Shock! Horror! HFT!

High frequency trading is suddenly back in the news. Yawn...

 

HIGH FREQUENCY TRADING has hit the front pages again, writes Miguel Perez-Santalla at BullionVault.

 

Not because of some new revelations. But because of the great public-relations team for financial author Michael Lewis. His PR team were able to land him a spot on the famed CBS news show 60 Minutes last Sunday, talking about his new book, Flash Boys.

 

What is High Frequency Trading? Academic study remains light, almost 4 years after HFT was blamed for the infamous "flash crash" of May 2010. Government has meantime been struggling to define it since 2012. But the name HFT goes part of the way to describing the broad business model. High frequency traders are typically hedge funds, raising money from wealthy investors who want wealthy returns. They hire top-of-the-line computer programmers and PhD mathematicians (known as "quants" in the finance industry). Together, these super-brains produce automated trading programs using the most advanced computer power. 

 

The aim? Trade the markets with little or no risk, creating and executing big or small volume trades on a very regular basis, and liquidating those transactions profitably in the fastest time possible.

 

Now, I did not watch the show which aired this past Sunday night. But I listened to all the jabber on the radio following the show on my drive into New York City on Monday. A few days later there has been tremendous outpouring of support for the High Frequency Trading community, something I did not expect. Still conspiracy theorists revel in the release of Lewis' new book, and the anti-Wall Street crowd is all in giggles.

 

There have already many books on the effects that HFT has had on the markets, some good and some bad. Sensationalism is nothing new. But most of what would be considered the bad is caused not by intent, but by programming that reacted in a manner that was unforeseen.

 

Yes, incredible I know, but we are still struggling as humans to adapt to the new technology we have created. Errors are still made. These sometimes hurt the markets, but I believe more often than not this development has been beneficial to the public.

 

Immediately we recall the famous "flash crashes", the most ominous being Fat Finger Thursday of May 6, 2010. On this day the stock market collapsed 600 points in a five-minute period, on what was deemed to have been caused by some computer glitch. It looks more like there was selling pressure that triggered "algo" trading programs to pull out of the market. These automated traders, also called HFT just to add confusion, saw a particular price point go past, and pulled all their orders out of the market at once, causing a complete disappearance of liquidity.

 

Such a 5-minute catastrophe is and should be the most important concern of the regulators. But the recent news however is causing a distraction into what I believe has been a net positive affect for longer-term investors, including private retail investors.

 

Because of the incredible volumes and liquidity generated by the HFT industry, it has plainly driven the cost of executing orders down to incredibly cheap levels compared to those paid less than a decade ago. This is one important benefit from the involvement of the HFT industry.

 

HFT is also charged by many (especially Lewis) with "Front Running" orders. Technically, this practice is where a stockbroker receives a client order, but acts first for his company's own account before executing that instruction. This is of course illegal, because the broker's duty is to the client. Driving the price higher before executing his/her trade means profiting from that relationship to the client's detriment. 

 

Today's "front running" claim against the HFT industry, however, is made because they pay fees for the ability to have faster access to pricing as it enters the market (system) through the super-fast speeds and colocation of their computers. Colocation means they have their own computers in close proximity to that of the exchange. This is usually a paid for service that is provided by the exchanges. This is deemed to add another level of unjust advantage.

 

Michael Lewis claims this colocation enables the HFT operators to pick pennies from the pockets of investors, adding up to millions of dollars a day.  This is done by getting in front of an incoming order, and then flipping it back to the same would-be order that in reality was the driver of the activity.

 

As an example, it would be as if you were going to the candy vendor across the street to get a peppermint patty. I happened to overhear you in the elevator mention it...so I quickly ran across the street and there was only one peppermint patty left for $1. I bought it though I do not really want it. When you get to the vendor he is out, but I'll sell mine to you for $1.10.

 

Is that front-running in the technical or legal sense? The HFTs claim they are adding liquidity, and earn the right to trade. Because of their activity, the actual spreads between bids and offers have tightened which saves the individual investor money.

 

I know experts from both sides of the camp and am not surprised that many of the old guard are against this new way of trading. Both have valid points but this is not something that should be sensationalized. Instead, HFT should be justly studied in an impartial manner, and rules set in place as discoveries and progress is made in our understanding of the nature and product of this newest trading behavior.