Friday, June 27, 2014

High-Frequency Trading

High-frequency trading (‘HFT’) has become a frequently bandied about term in the financial system in recent years. In this technologically-advanced age, the increased use of computers is evident for all to see, and through HFT, the role computers play has become even more profound that ever before. In 2009, HFT orders accounted for more than 50% of exchange volume in the market and as much as two-thirds of all stock trades in the U.S. from 2008 to 2011 were executed by high-frequency firms using sophisticated technology.
HFT is a type of algorithmic trading which employs the use of powerful computers to transact a large number of orders at very high speeds. It uses complex algorithms to study multiple markets and executes orders based on market conditions. HFT utilises highly sophisticated proprietary trading strategies carried out by computers to allow traders to move in and out of positions within mere seconds. In other words, traders with the fastest execution speeds will be more profitable than their slower counterparts. HFT has brought about a high level of efficiency and efficacy in the trading of stocks, and has become a vital cog in the rapidly moving financial industry.

However, HFT has become an area of concern of the investing public ever since the May 6, 2010 Flash Crash where it contributed to volatility when high-frequency liquidity providers rapidly withdrew from the market. Risk controls in HFT are also less stringent because of competitive time pressure to execute trades which are done without the extensive safety checks normally used in slower trades. Instances whereby trading firms experienced errant algorithms which reduced the likelihood of profitable trades to be executed have also happened in the past.

There have also been cases of a new type of insider trading occurring as a result of HFT, most notably, in the New York Stock Exchange (NYSE) probe by the Federal Bureau of Investigation (FBI) in June this year. The FBI is looking into allegations that the Exchange had provided customers with an advantage of more than 1,000 microseconds over other customers to the market data they used to make high-frequency trades. Given that it only takes these “preferred data customers” a handful of microseconds to cancel orders and execute trades, this was more than ample time for them to generate huge profits from the advance information they had received.

The financial system has undergone a transformation with the advent of HFT, and with this lies the need for controls to mitigate these new risks. Several European countries have proposed curtailing HFT to have at least a modicum of control over the trading practices of high-frequency traders amid concerns of volatility. The US Securities and Exchange Commission (SEC) has also recently announced new measures to promote fairness for investors and bolster the stability of HFT.

The measures proposed include an "anti-disruptive trading" rule to control aggressive short-term trading by high-frequency traders during vulnerable market conditions, and a plan to force more proprietary trading firms to register with regulators and open their books for inspection. The SEC is also working on measures to improve how trading firms manage risks around their use of computer algorithms.

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