Should High Frequency Trading Be Regulated?

Should high frequency trading be regulated?

High frequency trading, or HFT, is simply a type of algorithmic trading in which firms use market data to identify trading opportunities in fractions of a second. Often, these opportunities are the result of predictable mechanical or behavioral traits of the financial markets.

Also called “equity market making,” high frequency trading is conducted by firms that only hold their positions for seconds or fractions of a second while identifying buying and selling opportunities. These transactions typically only take microseconds, and HFT firms place thousands of them a day, often only profiting less than one penny for each share that is traded.

In recent years, concerns have surfaced regarding the potential risks HFT poses to the world markets. Those opposed to this relatively new form of trading argue that it threatens the integrity and stability of the financial markets and requires aggressive regulation. Some potential issues include the development of a two-tiered system of trading, increased volatility, flash crashes, and added market noise. Evidence suggests, however, that some of these concerns are not exclusive to HFT.

Two-Tiered Market System

Critics of HFT have voiced a concern that increased algorithmic trading will lead to large brokerage firms who practice HFT operating on one tier while every other type of trader operates on another. However, this problem has existed before HFT. Large firms with massive resources have always had access to more information than individual investors. Individual investors have always lacked the resources to conduct the in-depth daily analysis performed by their professional counterparts. In fact, the informational challenges experienced by individual investors were the primary motivation behind the creation of the Massachusetts Investors Trust, which was the very first modern-day mutual fund model, allowing individual investors to seize the opportunity to reduce informational gaps by investing in professionally managed funds.

Individual investors may not be able to access microseconds of information found in HFT algorithms, but modern retail investors can access much more information than they could a couple of decades ago. Today, individual investors can access the markets, gain near-real time market data, and trade securities from their laptops anywhere in the world, providing evidence of improved information accessibility.

Although nearly every modern broker can execute transactions in under 10 seconds, most individual investors choose to invest in one or more mutual funds and hold them for the long-term, which is a stark contrast from the high-risk trading practices of HFT firms, only enforcing the belief that the risks associated with HFT are not suitable for the majority of individual retail investors.

Volatility

In 1927, decades before computerized algorithmic trading, Frederick C. Mills identified overcorrections and overreactions that created market volatility. Mills observed that stock prices randomly move the majority of the time, but when stock prices move rapidly in one direction, they do so much faster and further than one would reasonably expect. Richard Thaler and Werner DeBondt also observed that traders have a tendency to overreact to unanticipated information and news, weighting more recent news much more heavily and often ignoring news released only one day prior. This overreaction typically leads to a market overcorrection, which results in a substantial price swing in the other direction.

In 2006, Michela Scatigna, Srichander Ramaswamy, and Stefan Gerlach conducted a 150-year review of worldwide financial data and observed that volatility in the stock market is highest in times of political and economic turbulence, especially in times of war. Similar to the observations of Mills, the majority of these observations occurred before the advent of HFT.

While increased market volatility from October 2008 to September 2011 existed, this volatility likely resulted from the economic turmoil created by the subprime mortgage crisis and the demise of numerous large financial institutions, rather than occurring due to an increase in HFT. This is evidenced by the reduced volatility of today’s markets as numerous economic indicators show that the economy is improving. All the while, HFT continues to be practiced during today’s less volatile markets, indicating that market volatility has no relation to HFT.

Flash Crashes

On May 6, 2010, the Dow Jones Industrial Average suffered a flash crash and dropped by over 600 points in only a few minutes. Within the next half hour, it corrected itself and regained all of the points that it had lost. Some commentators and analysts argue that HFT was responsible for this flash crash, but a report commissioned by the CFTC and SEC determined that the cause of the crash was the sale of 75,000 e-Mini contracts in only 20 minutes by the mutual fund firm Waddell and Reed.

It is not clear if this trading strategy by Waddell and Reed was accidental or intentional. However, the joint report clearly stated that HFT actually helped the market through the absorption of a portion of the sell pressure, but HFT firms quickly began selling themselves when prices dropped rapidly, which would be expected from any investor holding an asset experiencing such a price drop. As a result of the crash, trading paused for a moment, but the market quickly recovered and was aided by HFT during the recovery.

This activity is consistent with the findings of a recent analysis performed by Eurex, a Deutsche Borse-owned derivative exchange. “HFT firms not only contribute to liquidity, but they also help stabilize the market during severe situations by continuing to perform their algorithms as usual,” stated Randolph Roth, head of the Eurex market structure division.

Evidence also suggests that short-term crashes, such as the 2010 flash crash, are implicit to equity markets themselves. Recently, Charles M. Jones, a professor at the Columbia Business School, released a paper that argued that crashes such as these were prevalent long before the development of HFT. In his argument, Jones pointed to the 1987 market crash, in which a 20 percent fall occurred in only one day. He also pointed to a similar crash that occurred in 1962.

Market Liquidity

A significant benefit of HFT that is often overlooked is the improved market liquidity that it provides. Through “market making,” HFT reduces spreads and improves market liquidity, because firms participating in HFT act as intermediaries that keep the markets moving. Most investors know that buy and sell orders do not always occur simultaneously. If an investor wants to immediately sell an asset at a specific price, a buyer may not be available. In such a case, a seller would have to hold an asset longer than he or she would like while waiting for a buyer. An HFT firm is able to buy an asset whenever a seller wants to sell and then almost simultaneously sell the asset to another buyer. This increases market liquidity and reduces spreads for investors across the board.

If regulators attempt to slow down the market by forcing investors to hold onto assets for a specific period of time, lower cancellation ratios, or charge a transaction fee, they will only create distortions in the market that will increase trading costs and ultimately hurt all investors. An investor providing market liquidity will only increase their spreads to compensate for their increased risk exposure and pass the costs along to other investors by charging higher fees. In the end, market liquidity decreases and trading costs increase, resulting in a less efficient market.

Market Noise and Integrity

Critics of HFT often argue that it creates “market noise” that negatively affects market integrity. Market noise takes place when contradicting or competing information is present or when there is too much information for the market to properly process. However, contradictory and competing information has existed in the financial markets for decades and predates the development of HFT. Since the 1920s, rumors, insider information, and technical knowledge known by a few investors have caused unforeseen market movements not expected from traditional supply and demand alone. In fact, market noise affects the world’s financial markets even when information is flowing slowly.

The noise found in modern markets is largely due to today’s computer environment, which creates a high-velocity flow of information, producing market noise that would exist without HFT. However, due to the use of test bids for specific price points and cancel orders, HFT algorithms do contribute to today’s market noise. Some HFT algorithms contribute to market noise by rapidly cancelling or submitting orders in order to spur market movement, which some argue is a practice that should be scrutinized by regulators. A majority of this type of market noise occurs when HFT firms are trading with other HFT firms. However, as these trading methods are increasingly understood, they are not as effective as they once were. Algorithms have been created that can detect HFT market noise, allowing them to ignore it and minimize its ability to spur market momentum.

At the same time, there are legitimate concerns that some HFT activities violate current SEC regulations. If this is the case, then the penalties for violating these regulations should be enforced against the firms that are violating them. This requires regulatory authorities to enforce existing regulations, but it doesn’t mean new regulations need to be put in place.

When enforcing existing regulations, regulatory bodies need to carefully distinguish between technology itself and inappropriate uses of technology, such as intentional quote stuffing, order ignition, and any practices meant to manipulate the markets. Developing additional regulations that restrict all HFT transactions will only disrupt market efficiency, create market distortions, reduce market liquidity, and negatively affect short-term stability. This will likely damage the markets more than the market noise created by high frequency trading.

Traditionally, regulatory bodies have not had the technology to successfully monitor illegal trading activity in the contemporary markets. Improvements can be made in this area, but due to the institutional nature of this problem, it is not a legal problem that necessarily requires additional HFT regulation.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

Posted-In: Markets

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