When it comes to matching buyers and sellers of blue chip stocks on the New York Stock Exchange, the era of the floor trader has passed. You’ll still see traders bustling around in the background whenever you turn on CNBC, but it’s just a sideshow. These days, electronic trading is king. This has helped democratize trading by freeing it from financial centers like New York, London, and Tokyo, but it has also given rise to the controversial practice of High-Frequency Trading (HFT).
Using a combination of lightning-fast computers and complex algorithms, high-frequency traders engage in strategies intended to identify and execute on very brief trading opportunities. Firms that employ the practice depend on the ability to see and react to order traffic before other market participants can jump in. Speed is the name of the game, and traders with the fastest execution will be more profitable than their slower counterparts.
The practice of HFT has received a lot of negative media attention in the past year, but as we’ll see, most of the criticisms either miss the mark or overstate the problem. Since most investors operate with a long-term time horizon (unlike day traders), we’re going to evaluate the effects HFT has on the market place through the lens of the longer-term investor.
The Benefits Of High-Frequency Trading
Contrary to what you may have heard, HFT offers some genuine benefits – particularly in the Exchange Traded Fund (ETF) market. ETFs have become very popular with investors over the years and high-frequency traders facilitate their purchase and sale through market making. Put simply, a market maker is a firm or individual with a standing offer to trade stocks at a publicly quoted price. As the most passive HFT strategy, market making adds much-needed liquidity to the ETF market. Firms monitor the difference between the price of an ETF’s underlying securities and the price for buyers and sellers of that ETF. Market makers compete for order flow by displaying buy and sell quotations for a specified number of shares on the exchanges or on electronic communication networks. High-frequency traders increase this competition for order flow and decrease the spread cost of the ETF to its underlying securities.
Additionally, market makers often use the creation/redemption mechanism to provide ETFs liquidity that would not otherwise be available in the secondary market. For example, if an investor wanted to buy more shares of an ETF than what might be available in its daily volume, simply placing an order to purchase would drive the price of the ETF higher as compared to its Net Asset Value (NAV). The market maker steps in to create more ETF shares by purchasing its underlying components and delivering them to the issuer. This mechanism benefits the investor by preventing large orders from driving the price of an ETF too far away from its NAV. In other words, through market making, HFT both contributes to the reduction of spread costs for ETFs and also keeps premiums and discounts to NAV at a minimum.
For good reason, HFT grew in popularity with the advent of the Maker/Taker system in exchanges. In order to attract liquidity, exchanges will create a pricing structure that rewards member participants for making a market. If a HFT member firm provides liquidity to the market through market making, the exchange will pay a rebate back to the member firm. On the other hand, if a member firm takes liquidity away from the market, it has to pay a fee to the exchange instead of receiving a rebate. In this Maker/Taker system, high-frequency traders use various practices to capture as many rebates as possible by identifying liquidity needs faster. While this can worsen short-term price movements in volatile markets, it also provides vital liquidity. Anyone trading stocks and ETFs should be aware of these pricing structures, and should take care in their execution strategy.
Front-Running: An Unfair Head Start
The problems with HFT center mainly around front-running: A trader learns of a large order about to be placed, and jumps in front of it to execute a trade before the sizable order moves the stock price. This isn’t new to HFT, of course. In the past, it was advantageous for a trader to be physically on an exchange floor where he or she might overhear talk about a large, price-moving order. However, technological advances have made this a more serious problem as high-frequency traders can complete the process in milliseconds, relying solely on network speed and algorithms to sniff out large orders.
High-frequency traders profit from the minute time differences between the transmission and reception of trade information in an exchange. In fact, HFT firms will often move their servers closer to the exchange’s servers, to give them a small but crucial head start over market participants with slower servers. The closer your server is to the exchange, the faster you will be able to see (and act on) order traffic. With high-frequency traders willing to pay millions for the advantage this gives them, exchanges are highly motivated to allow it. Popular financial journalist Michael Lewis exposed this practice in his best-selling book, Flash Boys, going so far as to say that markets are now rigged because of it.
No honest investor – including those who support HFT – can deny the abusive nature of front-running. The practice offers an unfair advantage to those who employ it, coming at the expense of other market participants who are left to pay more for their investments than they should.
How Serious Is The Problem?
We believe that markets – and the regulatory landscape – must evolve as new trading technologies develop. Market predators who attempt to compete unfairly have existed since the birth of the stock market; HFT is just the latest battleground.
Nevertheless, with HFT, spreads have narrowed so greatly that anyone trying to game the system is usually dealing in fractions of a cent. While that doesn’t make it excusable, when your investment time frame is measured in months or years, the possibility of losing fractions of a cent to a high-frequency trader becomes almost negligible. The wise investor should stay focused on picking good investments with reasonable management fees and sticking with a moderate to long-term time horizon. If you do that, the additional liquidity provided by HFT could actually work to your benefit.
Pinnacle’s Technical Analyst, Sean Dillon, also contributed to this article.
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