What is high-frequency trading?
It’s a catch-all term for some of the latest computer-based trading techniques. Many of these depend on super-fast, automated order placement in pursuit of tiny profits (as little as fractions of a penny). These cumulatively add up to massive profits when the trades are big enough and repeated often enough. High-frequency trading (HFT) differs from standard trading in its speed, frequency, and complexity. Hedge funds, brokerages and the many specialist trading firms that have sprung up over the past decade all use super-fast computers and complex programs to trade in and out of securities thousands of times a day, often only holding positions in an underlying asset for a matter of seconds.
How fast are these trades?
A report out earlier this week by the Bank of International Settlements (BIS) looks at HFT in the currency market. These specialist firms can fire out orders in less than one millisecond, compared with ten to 30 milliseconds for most banks. “For comparison, it is said to take around 150 milliseconds for a human being to blink,” says the BIS. That’s much faster than even ten years ago – leading to a surge in HFT. Indeed, in terms of volume, high-frequency computerised trades now account for between two-thirds and three-quarters of all dealing on Wall Street, according to most estimates. For Britain and Europe the proportion is significantly lower.
Why are people worried?
Many fear that HFT destabilises markets and makes it easier to manipulate them (see below). In a study published last month called The Dark Side of Trading, three US-based academics found that “high volumes of trading can be destabilising, injecting a sizeable layer of trading-induced volatility over and above the unavoidable fundamentals-based volatility”. They argued that, while “low to medium” levels of trading tend to benefit most investors, there may be an inflection point beyond which massive levels of trading accentuate volatility and benefit “only a small circle of investors”. Indeed, a study last November by a Yale professor found that HFT in US markets is positively correlated with stock-price volatility – especially for the top 3,000 stocks and those with high institutional holdings. “HFT hinders the market’s ability to incorporate information about firm fundamentals into asset prices, as it causes stock prices to overreact to fundamental news.”
Is this a common view?
It certainly tallies with the findings of a study of the 6 May 2010 ‘Flash Crash’ by the US Securities & Exchange Commission. It found that HFT programs were “clearly a contributing factor” in the crash (when the US stockmarket plunged 10% in minutes, and some blue-chip stocks traded briefly at a penny). In Britain, one of the loudest voices warning of the dangers posed by HFT is Lord Myners, the former City minister and trading veteran. He blames the volatility seen over the summer on “black box” trading (rather than shorting). “HFT appears so detached from the true function of capital markets, but is potentially fraught with hazard,” he said last month. “It definitely deserves more attention than either the Financial Services Authority or the Treasury have given it.”
How are the British authorities reacting?
They’re worried, but not panicking. Andy Haldane, the Bank of England’s executive director for financial stability, warned in July that it might be time to set a “speed limit” on market trades to minimise the threat from flash crashes. And a Treasury Foresight study into the ‘Future of Computer Trading in Financial Markets’ is due to report in autumn 2012; three academic papers commissioned by the project were published this month. The main conclusion is reassuring: there is “no direct evidence that high-frequency computer-based trading has increased volatility”. This view is backed up by the BIS report, which says that high-frequency traders help to make trading cheaper for everyone by narrowing spreads, improving efficiency and increasing liquidity.
However, there are two caveats. Foresight researchers note that “the scientific literature on complex nonlinear dynamics of networked systems is in its infancy with regards to concrete predictions”. In other words: we’re not sure and it’s too early to tell. Moreover, tiny changes in trading behaviour may trigger larger events and “lead to undesired interactions and outcomes”. In particular, “it might be argued that the more trading decisions are taken by ‘robot’ computer-based trading systems, the higher the risk of wild feedback loops” of the kind that contributed to the Flash Crash of May last year.
Dark arts on the edge of legality
Some HFT firms operate at the edge of legality in terms of market tactics. According to a recent paper by academics Bruno Biais and Paul Woolley, cited recently by The Economist, firms are actively engaged in “dark arts”, such as placing “spoof orders” selling shares at attractive prices. “These are designed to scare gullible investors into offloading their own shares, at which point the HFT investors withdraw their own spoof trades and snap up the real ones” at lower prices. This kind of profiteering might be viewed generously as a kind of “informational rent” earned at the expense of less informed investors. But it is the kind of problem that regulators are grappling with as they work out how to deal with the growth of HFT. As usual, the markets are at least one step ahead of them.