By: Jason Hsu
High frequency trading (“HFT,” and also known as low-latency trading) is the use of automated programs to execute securities orders rapidly, generally to take advantage of small market disparities. Importantly, statistics indicate that HFT currently comprises approximately 50% to 70% of United States daily equity volume.
While HFT has undeniably provided important benefits for investors, it has also been heavily criticized, receiving blame for the May 2010 “flash crash,” and other recent ‘market glitches.’ As a result, HFT has become increasingly scrutinized by regulators around the globe, with Germany recently unveiling broad legislation over the practice, and with the EU and the SEC considering similar measures.
There is general agreement that HFT provides two major benefits to the market: providing market liquidity and reducing transaction costs for investors. As HFT has substantially increased equity volume, liquidity is improved by allowing investors to enter and exit the market at their desired prices. Indeed, some commentators suggest that the United States’ preference for increased liquidity has been an obstacle to increased regulation. Moreover, as HFT firms attempt to arbitrage bid-ask spreads, spreads tighten and lower transaction costs for all market participants.
Nonetheless, HFT has increasingly attracted criticism from academics, media, and industry experts alike. The undercurrent of criticism appears to be leveraged at the diminishing returns that HFT provides, with some claiming that further improving HFT has “no social benefit.” This argument posits that most investors do not require the speed that HFT firms can harness and only marginally benefit from further increases in trading speed generally, if at all.
While HFT has been credited with reducing market volatility by reducing spreads, major criticism has also been leveled that HFT may actually increase market volatility. The most common way that HFT may lend to market volatility is by facilitating “flash crashes,” where unexpected market events lead to sudden and significant sell-offs by automated trading – the most prominent example occurred in May 2010, when the Dow Jones Industrial Average dropped over 1000 points within five minutes. Furthermore, David Lauer, a former HFT consultant, testified before Congress that “mini flash crashes” occur nearly every day on individual stocks.
HFT has also been blamed for various recent stock market ‘glitches’ (thus affecting market volatility), including the botched Facebook IPO, when trade cancellations repeatedly interrupted the computer system attempting to settle on an opening price for the stock, and the Knight Capital fiasco in early August, when the firm lost $440 million dollars due to software that entered into “millions of faulty trades in less than an hour.”
Such incidents can be largely attributed to accidental glitches or misunderstandings of how the HFT algorithms work in complex or novel situations. However, allegations have also surfaced of illegal activities involving HFT such as flash trading, front running and “hide not slide” orders. All of these activities capitalize on the sheer speed of HFT: issuing high volumes of orders that will not be filled to gauge market interest and capturing arbitrage by selling to less nimble firms at a higher price (flash trading); simply placing new orders ahead of existing ones to capture that arbitrage (front running); or placing orders that will either eventually be placed ahead of existing orders (hide not slide). The law generally requires that orders placed first are filled first (although front running is illegal by SEC judicial and administrative precedent and SEC SRO rulemaking; see generally, 17 C.F.R. § 240.10b).
Current and proposed regulations
In light of heightened concerns about HFT, regulators worldwide have increasingly begun to investigate HFT practices. The most recent and broad legislation in the area comes from Germany. Among its provisions, Germany seeks to require traders using HFT to register with a supervisory agency, collect fees from frequent HFT users, and install kill switches to halt trading if problems are detected. The EU is also considering placing a speed limit on HFT orders, by requiring firms to hold their orders for at least half a second (where most HFT orders are issued in milliseconds). Such a regulation would directly interfere with the HFT practice of ‘flash trading,’ where buy and sell orders are issued in rapid succession simply to gauge interest and confuse other traders.
In the U.S., the SEC has been slow to regulate HFT. However, the increasing visibility and media scrutiny of HFT has brought calls for reform by legislators and the public. For example, the Senate recently held a hearing wherein industry professionals and experts provided written testimony related to HFT. The SEC has also ramped up its own efforts to understand and better regulate HFT. Numerous regulations to reign in HFT have been proposed. These proposals include installing systems to track and audit trades, requiring firms to install kill switches to halt trading instantly, requiring more thorough testing of software, and imposing fees on canceled trades.
High frequency trading has undoubtedly produced real benefits for average investors, by improving market liquidity and reducing transaction costs. However, it also appears clear that incremental improvements in HFT are producing diminishing returns and may even be detrimental to the overall market – the botched Facebook IPO and the Knight Capital fiasco are prime examples, as well as possible illegal activities that exploit HFT’s capabilities. As a result, regulators worldwide are investigating HFT more closely. Hopefully, such regulations will be able to preserve the benefits that HFT provides, while reining in exploitative practices.