Michael Lewis’ new book “Flash Boys” explores the world of high frequency trading, a new trading method that is changing the stock market landscape. His book has sparked much debate among investors with the ultimate question being: Is High frequency trading good or bad?
High frequency trading (HTF) is a trading platform that uses algorithms to determine trades and powerful computers to carry out large orders at ridiculously fast speeds. These algorithms analyze data from multiple markets and execute orders based on a strategy of edging out a profit of a fraction of a cent per share. This approach has become more popular as connection speeds have amped up: stock exchanges can now execute trades in less than a half of a millionth of a second, such that as of 2009 it is estimated that more than 50% of exchange volume comes from high-frequency trading orders.
The market collapse in 2008 paved the way for a wider acceptance of HFT, since liquidity was such a major concern for investors during the chaos that followed the collapse of Lehman Brothers. Liquidity is how quickly one form of an asset can be changed into another or in the stock market, how soon you can buy or sell a stock. Exchanges started offering incentives for companies to add liquidity to the market, precisely what HFT does best. The New York Stock Exchange has its own system to provide liquidity and increase competition in the market; these providers are called supplemental liquidity providers (SLPs). While the rebate for providing liquidity is negligible for the average trader, $.0015 per share, HFT firms make a profit from this rule since they make millions of transactions a day. Their main strategy relies on being able to execute trades first to take advantage of slight price discrepancies. By buying a stock first, they can turn around and sell it seconds later for a slightly higher price, and when this is done frequently enough, HFT firms make bank.
Some issues with this new approach to the stock market include regulatory concerns and market stability. The SEC has not been able to effectively monitor or regulate today’s market since the extent of this trading strategy and its effects have only recently come to light. However, the SEC is planning a campaign to tighten regulations on this aspect of the financial industry but as of now, the SEC has not addressed HFT firms directly. Concerns about market stability were raised after the “flash crash” in 2010 when the market plunged by 10% only to recover in minutes. Nearly one trillion dollars in value was wiped out momentarily before the market bounced back up. It was later found that a single massive sell order from an algorithm belonging to a Kansas firm was responsible for a domino like series of events that sent the market into a temporary panic. Another example of HFT gone bad was when Knight Capital, a midsize financial firm, had a program go rogue when it was supposed to be deactivated. This program continued to place trade orders for 45 minutes before it could be deactivated, costing the company about $10 million per minute. If something like this were to happen to a firm that was considered to be too big to fail, the market could be wrecked and the company might have to be bailed out by the government.
Supporters of HFT insist that it contributes a service to the market and that it isn’t so different from what other investors do. HFT does add a lot of liquidity to the market, which may help prevent a lock up of assets in the stock market. The amount of trading and strategies used by these firms add competition to the market, which could drive down the price of stocks and more efficiently allocate capital. Also, since most trades are carried out by algorithms, human vulnerability is removed, which may help to prevent market drops due to fear. HFT helps investors cut transaction costs by adding infrastructure to the stock market and opening up networks between the different exchanges. Only time will tell whether or not HFT will be here to stay or will be wiped out by regulatory rulings and intense competition.