Myths behind High Frequency Trading

Jack Bouroudjian
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Posted: Mar 02, 2012 12:01 AM

Recently a Luddite mentality has worked its way into the debates centered around High Frequency Trading and the effect it might, or might not have, on the overall market.  Let’s understand something right away: Not all HFT is the same.  There needs to be a basic understanding of a strategy which now makes up an estimated 50 to 70 percent of overall exchange volume.  It becomes painfully obvious to those of us who are veterans of the industry that there is a basic misunderstanding of what HFT is and how it contributes to the market.  The upcoming anniversary of the ‘flash crash’, which put the entire subject in the spotlight, needs to be understood before ‘new regulations’ are imposed to stop them from happening.  That isn’t to say that nothing should be done, on the contrary, I think there needs to be a coordinated effort by various regulators to enforce certain rules and regulations. (Equities are governed by the SEC while futures are governed by the CFTC) There are predatory programs which need to be understood and monitored and the concept of having a dislocation caused by two different sets of regulations is confusing.

Too often the general public is confused by equating HFT with ‘trading in front of customer orders’.  If a HFT system or trader is caught trading in front of customer orders then the rules are very clear on what the consequences for such an action might be. Fines, prison etc… Unfortunately it’s not a question of adding new regulations to the books: Believe me, we have more than enough.  It’s making sure the regulators who are watching the markets understand what they are watching…Period. 

If you listen closely you can hear the exact same arguments about HFT as you did about Index arbitrage and program trading in the 1980’s. If you remember, the entire financial community was up in arms in 1987 because they were convinced that a bunch of traders in Chicago were responsible for a near market meltdown.  History not only exonerated the futures markets but many market historians such as the late Merton Miller would have argued that they saved the system from real collapse because of the liquidity which was provided through the mark to market(Something which does not exist in Stocks).

So why don’t people like HFT?  It’s because they make money, plain and simple. 

One of the biggest complaints by market participants is that they don’t like when “traders make money without taking risk!” Well guess what?  Smart people have been making money in capital markets from their inception, sometimes taking little or no risk in the process.  As the markets moved from the Stone Age of the trading pits to the space age of computers, the HFT shops were the first ones to take advantage of the inefficiencies which exist in every new market.  Was it a sure thing?  No, most of the HFT shops spent countless hours and a lot of capital on a concept that was new and experimental at best. There were plenty of naysayers who were convinced liquidity would dry up and it would not be possible to create a central price discovery mechanism strictly on the screen.  It was a risk…One that paid off handsomely for those that had the correct view of the future.  If they were losing money then there would be no issue. 

The reality is that the geographical edge which traders inherently had while standing in trading pits or at a specialist post next to customer order flow has given way to a technological edge.  What was once a question of ‘where you stand in the pit’ now becomes a question of better technology.  Do you think index arbitrageurs lose money?  Of course not.  They didn’t lose money in the 80’s and they don’t lose money today.  They inherently take very little risk. They have moved their strategies from the trading pits to the computer screen and in the process have increased their volume dramatically.  Let’s face it; they are not in the business of taking risk.  They are there to make the market more efficient, which they do, by taking advantage of aberrations in pricing.  In fact, the truth is that index arbs are buyer of futures on the way down and sellers on the way up.  It’s all part of the eco-cycle of the market.  99.9% of all Index arbitrage and statistical arbitrage is now done through high speed computers and guess what, they are considered HFT.

So before you go blaming HFT for everything from the Chicago Fire to the ‘Flash Crash’ remember that most every strategy done manually 20 years ago is now done through automated systems which are all considered HFT…It’s just done much faster and much more often, hence the explosion in exchange volume. The cause of volatility wasn’t Index arbitrage in 1987 and it’s not HFT today!