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The Truth About High Frequency Trading

Rishi K Narang separates the facts from the misguided vitriol.

Rishi NarangThere has been a great deal of fuss this summer about high frequency trading. The complaints range from the idea that HFT creates an unfair system in which some traders can make money by front-running the masses, to the notion that it can be used to manipulate markets and wreak havoc on our financial system. Much of the criticism is rooted in misguided populist rhetoric rather than facts. An objective analysis of HFT might help separate the facts from the vitriol.

High frequency trading benefits the markets because it adds considerable liquidity. For example, in U.S. stock exchanges, HFT participants account for a significant portion of all volumes (50 to 70 percent, according to many experts), which keeps bid-offer spreads a penny wide in most stocks. This benefits every level of market participants — from mom-and-pop investors to pension funds — because narrower spreads mean lower trading costs.

Furthermore, there is nothing preventing anyone from competing in the high frequency space, and there is no special treatment given an HFT operation. To argue that HFT is unfair is like claiming that Warren Buffett should be given a lobotomy because he has better skills and resources at picking stocks. Someone who takes the risk of investing considerable resources and talent into an endeavor that is open to all comers, with no guarantee of success, should not be maligned because he has succeeded. It is also worth noting that HFT is considered extremely valuable to the marketplace by nearly everyone in a position to know, including people running exchanges and mutual funds.

There are two major classes of HFT strategies: those that provide liquidity and those that speculate. Liquidity providers seek to profit by earning the bid-offer spread and the liquidity-provision rebates market centers pay (exchanges or Electronic Communication Networks, for example). When they provide liquidity, HFT players are taking the opposite side of other market participants’ trades, and this implies taking risk. This also explains why HFT players depend on lightning-fast executions. They are reacting to other traders’ desires to buy and sell, so they need to know about these events extremely — and process them — quickly in order to produce a timely response.

Additionally, liquidity providers compete with each other for the same orders. Market centers determine which order at a given price gets the first priority, usually based on the time orders were received, so speed matters explicitly in this sense.

Finally, liquidity providers are eager to get rid of the positions they acquire — preferably by providing liquidity on the opposite side — before the market moves too much, and this also necessitates speed.

Some HFT firms are speculators. To the extent that they are trying to profit from short-term movements in various instruments, they need to be able to get into and out of their trades before the move they are expecting to happen has already occurred. For speculators that are also trying to capture the liquidity-provision rebate in the implementation of their strategies, speed matters because they are competing with the market makers.

Let’s now turn to the specific complaints about high frequency trading. Some critics claim that it creates a two-tiered marketplace, where some participants are favored over others. They specifically point to flash trading. And they’re right about flash trading. It allows some orders to be seen by exchange insiders (members) before being visible to others. In theory, this would allow the exchange’s insiders to front-run the order that has been flashed. But flash trading has little to do with HFT. In fact, flash trading predates HFT substantially. Even the name “flash order” comes from the old days when specialists engaged in exactly the kind of front-running made possible with modern flash orders.

Other opponents claim that HFT allows dangerous market manipulations. Earlier this month, news emerged of a Dutch HFT firm that is alleged to be manipulating the crude oil markets. Some in the media are insinuating that such practices may be widespread. But market manipulation is unrelated to HFT. The Hunt Brothers manipulated the silver market in the late ’70s, and Enron manipulated the California electricity market from 2000 to 2001, neither of them using HFT.

Market manipulators usually accumulate large positions in order to affect a manipulation, and this is normally the opposite of the approach of HFT. That such an example exists of a firm manipulating markets using high speed computing is hardly a valid condemnation of HFT generally.

Given all the controversy surrounding high frequency trading, the SEC and other regulatory bodies are “carefully examining” this niche to ferret out any wrongdoing or uneven playing fields. This is good. I only hope that regulators seek facts and objective reality, rather than succumb to the sort of wild fears that bring to mind films like The Terminator or The Matrix. There is no robot revolution looming, and the machines still have off switches.

Rishi K Narang is the Founding Principal and Portfolio Manager of Telesis Capital LLC, which is based in Marina del Rey, CA. Narang has been involved in hedge funds since 1996, with a focus on quantitative hedge funds. He is the author of Inside the Black Box: The Simple Truth About Quantitative Trading (Wiley Finance, 2009), and speaks widely on the subject of quant trading. For more information about Narang or his book, visit http://www.thequantbook.com.

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