High-frequency trading, rapid-fire securities dealing using powerful computers, is hugely controversial. To some, it is unethical and close to being a form of insider dealing. To others, it is the entirely defensible employment of cutting-edge technology to improve returns and sharpen competition in the market.
Critics say high-frequency trading generates volatility in major indices such as the Dow Jones Index, the Standard & Poor’s 500 and London’s FTSE 100 Index. Supporters counter that high-frequency trading helps stabilise these markets, by smoothing out price movements.
There is not even agreement on whether high-frequency trading was to blame for the so-called flash crash of 6 May 2010, when the Dow Jones plunged for no apparent reason only to claw back much of the loss a few minutes later.
The “need for speed”
More on that event in a moment.
First, a general look at high-frequency trading. The first thing to say is that there is no one definition, but most observers would agree that it involves algorithmic trading strategies executed by computers without human intervention. It is delivered at both high speed and, as the name suggests, high levels of activity.
The game of chess has been described as the patient exploitation of tiny advantages, and high-frequency trading can be seen in the same way. The algorithms are designed to detect opportunities in the market place, acting in milliseconds when any departure from market norms suggests a change in prices or trading behaviour.
For example, the first indication of a change in volumes or quotes may indicate that a big buy or sell order is about to be made, although there has been no announcement. High-frequency traders are thus one step ahead of the rest of the market, and their trading platforms can act accordingly, taking advantage of the anticipated action.
Front running – or legitimate trading?
To work effectively, high-frequency trading systems must be able to operate at ultra-fast speeds, given that the advantage conferred by the detection of a new market patterns can disappear in seconds. Sometimes this “need for speed” is taken to what can seem extraordinary lengths.
The cable’s dominance in terms of rapidity of transmission was short-lived, notes Mr Lewis. A microwave link across the same distance has since cut the time to 8.5 milliseconds.
Describing high-frequency traders’ “exploitation of tiny advantages” takes us to the potential ethical problem at the heart of this type of trading. In conventional trading, someone who gets wind of a major order – buy or sell – for a particular asset and deals ahead of it is engaging in what is known as front running, a practice illegal in most jurisdictions as it is a form of insider dealing.
Thus, a trader who buys a security ahead of a major purchase order by a big institution will, if discovered, face regulatory or criminal action.
But high-frequency traders are not acting on inside information but on information that is public, in that anyone can see changes in prices and order sizes, or in announcements or other statements by companies. It is simply that high-frequency traders are better positioned to take advantage of it.