Truth, Lies And H(FT)ysteria – The HFT Conundrum
Fidessa’s Group Strategy Director, Steve Grob, puts some of the major myths around HFT under the microscope.
High frequency trading (HFT) has been the hottest topic in the financial world for at least two years now, and this debate has now reached Australia, which has been busy introducing its own multi-market structure over the past couple of years. Nothing, it seems, raises as many hackles and divides as many opinions as those three words – “high frequency trading” – and this is as true in Australia as anywhere else.
But what is the truth about HFT? Is it the devil, a scourge to markets? Or is it simply the evolution of trading – computer driven trading replacing human trading in the way computers are replacing so many other aspects of our business and personal lives?
Whatever the answer to these questions, there can be little doubt that HFT activity has taken hold and accelerated wherever multi-market trading structures have been introduced. Shrinking average trade size can be seen as a proxy for HFT. Take the FTSE 100, for example. As chart 1 shows, average trade size has reduced significantly since 2008 and a similar trend looks set to impact Australia’s main index too (chart 2).
So, to unpick the problem, let’s look at some commonly held opinions about HFT.
HFTs see market data before other participants, giving them an unfair advantage.
This myth has been making its way around the market in Australia for a while now, but it simply isn’t true. The ASX and Chi-X both have co-location centres where firms can pay to have their computers close to the source of market data. While this does advantage those firms within the co-location environment, or ‘colo’, it’s a level playing field – any firm can enter the colo and all the computer racks are connected to the market data distribution engine such that they all receive it at exactly the same time.
It’s also worth considering what other kinds of firms are in the colo. Many, or most, fund managers (who are aggregators of ‘mum and dad’ retail money) execute their trades through a third-party broker, usually an investment bank or an agency broker like Instinet. It’s these firms that are first in line to buy rack space in colos, and their proximity puts them – and their end investors – on the same playing field as the HFTs. Where the waters become a little murkier is in the US, where it’s claimed that exotic order types such as DAY ISO and “hide and light” orders can be used to almost pre-empt market data and push HFT orders to the front of the queue. Protests from both sides are vociferous and the jury is probably still out as to the truth of the claims.
HFTs don’t follow the rules.
HFTs have to follow the rules just like every other market participant. Those who don’t are breaking the law – pure and simple. Where regulators are struggling is in keeping pace with the rapid-fire trading taking place on their exchanges, and this goes for standard algo trading as well as HFT. ASIC, for example, has been very conscientious in looking at best-practice around the world and is procuring its own fast technology to ensure it can keep pace with its participants. Other regulators would do well to follow their example.
HFT is a completely new phenomenon and markets can’t deal with it.
HFT and algorithmic trading generally are not, in fact, new ways of trading. They’re simply much faster ways of doing the kinds of trading that traders have been doing for decades.
Specific new order types have, however, evolved to tackle the fast and complex environment traders now face. But these are not restricted to HFTs. Each venue publishes the types of orders it allows. The order types are available to all participants, and participants can only trade within these rules. This is true even in the US, where the exotic order types mentioned before are allegedly used to bend the rules in favour of fast-moving participants. If it is found that order types can be used to confer advantage on specific participants, then regulators should act to rectify those situations.
One complaint leveled at HFTs is around ‘quote stuffing’ – sending huge numbers of quotes to a venue to try to determine the trading intentions of other participants.
Quote stuffing is illegal, and any firm participating in this kind of activity should rightly be penalised.
HFTs have superior technology, which gives them an advantage over other investors.
It’s definitely true that HFTs have superior technology. These firms spend millions hiring the brightest minds and build much of their technology in-house, keeping it and the strategies it runs closely guarded secrets.
HFTs argue, however, that none of what they’re doing is outside the law, which is true. It’s also true that they spend their own money on both their technology and their trading. And it’s simply true that great technology in any field is an asset that provides its owners with an advantage.
Another criticism of HFT is that the constant adjustment of thousands of quotes requires huge bandwidth, which puts a strain on market infrastructure. Exchanges have indeed spent millions increasing their capacity and upgrading their technology, and other participants have had to spend in turn to be able to take advantage of the new, faster exchange environments. Constant pressure to upgrade technology is a vicious – or virtuous – circle, depending who you’re talking to. But HFT is more a consequence of this environment than a cause.
HFT is the reason for the volatility and low returns we see in today’s markets.
Since 2008, the whole world has faced extremely challenging market conditions. But to point the finger at one market participant and type of trading is absurd. America and the Eurozone’s ongoing struggles, combined with continuing knock-on effects from the global financial crisis, are first among many obvious macro factors depressing markets around the world. More than four years of bear markets have left investors understandably wary, and volumes are consequentially low. In such an environment, small changes in sentiment create volatility effects that are highly amplified compared to what they would have been pre-2008.
HFT is complex and poorly understood, making it an easy target for firms that are struggling.
The other concern investors raise is around issues like the much talked about ‘flash crash’, and more recent market events. These are serious and legitimate concerns. New regulations that put tools like circuit breakers in place are now being implemented, and tougher requirements are being put on participants to test their strategies before they go into live markets. Such developments can only benefit those who are doing the right thing.
HFTs must be taking money from investors – their profits have to come from somewhere.
This is a far more complex question than it may appear on the surface. But fundamentally, HFTs make money from tightening the spread – the gap between the bid and offer prices for any given stock on an exchange. Nobody is arguing the fact that spreads have shrunk to fractions of what they were before algorithmic trading and HFT came on the scene. HFT profits actually derive from the inefficient trading practices of other market participants and tighter spreads are generally seen as a sign of more efficient markets. On top of this, HFT profits are starting to shrink – evidence perhaps that the industry is reaching a tipping point where spreads have shrunk to the point that profit opportunities are becoming increasingly difficult to find.
The genie is out of the bottle.
The fundamental fact is that HFT is such a huge part of markets that it cannot be ignored. Pandora’s technology box sprang open years ago, and it’s simply not possible to reverse back into the days of floor or telephone trading. Any firms found to be manipulating markets should be disciplined, whether at high or low speed. Clever firms, rather than using HFT as a scapegoat or complaining to each other and the press, should take advantage of the many ways they too can use technology to better navigate markets and deliver better returns for their investors.