Is High-Frequency Trading A Fancy Term For Cheating?

By Tim Parker AAA

If you are an investor, high-frequency trading (HFT) is a part of your life even if you don't know it. You have likely purchased shares offered by a computer or sold shares purchased and then instantly sold by another computer. HFT is controversial, especially of late. In March and April 2014, both the FBI and the Securities and Exchange Commission (SEC) announced that they were launching probes into HFT - as part of their ongoing investigation into insider trading on Wall Street. Coincidentally - or perhaps not - author Michael Lewis' book, "Flash Boys: A Wall Street Revolt," was released in March 2014. Lewis, who two decades ago made a name for himself as a Wall Street detractor with his bestselling "Liar's Poker," has compared HFT to cheating at poker

What Is HFT?

In principle, HFT is not a nefarious concept at all. It's a broader term for various trading strategies that involve buying and selling financial products at extremely high speeds. It takes advantage of the fact that computer processors are becoming exponentially faster, to divide trading periods into smaller and smaller increments - milliseconds, microseconds, and beyond. Computers can identify market patterns and buy or sell these products based on algorithms or "algos."

One strategy is to serve as a market maker where the HFT firm provides products on both the buy and sell sides. By purchasing at the bid price and selling at the ask price, high-frequency traders can make profits of a penny or less per share. This translates to big profits when multiplied over millions of shares.

So What's So Bad About Speed?

On its own, nothing. But Lewis and federal authorities have said that HFT starts to get dubious when it includes such practices as moving servers increasingly closer to the floor of the stock exchange in order get information ahead of everyone else. This competition amongst traders for speed - and, in fact, geographic proximity - has been compared to an arms race. And some claim that this battle impinges on the principles of fair play. 

There is also some speculation as to whether HFT is prone to too many errors. In October 2012, Nasdaq canceled the trades for Kraft (Nasdaq:KRFT) that occurred in the one minute after trading opened, after noting that the stock price in that one minute had surged 29%. At the time, Nasdaq attributed the glitch to "possibly erroneous trades."

Does It Hurt the Market?

One would think that because most trading leaves a computerized paper trail, it would be easy to look at the practices of high-frequency traders to provide a clear-cut answer to this question, but that is not true. Because of the volume of data and the firms' desire to keep their trading activities secret, piecing together a normal trading day is quite difficult for regulators. Those who debate this issue often cite the "flash crash."

On May 6, 2010, the Dow Jones Industrial Average mysteriously plummeted 10% in minutes, and just as inexplicably, rebounded. Some large blue chip stocks briefly traded at one penny. On Oct. 1, 2010, the SEC issued a report blaming one very large trade in the S&P e-mini future contracts, which set off a cascading effect among high-frequency traders. As one algo sold rapidly, it triggered another. As more sell stops hit, not only were high-frequency traders driving the market lower, everybody, all the way down to the smallest retail trader, was selling. The "flash crash" was a financial snowball effect.

This incident caused the SEC to adopt changes that included placing circuit breakers on products when they fall past a certain level in a short period. In the wake of the flash crash, many asked whether imposing tighter regulation on high-frequency traders made sense, especially since smaller, less visible flash crashes happen throughout the market with regularity.

Does It Hurt the Retail Investor?
What is important to most of the investing public is how HFT affects the retail investor. This is the person whose retirement savings are in the market, or the person who invests in the market in order to gain better returns than the near non-existent interest that comes from a savings account. Several economic studies have light on this question, some of which are detailed in this SEC report.

A 2012 study conducted by economists Matthew Baron (Princeton University), Jonathan Brogaard (University of Washington) and Andrei Kirilenko (Commodity Futures Trading Commission) focused on the S&P 500 e-mini contracts. The researchers found that high-frequency traders made an average profit of $1.92 for every contract traded with large institutional investors and an average of $3.49 when they traded with retail investors. This allowed the most aggressive high-speed trader to make an average daily profit of $45,267 according to the data gathered in 2010. The paper concluded that these profits were at the expense of other traders and this may cause traders to leave the futures market.

Although the authors did not study the equity markets where high-frequency traders account for a large amount of stock trading volume - possibly 70% or more, according to some reports - they say it is likely that they would reach the same conclusions.

The Bottom Line
Because of the relative newness of HFT, the process of regulation has come slowly, but one thing that does appear to be true is that HFT is not helping the small trader.

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