High Frequency Trading

IS HIGH FREQUENCY TRADING ETHICAL?

What is High Frequency Trading?

High Frequency Trading (HFT) involves the execution of complicated, algorithmic-based trades by powerful computers.  The objective of HFT is to take advantage of minute discrepancies in prices and trade on them quickly and in huge quantities.  These practices have been around as long as computer systems have been in our lives.  As computers get more technically advanced, trading practices have increased in size and algorithms have become more sophisticated.  The trades are done at close to the speed of light.  Remarkably, HFT firms have moved their server farms near an exchange computer to further increase trading speeds.[1]

HFT firms design a variety of strategies to take advantage of various market scenarios.  Algorithms trade on price movements past a certain threshold, corporate actions, price ceilings, price floors, and discrepancies in bid/ask spreads.  The trades are executed without any human action except for initial programming.  In most cases, the trades are executed before individual investors know the quotes of prices, or that the trades happened at all.

For instance, a computer recognizes when one exchange quotes an ask price of one cent more than the quote on another exchange.   This computer then trades in extraordinarily large volumes on this information, taking advantage of the arbitrage opportunity in a split second.  Before individual and other investors who do not possess the same sophisticated technology realize, the one-cent spread between the two exchanges is erased and the stock price trades at the same level.

HFT firms have become more fragmented.  In the past, large investment firms who had proprietary trading arms experimented with HFTs as a way to supplement their human traders’ activities.  Now there are entire hedge funds devoted to this strategy.  Managers pool capital based on a proven computer technology and allow the program work for them.  In addition, large trading shops incorporate these HFT strategies as part of their overall practice.  Such large volumes of HFT trades are being executed that most of the liquidity in daily trading is a result of these trades.  By some estimates, HFT makes up 60 to 70% of all trades done in the US on a daily basis.¹ Other estimates project that if these strategies keep proliferating at their current rate, 80% of trades will be HFT trades by 2012.[2]

Arguments in Favor of HFT

1. Liquidity

For markets to function properly and for investors to have confidence putting their money into the stock markets around the world, there must be an adequate amount of liquidity.  Investors want to know when they put their money into the market they will be able to sell their investment at a later time.  HFT strategies improve market liquidity.  The amount and volume of the trades using this strategy ensure a liquid market.  HFT traders act as makeshift market makers who buy and sell when no one will.  In fact, the spreads they make off their trades are “likely less than what was taken out of the system previously by traditional market makers.”¹ As HFT trades can make up as much as 70% of the trading volume in a given day, investors have a greater ability to be matched up with a counterparty i.e., the HFT trader, willing to either buy or sell at their desired price.  Currently, especially for highly followed companies, it is relatively simple to buy or sell a reasonably large amount of shares.

2. Market Efficiency

HFT contributes to market efficiency.   According to the efficient market hypothesis stock prices already have all public and non-public information priced into them.  HFT takes advantage of price discrepancies and arbitrages any discrepancies away.   Many believe that, “Narrow spreads mean the market is working better.”¹ Without the large HFT trades that take advantage of the market’s inefficiencies, there would be larger bid/ask spreads.  Consequently, investors may be less satisfied with the prices they get in their trades.

3. Reduced Costs

Increasing liquidity and market efficiency may, some argue, also contribute to falling trading costs for smaller investors.  A major cost to mutual funds results from the bid/ask spread.¹ This cost may be mitigated by the activities of HFT that narrow bid/ask margins.  Narrower spreads also reduce costs that arise from large fund transactions that affect the final price of a security.  HFT traders are able to break these big trades into a many small trades to reduce the effect of a large buy or sell order.¹

4. Profitability

One last benefit provided by HFT strategies is their profitability.  There is no reliable information on the profitability of HFT firms.  Hedge funds do not like to disclose their strategies or profits.[3] Despite the lack of concrete information, HFT profit potential can be inferred from statistical data.  The below chart shows the Sharpe ratio potential on a typical HFT strategy as opposed to slower implemented trades.³

As shown, the potential for higher returns exists based on the strategy alone.  In fact, the Sharpe ratio is over 200% higher for the 10 second trading frequency than for the 1 minute frequency.  The ratio indicates the enormous potential of these strategies and how they can be used to take advantage of market events without significant man-hours spent on research and other due diligence.

But HFT can be Used Unethically

1. Market Manipulation: Trillium Capital

HFT can give traders an unfair advantage if they engage in market manipulation.  HFT computers can influence the market for the trader’s own advantage.  Take the case of Trillium Capital.

Trillium Capital is an HFT firm in New York that engaged strictly in HFT trades.  Trillium entered many trades that were considered non-bona fide because Trillium had no intention of following through on these orders.  The placement of the orders was to deceive the market into thinking there was a large amount of activity happening in certain securities.  These orders induced other traders to trade based on the mirage of demand or supply created by Trillium.  Before these non-bona fide trades were entered, Trillium had limit positions, which executed as a result of ther traders creating buy or sell side demand which moved the prices in certain directions.  Once the real trades were executed, Trillium immediately cancelled their non-bona fide trades and profited from their limit orders.[4] These types of trades are illegal and cause market movements or prompt market activity that would not have happened had these HFT traders not manipulated the market to their advantage.  Thus, investors and regulators rightly worry about the opportunity for these types of illegal and unethical trading activity that HFT provides.

2.  Unfair to Small Investors

Another argument against HFT practices is that they are unfair to small investors. Small investors do not operate on an even playing field because they lack resources to do so.  They also are unable to see information as quickly as HFT computers.  Arguably, this resource and informational imbalance creates inequity.  Charles Schumer, a New York Democratic Senator, is actively campaigning against HFT practices.  He argues that the markets work because small investors have just as much of a chance to be successful, and this opportunity is severely diminished with the proliferation of HFT.[5] Senator Shumer is strongly against HFT traders having access to information milliseconds before other market participants and, by virtue of their size and opacity, unfairly influence the market.

3.  The Cascading Effect of HFT

The best example of the cascading effect happened on May 6, 2010 in what has become known as the “flash crash.”  In this instance, there were a series of global events that made investors nervous about equity markets.  This unease contributed to the dramatic fall that day.  Initially, the Greek debt crisis led to a market decline early in the afternoon.  Other traders bet on a continuous decline in the market by executing short trades on the market.  The wave of activity triggered HFT models that track this kind of activity resulting in a further sell-off.   The large number of orders overloaded the exchange systems.  Information became delayed, which caused many trading firms to exit the market altogether.  The simultaneous exit caused a serious liquidity problem.  The last straw occurred when a trade for securities known as E-minis was entered (by Waddell and Reed), causing the stock market to crash.  Although the market eventually gained most of the losses back investors were scared and shaken by this incident.  Below is a chart showing the massive price movements in a day.[6]

This event shows how much of a snowball effect HFTs have on the markets.  When one big sell-off occurs, HFT traders using similar strategies sell off as well with dangerous implication for markets.

The Ethics of HFT

HFT is another financial innovation that uses sophisticated computers and software.  Ostensibly HFT users do not intend to deceive.  Instead, the aim of HFT is to give its users a competitive advantage.  Yet, HFT strategies affect more parties than just HFT traders  – small investors, large trading firms, analysts, brokers, and other market participants may also be affected.  Is HFT good for the majority?  May 6, 2010 is an example of how HFT can adversely affect markets.  The intense and steep market fall touched all market stakeholders in a negative way.   One could argue that the flash crash was a singular and rare event.  However, singular market events, like magnitude 7 earthquakes, can be catastrophic.  The possible disastrous consequences of the cascading effect of HFT call for early warning and prevention systems.   There should be a way to stop the cascading effect.  Circuit breakers are a first defense.  More should be put in place.

As with many innovations, there is the opportunity for misuse of HFT.  Misuse may be hard to detect but the consequences can be severe, harming a number of investors.  The mere existence of the opportunity to misuse HFT does not argue for the activity’s immorality.   HFT also provides benefits by way of liquidity, jobs, and market efficiency.   The opportunity for misuse and its damaging consequences may argue, however, for the intense scrutiny and policing of HFT.

Contributed by: Ryan Wagner

Edited by: Dr. Kara Tan Bhala

[1] The Impact of High-frequency Trading:  Manipulation, Distortion or a Better-functioning Market? Knowledge @ Wharton.  September 30, 2009.  http://knowledge.wharton.upenn.edu/.

[2] Krudy, Edward.  Is the May 6 “flash crash” in US stock markets the new normal? Reuters.com.  June 10, 2010.  http://www.reuters.com/assets/print?aid=USTRE6595GO20100610.

[3] Aldridge, Irene.  How Profitable Are High-Frequency Strategies? The Huffington Post.  July 26, 2010.  http://www.huffingtonpost.com/irene-aldridge/how-profitable-are-high-f_b_659466.html.

[4] Comstock, Courtney.  Huge:  First High Frequency Trading Firm is Fined For Quote Stuffing and Manipulation. Business Insider.  September 13, 2010.  www.businessinsider.com/.

[5] Duhigg, Charles.  Senator Wants Restrictions on High-Speed Trading. The New York Times.  July 25, 2009.

[6] Lauricella, Tom, Scannell, Kara, and Strasburg, and Jenny.  How a Trading Algorithm Went Awry. The Wall Street Journal.  October 2, 2010.