Taking a long look at HFT

How do high-frequency trading firms' short-term trading horizons hurt long-only investors?
By None

Is high-frequency trading (HFT) synonymous with short-termism?

While specific strategies may vary, virtually every HFT firm consumes large volumes of market data and issues a lot of buy and sell orders, generating substantial amounts of liquidity. Typically they make their money by trading in high volume across tiny margins, often arbitraging across markets and participants, in turn tightening up spreads.

Some 90% of HFT orders are cancelled, as in most cases they are issued only as feelers, to provide detailed intelligence on market activity. Because they take no interest in stock direction, HFT firms do their best to end the day without holding a stock position.

Almost by definition, the more often an HFT firm trades, the bigger the profit it makes. The long-term fate of the names they trade is largely irrelevant.

How do these activities impact other market participants?

The provision of liquidity and smaller spreads makes life easier for other market participants, particularly when trading volumes are low, as they have been in the first half of 2011. But some argue they can also increase trading costs.

Richard Saunders, chief executive of the Investment Managers Association (IMA), the UK buy-side industry body, recently asserted that HFT firms are making money from long-term investors without giving anything back, as market liquidity levels have not reached a point low enough to merit payment of costs associated with HFT liquidity.

Institutional investors worry that HFT firms are using their superior ability to track market activity to spot buy-side firms building up large positions in a particular company, then peppering the market with sell orders that push the price of the stock up incrementally. The dispersal of multiple orders into the market to bid up the price can also give the impression of high levels of liquidity, but these orders may prove illusory, cancelled and replaced once the buyer bites.

Algorithmic trading platforms frequently deploy anti-gaming tools to prevent predatory behaviour. Nevertheless buy-side traders say the threat of gaming is leading them to push greater amounts of trading over-the-counter (OTC). In H1 2011 52.8% of trading in FTSE 100 stocks was conducted on the lit market down from 61.58% in 2009, according to trading technology provider Fidessa.

This produces its own problems. MEPs and regulators in Europe have made the case that trading in the dark damages price formation and weakens equity market transparency, especially for the retail investor.

HFT firms may be focused on the short term, but surely there's little wrong in them making a profit from providing liquidity to longer-term investors?

Perhaps not, but there are also arguments that HFT also introduces risks into the market. For example, the disproportionate amount of liquidity provided by HFT firms can be seen as a weakness as well as a strength; the sudden withdrawal from trading by high-frequency traders during the 6 May ”flash crash' was blamed by regulators for exacerbating the situation.

Arbitrage strategies conducted at high speed and volume can also lead the HFT firms to transfer distortion from one market to another, says Andrew Haldane, executive director for financial stability at the Bank of England. As well as contagion, regulators are also worried about confidence. It took almost six months for the US to record a net inflow from equity mutual funds after the flash crash.

Globally, authorities are trying to evaluate the role of HFT. The IMA's Saunders has said that a review by the UK government into the impact of short-termism on long-term investment in the equity markets is an opportunity “to ensure that excessive value is not being extracted by intermediaries”.

Haldane has suggested more bluntly that high-speed trading needs to be kept in check.

“Flash crashes, like car crashes, may be more severe the greater the velocity,” he said.

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