Resistance to High Frequency Trading (HFT) Strategies

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“This is John Connor – if you are reading this, you are the Resistance. Listen carefully. We have been fighting a long time and we are outnumbered by machines. Humans – have a strength that cannot be measured.” (Terminator Salvation)

I see it now; this is tomorrow’s over dramatised headline. A strange world where we are trapped somewhere between the Matrix and Terminator franchises.

Recently, on 31 March 2014 there was an interview by CBS 60 Seconds in which famous author Michael Lewis states: “The insiders are able to move faster than you. They are able to see your order and place it against other orders in ways that you don’t understand. They are able to front run your order … .” The biggest surprise to me was his comment, “The United States Stock market is rigged!” Talk about a sensational notion. (Bloomberg TV, 2014).

But what is high-frequency trading?

HFT is defined as a quantitative trading technique that utilises super computers and complex algorithms to push mass volumes, with some HFT firms like Citadel trading more stocks every day than the New York Stock Exchange (Meerman, 2013), with holding periods of but a few microseconds, keeping in mind that it takes up to 400’000 microseconds to blink.

It all started not so long ago when the SEC authorised electronic exchanges in the late 90s but HFT only really hit the ground in 2006 – 2007 and has since caught the attention of public. The major concern from sceptics being: does it now pose a systemic risk due to the fact that around 70% of the trading volume on the American equity markets is generated by HFT?

Why are people making such a big deal about HFT?

The first obstacle thrown at advocates of HFT is usually the Flash Crash of May 2010, where the Dow Jones dropped 1000 points in half an hour and then bounced back equally as fast. Protestors then back this up with a cheeky smile and point fingers to similar crashes. A common example being the Twitter Crash where the Associated Press was hacked and released a tweet stating that the White House had been bombed: you can imagine the havoc that followed.

The truth is that there is too much smoke and fog surrounding the Flash Crash for anyone to blame it on HFT. The SEC launched a full scale investigation for months, ferreting for answers, only to blame it on a single algorithm and technological problems. Of course there are those that argue HFT systems blocked the network, but regulators concluded that HFT as such was not to blame for the crash.

The cherry on the top for me as a “wanabe” poster boy for disruptive innovations is when I heard the hypothesis that HFT systems helped improve the situation by aiding in correcting the market. According to Dave Lauer, a previous trader and analyst at top HFT firms Austin and Citadel, you can’t explain the Flash Crash using a cause and effect methodology. If we reconstruct the 6th of May 2010 using exactly the same sequence of events, there is no guarantee that the crash would happen again. He is, by the way, not in favour of HFT. (Meerman, 2013)

So why does the focus keep coming back to HFT?

I’m not blind to the new problems that HFT introduces and I certainly don’t pretend to be but I’m just putting things in perspective. The whole topic has become very sensational, to the point where influential persons believe that the stock market is rigged and HFT is to blame.

Let’s just stop and look at that for a second. I agree that market manipulation is unethical, but HFT is not the devil, it is the use of high frequency tactics in unethical practices (quote stuffing, cross market layering and computerized front running to name a few). It is however no different than two discretionary fund managers taking part in insider trading. It would be like condemning all brokerage houses for making profits when very few of them take part in illegal activities.

In an interview, Tradeworx CEO Manaj Narang, leads us to an additional point of interest which is that the uproar against HFT could be due to the disruptive nature technology has on old business models that then results in defensive behaviour where the slow to react complain. What you see in the financial industry are asset managers under pressure to perform and because they have visibly underperformed their benchmarks, it leads to a case of ‘sour grapes’, a typical scapegoat syndrome. (Narang, 2013)

But let us address the elephant in the room: Does HFT pose a risk? Some academics, not all, have made it clear: “study after study has shown that HFT has produced incalculable benefits to stock investors, making the prices they pay for stocks more accurate and less prone to manipulation than they had been in the past” (Corcoran, 2014). I prefer the view that “existing literature on the subject is scarce and provides no direct evidence. There is no useful data on HFT’s effect during a financial crisis. That being said, the current general opinion of the academic world seems to be slightly positive towards HFT … .” (Ahlstedt & Villysson, December 1, 2012)

After the 2008 financial crisis, the G20 aimed to improve and broaden the regulation and oversight of private pools of capital, including hedge funds. This was aimed at addressing the need to regulate an unregulated financial services industry together with its products; to grow and ensure financial soundness, transparency and investor protection. By regulating the industry, it improves investor confidence both locally and abroad. I say: HFT requires the same attention with the focus on evaluating possible risks and lack of transparency.

One way in which countries have begun to regulate HFT is to ensure that financial markets contribute to public finances. Italy and France have instituted a tax on HFT in an attempt to “discourage financial transactions which do not contribute to the efficiency of financial markets.” (CNBC News, 2013)

Concluding remarks:

The world around us is constantly evolving, at a pace much faster than most of us can keep up with. “HFT is simply an updated and more efficient version of day trading” (Ahlstedt & Villysson, December 1, 2012). It is all part of our natural progression.

I do believe that the older business models of asset management are having change forced upon them that naturally is met with resistance.

We need to remember that we are not fighting against the fictional terminators of Skynet and that the algorithms we employ are developed by human beings; it is our thoughts manifested into being – quantified and beautiful in complexity. It is all part of our immeasurable strength.

For me the most thought-provoking statement was made by Dave Lauer when he says: “My friend has a Ph.D. in climate science from Harvard, who was working there. There was a Ph.D. in bio-informatics sitting next to me; a semiconductor designer on the other side. Sitting behind me was a Masters in math from MIT. And these people are taking their huge brain power and devoting it to making pennies in a high frequency trading system. And I couldn’t really justify it anymore. Because… they should have been doing… they should have been curing cancer or global warming. And here they are. They’re making a fortune. And were we making the markets a better place?

Were we increasing efficiency or stability?” (Meerman, 2013)

Reference

  • Ahlstedt, J., & Villysson, J. (December 1, 2012). High Frequency Trading.
  • Bloomberg. (n.d.). Dow Industrials: SEC.
  • Bloomberg TV. (2014, 03 31). Iconic U.S. Stock Market Is Rigged. Retrieved from Bloomberg TV: http://www.bloomberg.com/video/michael-lewis-iconic-u-s-stock-market-is-rigged UiJBxqrZR8Oh6ZP0oYKyBQ.html
  • CNBC News. (2013, September 2). Italy launches tax on high-frequency transactions. Retrieved from CNBC.com: http://www.cnbc.com/id/101002422
  • Corcoran, T. (2014, April 2). Flash Boys’ rigged tale ignores high frequency trading’s revolutionary effect on markets. Retrieved from Financial Post: http://business.financialpost.com/2014/04/02/terence-corcoran flash-boys-rigged-tale-ignores-high-frequency-tradings-revolutionary-effect-on-markets/
  • Meerman, M. (2013, November 4). The Wall Street Code. Retrieved from VPRO: http://www.youtube.com/watch?v=kFQJNeQDDHA
  • Narang, M. (2013, September 13). High-Frequency Trading (HFT) Part 3. Retrieved from YouTube: http://www.youtube.com/watch?v=mZv14Tl_1To
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