Table of Contents
What is High-Frequency Trading?
High-frequency trading (HFT) refers to a form of electronic trading harnessing powerful computers that can make millions of trades in milliseconds. Complex algorithms make these high volume and high speed orders possible, as they rapidly analyze markets and execute orders without requiring human confirmation. Typically, brokers who trade faster tend to profit more than those with slower execution speeds.
DID YOU KNOW?
When HFT reached its peak usage in 2009, it accounted for about 61% of the 9.8 billion average daily shares traded.
HFT, however, has divided public opinion. Some believe that it is not only necessary but fair. Others think that it provides an undue advantage to those who have access to supercomputers (in this case, Wall Street companies).
In this article, the Zero Theft Movement will cover:
- Why use HFT?
- Arguments for and against HFT
- The ‘Flash Crash’
- The current state of HFT
Why use HFT?
The answer to the question above should be evident: $
At least, during the mid to late 2000s, high-frequency trading was viewed as a huge money-making opportunity. The capacity to trade at high speeds and volumes we mentioned above made HFT an attractive prospect.
Let’s take a closer look at the profitable advantages HFT provides.
Just take a second to think about it once more. Supercomputers, unlike us mere mortals, can make millions of trades in milliseconds. If you’re making a dollar profit from one million trades, you would be making a million dollars a millisecond.
Perhaps, that’s a bit of an idealized picture of the potential profits HFT can yield. But you get the point. Automation enables high-frequency traders (or more accurately, their technology) to trade in high volumes so they can generate profits even with minor fluctuations in share prices.
Those small, even miniscule, fluctuations are exactly what the HFT algorithms are designed to detect and act upon. These millisecond moments million times over can yield colossal returns. The algorithm enables HFT firms to capitalize on these momentary opportunities while main street and manual investors cannot.
Do you know that high-frequency trading firms could be accessing dark pools to make millions of financial transactions in a millisecond?
Don’t believe us? See what your fellow citizens are saying on Zero Theft…
Arbitrage refers to when you capitalize on the same asset having two different prices concurrently.
But how can the same asset have two different values at the same time?
To use a basic example, you notice that a certain popular sneaker regularly sells for $100 in your city. But in the next city over, people buy the exact same shoe for $110. If you have an entrepreneurial spirit, you might try to take advantage of this arbitrage opportunity.
Just buy multiple pairs of the sneakers for $100 each, and sell them for $105 in your neighboring city. That’s $5 profit for each.
Arbitrage opportunities prove few and far between real-world trading situations because global markets can generally update stock prices at the same time. However, when there is a slight delay between different markets, HFT firms can take advantage of the price differentials by buying at a slightly lower price and selling at a slightly higher price.
DID YOU KNOW?
A report by the Financial Conduct Authority examined how much profits HFTs make from arbitrage opportunities. It reached a figure of $5 billion by extrapolating its findings. Senators Elizabeth Warren and Bernie Sanders have looked into establishing a financial transaction tax on these earnings.
The HFT Debate
Proponents argue that HFT promotes both liquidity and stability across markets.
HFTs can quickly and efficiently connect buyers and sellers when the buying and selling prices match (a.k.a. the bid-ask spread). With higher volumes in trades, market activity (and thus, competition) increases. That means that capital is getting circulated in the marketplace. The greater amount of liquidity, in turn, causes bid-ask spreads to decrease. A more liquid market is a more stable, or less risky, market, as there’s a high chance there’s a buyer for every seller and vice versa. As mentioned above, the bid-ask spread narrows with more liquidity.
Advocates have also argued that markets can use several strategies to limit any potential risk. A stop-loss order is one such strategy, wherein positions automatically get sold if their prices drop below a certain percentage of their purchase prices. For example, if you purchase an asset for $100 and have a stop-loss order set at 10%, your asset automatically gets sold if its price goes below $90. That means you are not incurring any more losses beyond the 10% floor.
High-frequency traders very rarely hold their portfolios overnight, accrue minimal capital, and establish holding for only a short period before selling. All of those behaviors make the risk-reward proposition, otherwise known as the Sharpe Ratio, exceptionally high.
Beyond the risk, the competitive and debatably undue advantage achieved through HFT firms’ access to supercomputers and complex algorithms has angered many. What manual investor can capitalize on fractional price changes that occur by the millisecond? Some have called HFT a form of market manipulation, where Wall Street investors (or their computers) can act on information that main street investors do not (a.k.a. front-run).
Critics of HFT argue that it does not create actual liquidity, only “ghost liquidity.” Because high-frequency traders usually hold onto securities for just a few seconds (if that), opponents claim that that liquidity should not be deemed “real.” The liquidity is not in the market long enough for most investors to respond or even notice the change. So by the time they place an order, the potential millions HFT isn’t present in the system.
Despite the contested increase in liquidity, critics would link HFT to increased market volatility and even market crashes. Regulatory agencies such as the Securities and Exchange Commission (SEC) have investigated high-frequency traders for engaging in illegal market manipulations.
In 2014, the SEC issued a press release, stating the following:
“…Athena Capital Research used an algorithm that was code-named Gravy to engage in a practice known as “marking the close” in which stocks are bought or sold near the close of trading to affect the closing price. The massive volumes of Athena’s last-second trades allowed Athena to overwhelm the market’s available liquidity and artificially push the market price – and therefore the closing price – in Athena’s favor. Athena was acutely aware of the price impact of its algorithmic trading, calling it “owning the game” in internal e-mails.”
Athena Capital, according to the SEC, paid $1 million to settle the charges.
Particularly though, the major claim against HFT emerged with the extreme market volatility that occurred during the Flash Crash in 2010.
The Flash Crash in 2010
On May 6, trading on major U.S. markets was trending downwards from the morning. This slight dip did not come as a surprise as the Greek government-debt crisis and the UK Prime Minister elections were ongoing. Come afternoon, however, the major indices of equities and futures had dropped 4% from their previous day’s close.
By 2:30 p.m., nervous trading caused the overall volatility to spike. The tumult caused the Dow Jones industrial Average to plummet almost 1,000 points by 2:46 p.m. The recovery, however, happened just about as quickly as the drop did, with the index recovering close to 600 points.
The major indices regained more than half of the lost values by the conclusion of the trading day. That being said, the Flash Crash still ended up tanking the market value by $1 trillion.
The SEC investigation
The SEC and the Commodity Futures Trading Commission (CFTC), after a near five-month long investigation, released a collaborative report identifying what caused the Flash Crash. and concluding that the actions of high-frequency trading firms contributed to volatility during the crash.
The SEC and CFTC pinpointed a single massive selling order as the trigger for the Flash Crash: “At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 EMini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position. “
Due to the $4.1 billion sale, the supercomputers from HFT firms started aggressively following suit, buying and reselling the EMini contracts between themselves. Market prices experienced a massive decline due to HFT trading in combination with markets that were already trending downwards.
The quick recovery, on the other hand, came after high-frequency traders had paused their trading to prevent further volatility and decline. When the trading of the contracts resumed, the price of EMini contracts stabilized, and markets started to regain their positions.
The Decline and Potential Return of HFT
Since the Flash Crash, HFT revenues have markedly declined as each year has passed.
Professors Jean-Philippe Serbera and Pascal Paumard published a 2016 survey explaining the decline in HFT. They write, “a continuous increase in competition, between high-speed trading algorithms themselves through predatory strategies and from professional human traders adapting and building adequate responses has made the business more difficult and has led to shrinking profits for HFT. In the end, we believe that excessive competition and a change in the current regulation (favorable to HFT) could kill the goose that laid the golden egg.”
More recently though, HFT seems to be experiencing something of a renaissance. The investment app Robinhood has faced criticism for selling customer trades to HFT firms. In December 2020, the SEC charged the company for “repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them, and with failing to satisfy its duty to seek the best reasonably available terms to execute customer orders. Robinhood agreed to pay $65 million to settle the charges.”
What should be done about HFT?
After reading our primer on HFT, what do you think? Should it be banned because it gives Wall Street undue advantages? Or should it remain as is, or come under stricter regulations, as it arguably provides liquidity and stability to markets?
For the issue of HFT, along with countless others across the economy, the Zero Theft Movement provides a platform where you and your fellow citizens work together to investigate and debate potentially rigged areas across the economy. You decide whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.