The sins of high frequency trading

16th April 2012

High-speed traders use powerful computers to identify orders as they emerge and instantly trade ahead of them, hoping to earn a small crust on each trade. They use complex algorithms to churn out thousands of trades, and to lesser extent orders, on multiple markets in fractions of a second. And if they can do this in huge numbers, the rewards can be immense. It's a ‘zero-sum' game that is being won by those trading outfits with the best computers, the smartest ‘quants' and access to the best algos, but lost by the rest of us.

Not only is HFT legalized front-running. It is also a socially worthless activity that amplifies market movements, increases market fragility, inflates asset price bubbles, and naturally worsens market crashes. And as we saw with the ‘Flash Crash‘ of May 2010, it can also fuel market mayhem.

One of the high speed traders' most outspoken critics is Charlie Munger, vice-chairman of the US insurance group Berkshire Hathaway. In an interview with CNN in May 2011, Munger said:

"I don't think the rest of us have anything to gain in having massive trading between computers which  try to outwit one another with their algorithms.  To the extent that one succeeds, the rest of us are all paying …"

And in a speech at the Institute for New Economic Thinking's Berlin conference on April 14, the Bank of England's Andy Haldane said that, at best, high speed trading creates a "mirage of liquidity":

"One reason [high frequency traders] dominate volumes is because they submit huge volumes of quotes in the market, the vast majority of which are never exercised. The firms cancel them before they are ever exercised … And currently [in the US equity market] for every order executed, 60 are cancelled. So what's going on here?

"One thing that's going is that, although there are loads of quotes on the screen, if you try and hit them, they have disappeared before you can ever transact as you would wish. There is a mirage of liquidity…

"Some have said this ‘quote stuffing' is imposing an externality, in terms of bandwidth, on slower traders … the ‘flash crash' was no one off. In the period since, although less publicised, there have been hundreds of mini ‘flash crashes'."

joint report published by the Securities & Exchange Commission and Commodities Futures Trading Commission (CFTC) in October 2010 concluded that the May 6, 2010 ‘Flash Crash' was fuelled when HFT algorithms "began to quickly buy and then resell contracts to each other – generating a ‘hot-potato' volume effect as the same positions were passed rapidly back and forth." In other words, the algorithms ran amok, and caused the market to tank.

Given this background, it's perhaps unsurprising that legislators, central bankers and regulators have been looking at HFT more sceptically since the crisis.

Continue reading…


More from Mindful Money:

7 investment sites you should be reading

Attack of the fund-sucking Zombies

The emotional rollercoaster of investing

Sign up for our free email newsletter here, for your chance to win an Amazon Kindle Touch.

Leave a Reply

Your email address will not be published. Required fields are marked *