Do high-frequency trading risks offset the advantages?
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By Ken Weise  July 31, 2014 10:18 am

Has high-frequency trading made things better on Wall Street or worse? It has its adherents and detractors. What does HFT amount to – a lurking danger, a market necessity, a hidden tax on the small investor, a net plus? Frankly, the answer may be all four. 

When HFT goes wrong, it goes very wrong. Flash crashes are proving inescapable in the era of platform trading – and while indices and equities rebound quickly from them, the damage can be deep.

Faulty HFT software produced the infamous May 6, 2010 flash crash, in which the Dow sank 800 points in less than 20 minutes with some blue chips briefly trading at $0. (A joint investigation by the Securities & Exchange Commission and the Commodity Futures Trading Commission traced it to a single $4.1 billion program trade emanating from one Wall Street firm.) Malfunctioning HFT platforms have also led to flash mini-crashes (such as the May 2013 drop of Anadarko Petroleum shares from about $90 to $.01) and snafus like the 2012 Facebook and BATS IPOs. 

“Flash Boys” author Michael Lewis argues that high-speed algorithmic trading essentially steals profit from retail investors through trading and dumping that imposes a “tax” of half a percent (or less) per trade. 

While high-speed trading may constitute front-running (and front-running certainly warrants investigation), thievery may be a stretch. An extra nanosecond or two may help a high-frequency trader profit more versus its competitors, but those competitors aren’t small investors. In some senses, HFT could even be considered a small investor’s ally.

What does HFT do right? HFT definitely gives the market a level of liquidity that didn’t exist before its arrival. Since HFT programs perform just over 50 percent of all trading these days, just over 50 percent of market liquidity can be linked to them.

Bid-ask spreads (the gap between what buyers want to pay for a stock versus what sellers believe the stock is worth) have slimmed significantly in the age of HFT. In fact, HFT has managed to do away with some of the smallest ones in the course of everyday trading. In the mid-1990s, bid-ask spreads stood at about 90 basis points. In 2014, they are at about 3 basis points.

“Flash Boys” follows Canadian trader Brad Katsuyama. His effort to alert the world to the flaws of HFT is presented as a David-vs.-Goliath story in which a Wall Street trader is motivated to become a stock market reformer. Katsuyama presents his trading venue, IEX, as an alternative to the perceived negatives associated with HFT. He is getting a great deal of positive attention, with a daily average of 31.3 million trades in May, a nearly 8 percent increase from the previous month. IEX is also attracting some big players, including Norway’s sovereign wealth fund, described as the largest in the world.

While this attention is food for thought, it’s also important to remember that not all trades are created equal; some of the concerns raised in “Flash Boys” don’t necessarily affect all investors.

 

Most buy and sell orders from individual investors don’t reach public exchanges. If you have a brokerage account and log in to place a buy order, it is probably headed for a wholesaler that will fill it internally. By handling the order internally, the brokerage avoids racking up a fee for sending it to an exchange – a fee that would likely be passed on to you. (Limit orders are a different story; they go straight to the exchanges.)

So in the big picture, the HFT platforms aren’t competing against the small investor. Instead, they are racing against each other to fulfill the small investor’s order.

There is actually less HFT than there used to be. In 2009, 61 percent of trading was conducted on HFT platforms; by 2012, that figure had dropped to 51 percent.  

HFT systems are making much less money than they once did. While the race to make HFT platforms speedier and more efficient continues, it seems to be producing diminishing returns. 

According to estimates from Rosenblatt Securities, the entire HFT industry made about $5 billion in 2009, but that was reduced to around $1 billion by 2012. To put this in further context, JPMorgan Chase realized $5 billion in profit in Q1 2014 alone.

Stay informed and keep a broad perspective. As with many of Lewis’ books, Flash Boys tells the story of an underdog/outsider taking on the established order and winning. What is often forgotten is that high-frequency trading networks were created by underdogs and outsiders themselves with the mission of upending and improving 20th century trading technologies. In time, other minds will come up with ways to realize greater market efficiencies. Being aware of the advantages and the perils of these changes is an important task for anyone investing in the 21st century.

 

Ken Weise, an LPL Financial Advisor, provided this article. He can be reached at 707-584-6690. Securities offered through LPL Financial. Member FINRA/SIPC. The opinions of this material are for information purposes only.

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