Policy Documents

Research & Commentary: High Frequency Trading

December 17, 2012

Increasing computerization of financial trading has had a profound effect on financial markets by introducing a new element: high frequency trading (HFT). In high frequency trading, a computerized system uses market data and sophisticated formulas to buy and sell financial instruments at a rapid pace. 

These sales can occur second-by-second, and profits or losses are realized through price changes of a hundredth of a percent. 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: They provide both liquidity and price discovery while lowering transaction costs. Many experts argue HFT also helps reduce volatility. 

This trading came under increased scrutiny after the “Flash Crash” on May 6, 2010. The event was unique—the Dow Jones Industrial Average plunged about 1,000 points (about 9 percent) only to recover those losses minutes later. Although their 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, the Securities and Exchange Commission and Commodity Futures Trading Commission proposed additional regulations on high frequency trading. 

In an October 2012 letter, the Chicago Federal Reserve outlined the results of a survey it held of financial industry professionals who voiced concerns about high frequency trading. Their primary worries were the level of risk control engaged in by firms and a perceived lack of adequate testing of new algorithms. 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. 

High frequency trading plays an important role in the financial market by reducing volatility, increasing liquidity, and lowering costs. 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. 

The Flash Crash: The Impact of High Frequency Trading on an Electronic Market
http://heartland.org/policy-documents/flash-crash-impact-high-frequency-trading-electronic-market
Andrei Kirilenko, Albert Kyle, Mehrdad Samadi, and Tugkan Tuzun examine the Flash Crash and attempt to determine what may have caused the crash and the role high frequency trades may have played. The authors conclude HFTs did not trigger the Flash Crash but their responses to the unusually large selling pressure on that day did exacerbate market volatility. 

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 that 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 that 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. 

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 is negatively related to 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. 

High Speed Trading Begets High Speed Regulation: SEC Response to Flash Crash, Rash
http://heartland.org/policy-documents/high-speed-trading-begets-high-speed-regulation-sec-respnse-flash-crash-rash
David M. Serritella examines the new SEC rules for high frequency trading against the backdrop of the current market characteristics that likely contributed to the Flash Crash. He analyzes the special threats posed by the current market practices of automated high speed and high frequency trading and the SEC response to them. Serritella concludes the SEC’s reaction may be as flawed as the system it is intended to protect, and he suggests areas in which the new SEC rules should be refined before being made permanent. 

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 our 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 as the culprit. 

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 that 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.