform used by large investment banks, hedge funds and institutional investors. The strategy that engages powerful computers and servers and the fastest connectivity technology to trade large numbers of orders at extremely high speeds.
This IFLR explainer looks at high frequency trading and the assertions that it can harm retail investors and recent changes.
What is high frequency trading
High frequency trading uses algorithms to analyse trading data and execute trades in fractions of a second. High frequency trading platforms allow traders to fill millions of orders and scan a multitude of markets and exchanges, providing split second arbitrage opportunities for institutions to execute trades before the open market.
Servers owned by the HFT shops and proprietary traders are located on the sites where exchange’s computers are placed. This allows HFT firms to get equity prices split seconds before the investing public, because of the discrepancy in connection speeds. Colocation is a profitable business for the exchanges, costing firms millions of dollars for the opportunity to trade with low latency ̶ the time between a signal being sent and received.
HFT was developed and took hold after 2005, when the SEC took efforts to modernise the securities markets.
This allowed cross-market trading to flourish, according to Scott Bauguess, head of the financial markets regulation at McCombs School of Business at the University of Texas.
“HFT really started with the deregulation of the markets and it was the SEC rules back in 2005 that allowed the further fragmentation of markets,” the former SEC deputy director explained. “As soon as we went away from centralised exchanges the specialist markets traders had to find ways to arbitrage across exchanges. The way to do that is electronically – so that's really the birth of today's HFT ̶ cross market trading.
The impetus for efforts to modernise the securities markets was detailed in an opinion to the SEC’s approval vote for Regulation National Market System (Reg NMS).
SEE also: PRIMER on the Consolidated Audit Trail
“The impetus for the Commission’s efforts to modernise the securities markets was the outdated Intermarket Trading System (ITS) trade-through rule that impeded the ability of electronic trading centres to compete against floor-based exchanges in the listed market,” SEC commissioners Cynthia Glassman and Paul Atkins, wrote in the dissenting opinion.
Marked by history
American author Michael Lewis’ 2015 critical account of HFT practices, impacts to markets and perceived unfair advantages to retail investors without access to the most powerful technology shone a spotlight on HFT. Many criticisms of HFT came from backlash to traders after the 2010 ‘Flash Crash,’ where some have alleged that high-frequency trading played a significant and deleterious role in the trillion-dollar stock market crash that roiled markets when exchanges experienced wild, rare swings.
The Dow Jones Industrial Average went through its second biggest intraday point decline, cratering 99.5 points, within minutes. This was the second-largest intraday point swing between intraday high and intraday low, to that point, at 1,010.14 points. Stock prices, stock index futures, options and exchange traded funds (ETFs) experienced wild volatility and trading volumes spiked.
The events reverberated through markets, Wall Street and business circles, and Lewis’ book ̶ a New York Times #1 best-seller ̶ blared that markets were tilted to favour HFT’s to the detriment of mom and pop retail investors.
Despite the backlash, seasoned academics, regulators and sophisticated investors quibble with this assertion.
Bauguess, describing what HFT promotes, said “better prices,” for market participants, retail and institutional alike.
However, with much talk in Washington DC about market volatility after the meme stock episodes of spring 2020 roiled markets, in comments on several occasions new SEC chair, Gary Gensler, has noted that market structure issues including payment for order flow (PFOF) is an area that he wants the regulator to explore possible new rules. Bauguess added that Gensler’s approach to PFOF and its mention in the SEC’s annual regulatory agenda has similarities with aspects of HFT that some see as a disadvantage to retail investors.
See also: Gary Gensler eyeing a total transformation at the SEC
“There's a lot of discussion on payment for order flow, predatory practices, lower bid ask spreads and how it's damaged small brokers,” he explained. “Many things have been brought up over the years about the negative aspects of HFT, but the bottom line is it has substantially lowered prices for all investors. You can't get away with a quote that’s far from intrinsic value when you've got millions of transactions a second, looking for better prices.”
He added, “there are definitely negative externalities, “there's no free lunch and nothing is ever better for everyone, but on average the benefits outweigh the costs for retail investor.”
Several assertions have marked the HFT space since its height, some unfairly because of backlash, according to a specialist in the space. Two stick out for Jeff Mezger, director of product management at Transaction Network Services.
“People have the perception that high frequency traders have some unfair advantage, unfair access to exchanges and the ability to manipulate or move markets that regular trading firms don't have, and mom and pop investors don't have,” he said. “That's not necessarily true. People get upset that they think that HFTs have special access that they can never get. [But] these exchanges ̶ at least the stock and derivatives exchanges are all regulated ̶ they're required by the regulators to give fair access.”
He added, “from an exchange perspective everything that an HFT does in terms of connectivity is something that's available to the masses.”
The second assertion is that HFT’s get special data feeds that send the data faster, Mezger said.
“From the exchange perspective, at least, they do have the same access as everyone else,” he said. “Now the caveat for that is that for a lot of exchanges this access is expensive. It might be a situation where, certainly a mom and pop investor won't be able to pay for the high-speed access or the high capacity access themselves.”
See also: Bumps in the road and IEX on the record
TNS – a managed service provider – aims to “democratise access” to the exchanges, he added.
“TNS keeps an eye on what HFT firms are doing, and we try to find a way to make that available to firms that aren't at the tip of the spear in terms of latency, cost and sensitivity,” Mezger explained.
Bauguess said claims that retail investors are harmed by HFT remains unclear, but that an SEC plan to study market structure effects, the Transaction Fee Pilot, was approved but then scuttled after being challenged in court.
“We don’t fully know how good or bad the different types of dealer markets are where you pay for order flow or allow different types of maker/taker markets in routing order flows,” he said. “The SEC and regulators have done a good job in bringing more transparency there, but we still don't know that, we've never run an experiment to understand whether all these different types of fee structures are good or bad for investors.”
“The SEC tried to do that with their transaction fee pilot, but the incumbents in the markets successfully sued the SEC and the courts upheld for the plaintiffs and struck down the pilot program,” he added.
Other assertions are that HFT firms, in fact, do not supply liquidity to markets but remove it. Another claim is that the purported liquidity brought about by HFT is, actually, fleeting. The idea is that the liquidity is really ‘ghost liquidity,’ available to the market, vanishing instantly.
These days HFT firms prefer to not carry that name, opting instead for titles including liquidity provider, systematic trader and electronic market maker.
One such large liquidity provider, who spoke anonymously to IFLR, bristled at the idea that HFT firms in fact rob the market of the vital liquidity needed for price discovery and markets optimisation.
“We use technology as much as much as everyone, but we use it to be a market maker, we're providing bids and offers we're putting passive liquidity out there in the market in the market,” they said. “That's our entire business model as a wholesaler and as a market maker, using technology to efficiently commit capital and bridge the gap in time between when buyers want to buy and sellers want to sell, transferring that risk from somebody who wants to buy and holding it for a moment until we can find somebody who wants to sell.”
In this way, HFT firms as market makers lower transaction costs across markets, the liquidity provider source said.
The days of ‘Flash Boys,’ may have passed, but with new crews of systematic traders, armed with high-powered technology and speed-of-light connectivity, HFT has entered a new era.
In the first decade of the 2000s, armed with degrees from top universities, ambitious, aspiring Wall Street climbers flocked to HFT to open their own firms. At this time, HFT proprietary traders flourished, Yue Malan, senior analyst and consultant for Aite Group, explained.
These heady days at the height of HFT fervour led to the incredible growth of some small shops but also to the dominance of now massive and highly profitable firms. Increased numbers of firms and new entrants like financial technology (fintech) vendors entering the market broadening access brought competition and eventually consolidation, Malan said.
Now, the firms that remain have become some of the biggest market makers.
“A lot of consolidation happened in the past ten or so years,” she said. “The smaller ones closed up shop, became less profitable and either died or were acquired. The technology was acquired by the bigger firms, so now the bigger firms are all very well known market makers like Citadel and Jump.”
HFT strategies have also been broadened out of equities to more asset classes including foreign exchange (FX), ETFs and from new corners of the market such as commodities trading advisors, she added.
“Officially, I consider them as systematic trading,” Malan said. “Everything is systematically traded and computer driven, and they can do high-frequency or medium-frequency.”
HFT firms are also aiming to work smarter, not only searching for speed, Mezger said.
“At the top end of the spectrum, you see the most latency sensitive firms running into diminishing returns,” he said. “The laws of physics are kicking in, and there's only so much more time that can be shaved off. They were in the realm of saving microseconds if not nanoseconds and to save those nanoseconds, the technology is about to get more and more expensive. It’s reaching a point where you have to throw a lot more money to stay ahead of everybody else from a latency perspective.”
Firms are also broadening beyond latency strategies towards large data analysis.
“It’s a pivot to looking to what else instead of just pursuing latency only strategies can be done, whether it's using big data to have more predictive strategies, performing more back testing and data analytics to have smart strategies that are smarter, not just faster,” Mezger explained
And geographic reach is also becoming more important as competition saturates established markets and exchanges. HFT firms are looking for fertile ground to plant their best strategy around the world where competition is less fierce.
“’People develop trading strategies that works great on interest rate derivatives in established markets, but it's tough to make that strategy successful there,’” he said. “We're seeing a lot of demand to set up shop in locales that people hadn't operated in before, to trade on exchanges they hadn't dealt with before, whether it's the Asia-Pacific region or in Brazil, or some of the non-London Germany markets in Europe.”