Market Analysis

High Frequency Trade-Offs

High frequency trading is back in the spotlight—how do its pros and cons really weigh?

Many worry about high frequency traders’ conducting markets at the speed of light. Source: Three Lions/Stringer, Getty Images.

A new book offers a scandalous caricature. A news magazine popularizes the tale. Regulators react, opening investigations into what seems a one-sided case: What does high frequency trading (HFT) actually do and how can regulators stop it to protect investors? While we have no vested interest in HFT, we’d suggest this story is much too unbalanced to reflect how it actually impacts the investment world. Yes, there is the potential for negative behavior. But that neither offsets nor outweighs HFT’s very real positives.

Before diving into its pros and cons, let’s review: HFT is much more common than most realize. It has been around since at least 1999 and accounts for about 50% of US markets’ trading volume. It’s a form of automated trading using algorithms—man-made mathematical models predicting probabilities based on data patterns—in an effort to find short-lived supply and demand mismatches and capitalize on them. Fi­rms execute these algorithms at high speeds (microseconds) and huge volumes (thousands of transactions per day) through super computers, typically holding positions for less than a minute, as they jump to pro­fit on the slightest price change.

Many think their speed gives them an unfair advantage, allowing them to engage in behavior most would consider front-running. However, the phrase “front-running” implies fraud. Illegal behavior. What most HFT firms do is different: They use their speed to exploit market inefficiencies—discrepancies in securities pricing across the more than a dozen US stock exchanges—well within the scope of the law. Here’s how it works: When John Q. (typically Institutional) Investor clicks “buy,” before that order is filled, HFT programs see the order hit Exchange A, buy it at Exchange B for a penny lower, then flip it to John at the price he saw on his computer screen—all within microseconds.

John probably never even sees the price move, but still, many argue, it’s unfair! Some invisible machine skimming dollars you could have saved! Let’s be clear—if HFT firms did anything illegal, we support regulatory action, but little suggests that’s the case across the board. HFT firms’ playing arbitrage with differing prices over multiple exchanges isn’t fraud—they’re using publicly available information, just at a speed approaching that of light. Is it an advantage humans don’t have? Yes. But the profits HFT firms make as middle men are mere fractions of a penny—far less than the human exchange specialists of yore. And often, the initial buyer still gets the security at the price he wanted!

For the long-term growth-seeking investor, the impact is largely invisible. If you’re holding shares for a significant period, a penny per share (or fraction thereof) doesn’t much detract from long-term gains. This is also true for mutual funds, money managers or any large institution trying to execute a big block trade. When HFT trades around firms moving hundreds of millions (or even billions) of dollars, its profits will look big, but they’re still fractions of a percent.

Much of the backlash seems based on the assumption HFT profits off every single trade. However, HFT trades are only profitable about half the time—often, the humans win! HFT-naysayers claim this is by design, arguing HFT deliberately enter loss-making orders to glean information about other traders’ intentions, which they then pounce on. But this ignores a critical point: HFT algorithms aren’t foolproof. They’re man-made and, no matter how brilliant their engineers, prone to humans’ cognitive biases, like assuming past performance is predictive. Seeing a large trade on one exchange and trying to front run it on another requires numerous assumptions by HFTers—which could be right or wrong—and thousands of simultaneous market inputs to go their way.

We won’t argue HFT doesn’t move prices. It has also rendered many formerly human functions obsolete—thanks to HFT, trading pits are largely ghost towns relative to the past. Like all technological advancements, there are winners and losers. But HFT firms aren’t the only winners. Not by a mile! The benefit of increased market competition—having more people (or robots) rushing to fill orders—is good for long-term investors. Historically, specialists or market makers intercepted traders’ orders—buy or sell—and filled them or found offsetting orders, profiting off the price difference. This ensured there was a seller for every buyer, and vice versa. (They were also often thought to have the market rigged in their favor.i) Adding HFT to the mix brings even more sellers and buyers. Many HFT algorithms are constantly going, quickly and in huge volumes—robots are the new market makers.

More trading, whether by HFT, market makers, retail or institutional traders, makes markets more liquid—easier and quicker to find a buyer or seller. It also narrows the bid/ask spread (the difference between the price a buyer is willing to pay and a seller willing to accept), which is driven by supply and demand. Less trading means a wider spread because there are fewer price points markets can use to determine the security’s fair value. More trading means more price points and competition for your order. No longer is one human determining your fate and pocketing several cents per share (or more) by being your middle man. Robots are competing and charging you far less. Fewer humans in the mix has also reduced exchanges’ and broker-dealers’ operating costs, resulting in lower trading commissions overall.

HFT isn’t perfect—there is room for abuses. A universal truth! In every industry, there are potentially bad players. However, the benefits aren’t eliminated because some potentially act dishonorably. To the extent wrongdoing can be proven—and is actually illegal—we fully support punishment. But we are highly skeptical of the assumption that’s the majority of the HFT industry or that the potential negatives outweigh the very real positives.

As technologies develop, many—especially those unfamiliar with the industry—are going to fear the change. The simple narrative where high-frequency traders wear black cowboy hats and other investors white is a powerful (and easy) tale to tell! The more complicated, less headline-grabbing truth, though, is HFT is just a technology—an automated assembly line for markets—with pros, cons and everything in between.

i See Where Are the Customers Yachts?, Fred Schwed, Jr., Wiley, original publish date 1940. Pp 157 – 160.

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