Policy Documents

Research & Commentary: The Future of High Frequency Trading

April 24, 2014

High frequency trading has come under increased scrutiny since the “Flash Crash” of May 6, 2010. Reports showed high frequency trades were not the primary cause of the crash, and the causes of the Flash Crash have yet to be fully determined. Nonetheless, the Securities and Exchange Commission and Commodity Futures Trading Commission proposed additional regulations on high frequency trading (HFT), including implementation of a “circuit breaker” that would end trading for any stock in the S&P 500 that moves up or down more than 10 percent within a five-minute period across all U.S. equity markets.

In an October 2012 letter, the Chicago Federal Reserve outlined the results of a survey it conducted of financial industry professionals who voiced concerns about HFT. The letter made several recommendations for new rules and controls, including new limits on the numbers of orders allowed in a given time period, the creation of a “kill switch” mechanism that would stop trading at one or more levels to avert widespread disruption, implementing position limits that set the maximum position a firm can take during one day, and limits on profit and loss.

Several proposals currently under consideration would either slow the rate and number of trades considerably or end them altogether. The first set of proposed changes would add new limits on how rapidly trades could be made. Instead of allowing a constant stream of transactions, trades would have to be processed in groups, or packets, after a certain interval of time. Other proposals would automatically disconnect a financial company’s session completely should messaging exceed a certain message speed.

The most popular—and most disruptive—proposal being considered to regulate HFT is the creation of a financial transaction tax to be imposed on every financial transaction that investors make. Proponents of a financial transaction tax argue it would deter firms from manipulating the HFT system and slow down the pace of trading. Two financial transaction taxes being considered are Rep. Keith Ellison’s (D-MN) Inclusive Prosperity Act, which would levy a sales tax of 0.5 percent on stocks and smaller amounts on the trades of bonds, derivatives, or other financial speculation; and Rep. Chaka Fattah’s (D-PA) Debt Free America Act, which would replace the personal income tax and the Alternative Minimum Tax with a 1 percent fee on all cash, credit, debit, and stock or bond transactions.

Financial transaction taxes are unwise because they raise the cost of investing, not only through the direct cost of the tax itself but also by reducing liquidity and widening bid-ask spreads. These taxes also disproportionally affect financial products important to middle- and lower-income families, including pensions, retirement savings, and financial tools such as annuities, charitable trusts, and low-risk money market funds.

Megan Morgan of Eurex notes several other mechanisms to regulate HFT already exist in the current financial exchanges, including self-trade controls such as those used by the Chicago Mercantile Exchange and the IntercontinentalExchange. These include self-match prevention systems, credit risk limits that impose trade throttles when loss levels are triggered, and intraday position limits which set the maximum number of positions a firm is allowed in one day.

High frequency trading currently accounts for around half of the trades made in U.S. exchanges. These trades play an important role in the market by providing both liquidity and price discovery while lowering transaction costs. Many experts argue HFT also helps reduce volatility. Regulators should make sure any regulations on computerized trading do not freeze the market or drive away trade.

The following articles examine high frequency trading from multiple perspectives.

Research & Commentary: Financial Transaction Taxes
http://heartland.org/policy-documents/research-commentary-financial-transaction-taxes
In this Research & Commentary, Heartland Institute Senior Policy Analyst Matthew Glans examines the proposed financial transaction tax and its possible effects, from multiple perspectives.

Debunking the Myths of High Frequency Trading
http://www.futuresindustry.org/ptg/downloads/Debunking_the_Myths_of_HFT.pdf
This article outlines several opinions published in response to Michael Lewis’s Flash Boys and recent comments by New York Attorney General Eric Schneiderman, both of whom criticize high frequency trading and call for strict regulations.

What Do We Know about High-Frequency Trading?
http://heartland.org/policy-documents/what-do-we-know-about-high-frequency-trading
Charles M. Jones of the Columbia Business School argues, based on the vast majority of the empirical work to date, HFT and automated, competing markets improve market liquidity, reduce trading costs, and make stock prices more efficient: “Better liquidity lowers the cost of equity capital for firms, which is an important positive for the real economy. Minor regulatory tweaks may be in order, but those formulating policy should be especially careful not to reverse the liquidity improvements of the last twenty years.”

The Future of Computer Trading in Financial Markets: An International Perspective
http://heartland.org/policy-documents/future-computer-trading-financial-markets-international-perspective
This paper from the Government Office for Science in London has two principal aims. First, looking out to 2022, it seeks to determine how computer-based trading in financial markets could evolve and, by developing a robust understanding of its effects, to identify potential risks and opportunities this could present, in terms of financial stability and other market outcomes such as volatility, liquidity, price efficiency, and price discovery. Second, using the best available evidence, the paper advises policymakers, regulators, and legislators on the options for addressing those risks and opportunities.

High-Frequency Trading
http://heartland.org/policy-documents/high-frequency-trading
Peter Gomber, Björn Arndt, Marco Lutat, and Tim Uhle provide up-to-date background information on HFT. The authors’ research includes definitions, drivers, strategies, academic studies, and current regulatory discussions. The paper evaluates proposed regulatory measures and offers new perspectives and proposed solutions.

The Volume Clock: Insights into the High Frequency Paradigm
http://heartland.org/policy-documents/volume-clock-insights-high-frequency-paradigm
David Easley, Marcos Lopez de Prado, and Maureen O’Hara argue speed is not the defining characteristic that sets high frequency trading apart from regular trading. The authors argue HFT is the natural evolution of a new trading paradigm characterized by strategic decisions made in a volume-clock metric. Even if the speed advantage disappears, HFT will evolve to continue exploiting low frequency trading’s structural weaknesses. However, LFT practitioners are not defenseless against HFT players, and the authors offer options that can help them survive and adapt to this new environment.

Some Evidence that a Tobin Tax on Foreign Exchange Transactions May Increase Volatility
http://heartland.org/policy-documents/some-evidence-tobin-tax-foreign-exchange-transactions-may-increase-volatility
Using regression analysis, Robert Z. Aliber, Bhagwan Chowdhry, and Shu Yan demonstrate volatility increases and volume decreases as transaction costs rise. These results are consistent with the expectation an increase in transaction costs would lead to a reduction in volume of trading, but the observed effect on volatility is the opposite of what proponents of the Tobin tax assume.

Some in Congress Want US to Follow France Down Transaction Tax Path
http://news.heartland.org/newspaper-article/2012/08/01/some-congress-want-us-follow-france-down-transaction-tax-path
Writing in the Heartlander digital magazine, Jeffrey V. McKinley, a Heartland Institute policy advisor and principal at Senex Solutions LLC, reports on the new taxes in France and the possible effects of financial transaction taxes in the United States.

High-Frequency Trading, Stock Volatility, and Price Discovery
http://heartland.org/policy-documents/high-frequency-trading-stock-volatility-and-price-discovery
Frank Zhang examines the implications of high frequency trading for stock price volatility and price discovery. He finds HFT is positively correlated with stock price volatility after controlling for firms’ fundamental volatility and other exogenous determinants of volatility. Zhang also finds HFT reduces the market’s ability to incorporate information about firm fundamentals into asset prices. Stock prices tend to overreact to fundamental news when high frequency trading is at a high volume. Overall, this paper suggests high frequency trading can have some harmful effects on U.S. capital markets.

High Frequency Trading and Its Impact on Market Quality
http://heartland.org/policy-documents/high-frequency-trading-and-its-impact-market-quality
Jonathan A. Brogaard of Northwestern University examines the impact of high frequency traders on the U.S. equity market. He concludes HFTs add substantially to the price discovery process, provide the best bid and offer quotes for a significant portion of the trading day, do not seem to increase volatility and may in fact reduce it, and provide other advantages.

How High Frequency Trading Benefits All Investors
http://www.tradersmagazine.com/news/high-frequency-trading-benefits-105365-1.html?zkPrintable=true
Cameron Smith of Traders Magazine argues critics of high frequency trading ignore the major contributions traders employing high frequency strategies have made in ensuring the nation’s equity markets remain the world’s most low-cost, fair, transparent, and resilient.

Financial Transaction Tax Bill to Fund Jobs Programs
http://news.heartland.org/newspaper-article/2012/09/18/financial-transaction-tax-bill-fund-jobs-programs
Writing for the Heartlander digital magazine, Heartland Senior Policy Analyst Matthew Glans explains the proposed transaction tax on financial exchanges and its potential effects on the market.

What Happened on May 6th?
http://heartland.org/policy-documents/what-happened-may-6th
The CME Group examines the probable causes of the Flash Crash and absolves high frequency trading from blame.

High-Frequency Trading Good For Small Investors: CBOE
http://www.forbes.com/2010/01/20/high-frequency-trading-personal-finance-cboe-flash.html
Emily Lambert of Forbes notes HFT is speeding up execution times for all investors, making it cheaper to buy or sell and posing no additional risk to small investors.

The Diversity of High Frequency Traders
http://heartland.org/policy-documents/diversity-high-frequency-traders
Björn Hagströmer and Lars L. Norden discuss the importance of distinguishing among different HFT strategies and their influence on market quality. Using data from NASDAQ OMX Stockholm, the authors empirically provide such a distinction for equity markets. In a natural experiment based on tick size changes, the authors found both market-making and opportunistic HFT strategies mitigate intraday price volatility. The findings indicate policies such as the financial transaction tax proposed by the European Commission, which would render most HFT strategies unprofitable, would primarily hit market-makers and increase market volatility.

High Frequency Trading and the New-Market Makers
http://heartland.org/policy-documents/high-frequency-trading-and-new-market-makers
Albert J. Menkveld examines the market-making role of HFT in today’s financial markets: “In sum, the HFT that ‘made’ the new market looks much like an electronic version of the classic market maker.”

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the FIRE Policy News Web site at http://news.heartland.org/insurance-and-finance, The Heartland Institute’s Web site at www.heartland.org, and PolicyBot, Heartland’s free online research database, at www.policybot.org.

If you have any questions about this issue or The Heartland Institute, contact Heartland Institute Senior Policy Analyst Matthew Glans at 312/377-4000 or mglans@heartland.org.