Should high-frequency trading be banned?

What is high frequency trading?

It's the use of powerful computers and trading algorithms ('algobots') to devise and execute trading strategies that rely on gaining a tiny edge over other investors and the market as a whole.

The many hedge funds, brokerages and specialist high frequency trading (HFT) firms that have sprung up since around the turn of the century use these complex computer programs to trade in and out of securities thousands of times a day, often holding a position in the underlying security for a matter of seconds, or less. This can add up to billions and billions in profits if repeated often enough.

Why is HFT in the news?

Because Michael Lewis, the former Salomon Brothers trader turned influential and popular author (Liar's Poker, The Big Short), has made HFT the subject of his latest book, Flash Boys and his verdict is damning. For years, critics have argued that high frequency trading is fundamentally destabilising, because (in the words of one academic study, The Dark Side of Trading) "it injects a sizeable layer of trading-induced volatility over and above the unavoidable fundamentals-based volatility".

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An investigation by the Securities and Exchange Commission (SEC), the US market regulator, into the 'Flash Crash' of 6 May 2010 when the Dow Jones Industrial Average plunged about 9% then recouped the losses in minutes found that high frequency trading was a contributory factor.

Michael Lewis argues that HFT's existence means the entire American stock market is now a giant scam rigged against ordinary investors.

How do HFTs get their edge?

Information and speed. The main goal of HFT is to profit from stock-price movements however small or temporary that are typically caused by large institutional trades.

When an investor presses the deal button, sending its instruction to its broker or bank, that intermediary then searches the different stock exchanges for the best price. But due to the mechanics of sending a signal down a wire, the broker's trading signals arrive at slightly different times and this is where the HFTs seize their moment.

Their computers will have been playing tiny buy or sell orders at individual exchanges, identifying signals that a big investor is itself about to make a buy/sell order and then jumping in a fraction of a second before that happens.

Is that legal?

Absolutely. HFTs now represent about half of all trades on the US market but submit almost 99% of all orders: many of them are never intended to be fulfilled.

"The best analogy", proposes The Economist, "is with the people who offer you tasty titbits as you enter the supermarket to entice you to buy; but in this case, as soon as you show appreciation for the goods, they race through the aisles to mark up the price before you can get your trolley to the chosen counter". That might be unfair, but it does not, under the current rules, amount to "rigging" the market.

Should HFT be illegal?

That's the multi-billion dollar question. Critics like Michael Lewis argue that the standard techniques HFTs use are merely a highly sophisticated version of illegal "front-running" knowing how someone is going to trade and profiting by getting in front of it.

Others, like James Rickards, author of The Death of Money, argue that HFT bids and offers "disappear as quickly as they appear" due to the algorithm and therefore they are options rather than firm orders. This adds to the already crushing weight of derivative instruments in the markets which currently exceeds 100% of global GDP.

But defenders of HFTs argue that Lewis has wildly overstated his case, and doesn't appreciate the valuable role that HFTs play in the market. On this account, HFTs are ultimately a force for good, since they make trading cheaper for ordinary investors.

How do they do that?

Because the sheer volume of business they drive increases liquidity, improves efficiency, and narrows spreads between bid and offer prices. It is also argued that Lewis fails to point out that HFT's dominance in the market peaked around the end of the last decade, and has been falling steadily as increased competition between HFT outfits means the overall potential gains are eroded.

Lewis has pointed out the bulk of "ordinary investors" don't really gain from HFTs because their main investment is via big institutional investors, such as pension funds the key people HFTs are taking advantage of rather than via direct investment in shares. In any case, it looks like the policy debate has been reinvigorated.

In the US, the SEC and FBI are both investigating the industry, and the European Parliament approved tougher regulations this week. Watch this space.

A fine job' or a pick pocket's trick'?

Two of America's best known retail investment firms have starkly different views when it comes to HFT illustrating the complexity of the issue and the challenges for policy-makers.

Joe Brennan, the head of Vanguard's equity index group, argues that HFT has encouraged competition, which means that transaction costs have fallen for all investors over the past 20 years.

He reckons some HFT traders "do a fine job" in helping to knit together the fragmented market, while conceding that others unduly burden the system with activities that are "arguably legal but not necessarily right".

By contrast, Charles Schwab of the eponymous investment firm, calls HFT a "growing cancer" that allows traders to "pick the pockets" of other investors.