There's been a lot of chatter lately about high-frequency trading. A recent piece in the New York Times painted it as the economic bogeyman du jour, and New York's irascible everyman Sen. Charles Schumer sent a letter to Securities and Exchange Commission head Mary Schapiro threatening to cook up legislation to ban certain types of HFT unless the agency took it up for him. Even Paul Krugman this week weighed in on the topic, blasting the practice as one that "degrades the stock market's function." So what exactly is HFT and why are people so concerned about it?
There's no official definition of high-frequency trading, which makes for inevitable confusion when discussing it. HFT is characterized by the use of superfast computers, but just about every trade executed these days takes place with the aid of a computer of some sort. Many of these are fast but just not as quick as their high-frequency counterparts, which can execute trades in a few thousandths of a second.
Aside from its speed, HFT stands out because it's triggered by computers. Auction site eBay offers a good, if crude, comparison: If you just have to have that vintage Optimus Prime lunchbox, but you're going to be away from your desk, you can set up your account to automatically bid in small increments up to a certain amount if a fellow Transformers buff makes a play for the item. In the case of HFT, complex and closely guarded algorithms sift through reams of data and buy or sell based on price movements or other markers. It's all done on autopilot.
How did we get to this point? Yes, computers have been getting faster, but there are a couple of other factors that have laid the groundwork for HFT. The first was a decision by the SEC in 1998 to allow electronic communication networks, or ECNs, to participate in equities trading in competition with the established exchanges. As startups trying to grab market share, the ECNs hit on the idea of offering rebates to companies placing a trade. The amount per trade is small, but with enough volume, a company can turn a profit buying and selling stock at the exact same price and pocketing the rebate.
The other influencing factor was the switch in 2000 to trading stocks in penny increments. Previously, stocks traded per eighths of a dollar, twelve and a half cents at a time. After the SEC enacted decimalization, players who made their money off the difference between the asking price and selling price, aka the spread, were hit hard. If they wanted to stay in business, they had to generate enough volume to make a profit off spreads as small as a penny. Newer and faster computers have made this possible, and it's a big part of the reason why the number of shares traded on a daily basis has jumped to more than 10 billion.
There's no question that HFT players have a leg up based on their speed. But is the advantage unfair? These companies do, after all, have to invest staggering sums of money on hardware and algorithms, so it's not like they don't shoulder some risk. Exactly how much is a number companies keep close to the vest, but the recent arrest of a Goldman Sachs computer programmer gives a small hint. Many assume that the stolen code, which Goldman said in the complaint against its former employee cost millions of dollars to develop, was used for HFT.
Market participants tend to pick their perspective of HFT based on whether they're the ones benefiting, in which case they think it's great, or whether they're being robbed of profits or market share. Those in the latter group are quick to point out risks and loophole abuses to get the attention of regulators.
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Regarding the largest of these, it helps to compare the stock market to eBay once again: When you put in a bid, you can't later change your mind and withdraw it. The one exception to this is tucked into Rule 602 of Regulation National Market System, the SEC's master document that codifies how various trading venues should interact. Rule 602 says that all venues have to publicly disseminate all offers except those executed or canceled immediately. According to the SEC, any offer that exists for less than half a second counts as immediate. HFT firms use computers that can execute transactions in amounts of time much smaller than this, which means they can more or less toss out and withdraw orders at will without running afoul of the rules.
Like an angler casting a line out, over and over, to see what's going to get a bite, HFT computers "ping" other players almost constantly with nearly identical bids, trying to push prices to the absolute limit to which a buyer or seller will agree. They may send out 100 orders and cancel 99 within a fraction of a second.
On one hand, this is just electronically aided haggling that occurs in less time than it takes you to blink. Is there anything inherently wrong with that? HFT firms say they're aiding the marketplace by keeping a lid on volatility, since all of that pinging tends to keep price spreads at a minimum. Detractors say HFT activity creates a two-tiered market, since very few players can make the kind of investment necessary to compete in the high-frequency arena. They also charge that retail investors and even some institutional investors don't get access to the best prices as a result.
That Rule 602 exemption gives another boost to HFTs in the form of flash orders, which is what Sen. Schumer was referring to when he urged the SEC to tighten HFT regulation, a prospect that now appears increasingly likely. A flash order sends out prices to a trading platform's own participants for a fraction of a second before publicly disseminating the quote. The ECNs initially offered flash orders as a way to gain market share; not surprisingly, the big exchanges loathe them. NASDAQ reluctantly started offering flash orders back in June, although it's said it backs a ban on the practice. The NYSE sent a letter to the SEC asking it to ban flash ordering and doesn't currently offer it.
HFT ties into this back-and-forth because these traders' computers are nimble enough to act in that split-second between the flash and the moment the price is made public. Right now, this is perfectly legal, but to many in the market (and on Capitol Hill), it looks a lot like front-running.
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HFT practitioners like to position themselves as the 21st-century version of specialists. In a pre-supercomputer era, specialist traders or market makers could get an early peek at prices, but they were also compelled to trade in a way that would benefit the markets as a whole—sometimes even taking a loss that they'd have to make up in the future. HFTs have no such strictures, and that's what worries some people. The contributions of HFT firms are strictly voluntary. If the stock market turned sharply lower, these players could just opt to sit on the sidelines until more favorable conditions returned. Only about 2 percent of the market's roughly 20,000 participants use HFT, but such trading makes up 46 percent of all trades in any given day. If these 2 percent sat on their hands for even a day, the drop in volume could send shock waves throughout the market. In a related concern, if everybody's using computer programs that have similar "sell" triggers, even a minor spate of volatility could snowball into a serious, systemic slide.
HFT is too entrenched at this point to be legislated away entirely due to the inevitable lag between technological innovation and governmental regulation, but it looks like flash trading is about to be a flash in the pan. The news today out of Sen. Schumer's camp indicates that a flash-order ban is "imminent," following a phone call between Schumer and the SEC's Schapiro on Monday.
Explainer thanks Sang Lee of the Aite Group LLC and Joseph Saluzzi of Themis Trading.